Vítor Constâncio: Principles of macroprudential policy
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
ECBIMF Conference on Macroprudential Policy, Frankfurt am Main, 26 April 2016.
* * *
Ladies and Gentlemen,
It is with great pleasure that I host this dinner today, in the first edition of our annual
Macroprudential Conference, this time jointly organised with the IMF. The Single Supervisory
Mechanism Regulation1 confers upon the ECB and National Competent Authorities or
National Designated Authorities specific powers and responsibilities in the field of
macroprudential policy. This calls for substantive conceptual and analytical work in this new
policy area which is very ambitious, requiring considerable research efforts that we want to
stimulate by launching this series of annual conferences.
The financial crisis and its aftermath confirmed the need for system-wide surveillance and led
to the establishment of macroprudential policy as a new policy area with the objective of
addressing systemic risk.
At the European Central Bank (ECB), systemic risk is defined "as the risk that financial
instability significantly impairs the provision of necessary financial products and services by
the financial system to a point where economic growth and welfare may be materially
affected".2 Important in this concept is the fact that the materialisation of systemic risk brings
along significant costs to the real economy - implying the destruction of economic value and
leading to losses in terms of economic growth.
The literature has identified three broad sources of systemic risk: (i) macroeconomic shocks
that are significant enough to cause distress in the financial system, (ii) the unwinding of
imbalances in the financial system generated by excessive leverage, and (iii) contagion risk,
created by increasing interconnectedness and herd behaviour.
Whatever the origin, the primary role of macroprudential authorities is to identify, measure
and reduce systemic risk. Identification of risks clearly needs to be probabilistic, attempting to
predict the level of overall risk of the system in different scenarios.
Many indicators to measure systemic risk have been proposed since 2008. Many of them
though, have a "micro-level" dimension dedicated to calculate the contribution of significant
institutions to systemic risk. The Marginal Expected Shortfall (MES), CoVar, CoRisk or
Conditional Tail Risk (CRT), for example, fall under this category.3 Taken in isolation, they
are not useful to predict future levels of systemic risk, as they tend to use contemporaneous
market prices and do not consider the system as a whole. The ECB has developed a
Composite Indicator of Systemic Stress (CISS)4 that comprises five aggregate market
segments accounted for by a range of variables and time-varying rank correlations between
them. More recently, the CISS indicator has been used by Hartmann et al. (2015), jointly with
credit to the private sector and cycle variables (industrial production, inflation and a
short-term interest rate) in a MS-VAR, to illustrate the dynamic interaction of systemic
financial instability and the macroeconomy in the euro area.5 CATFIN, a VAR and Expected
Shortfall measure at system-wide level calculated with non-normal distributions with fat tails,
showing the predictive capacity of financial volatility regarding real economic downturns was
proposed by Allen et al.6 Similarly, Giglio et al. examine 19 measures of systemic risk for the
US and 10 measures for the UK and the EU from the perspective of how well they forecast
macroeconomic downturns.7 They also build dimension-reduced risk indexes using principal
components and partial quantile regression to demonstrate the robust performance of some
indexes in anticipating future macroeconomic downturns.
These efforts in developing composite indexes are complementary to the on-going research
on the concept of a financial cycle as a sort of a generalisation of the old concept of credit
cycle, distinct from the concept of the economic or business cycle. The ECB paper presented
this morning by Hiebert et al.8 builds and extends on work done at the BIS.9 It shows how
credit and asset prices share cyclical similarities, captured in a synthetic financial cycle index
that outperforms credit-to-GDP gap measures in predicting systemic banking crises, on a
horizon of up to three years. They also demonstrate how the financial cycle is different from
the business cycle.
Based on this research, we conclude that financial variables (credit volumes and asset
prices) in EU countries have historically exhibited higher average volatility than economic
variables (volume of activity in goods and labour markets, as well as consumer prices).
Financial cycles have also exhibited a higher duration than business cycles on average.
Lastly, asymmetries appear to exist, whereby financial cycles tend to build up slowly and
correct more abruptly.
Taken together, these findings have at least two policy implications. First, they establish a
rationale for differentiated financial and macroeconomic policies, and are thereby
fundamental to the newly established macroprudential policy area. Policies targeting financial
cycles, such as countercyclical macroprudential policies, can act as a powerful complement
to policies targeting the business cycle, such as monetary policy. Policy trade-offs may
emerge in the short-run, as the propensity for such cyclical divergence seems to be greatest
at short frequencies. Second, the results present a strong case for a differentiated national
application of macroprudential policies, amid a far from complete convergence of country
financial cycles. This latter aspect is particularly compelling in a currency union with shared
monetary policy, where macroprudential policies represent an additional and potentially
powerful element to cushion conditions specific to member states. This underpins several
principles that should guide macroprudential policy that I would like to address in the
remaining of my remarks.
Principles of Macroprudential Policy
The ultimate objective of macroprudential policy is to prevent and mitigate systemic risk,
which includes strengthening the resilience of the financial system and smoothening the
financial cycle, in order to preserve the effective provision of financial services to the real
economy. In shaping the macroprudential policy framework, six aspects can be identified as
guiding principles:
First, macroprudential policy should be pre-emptive and strongly counter-cyclical.
Early identification of risks is an essential first step in the policy-setting process supported by
early warning indicators and models to predict potential sources of systemic risk.
Macroprudential policy should then act forcefully to smoothen the financial cycle avoiding
that it reaches a dangerous peak.
Second, and relating to the first, macroprudential policy should rely on the concept of
the financial cycle in order to assess the position of the economy, predict its development
and appropriately calibrate the use of macroprudential instruments. The concept of a
financial cycle is therefore crucial for the rationale of macroprudential policy, justifying the
need for dedicated policy instruments. To effectively tame the financial cycle, a time-varying
dimension is crucial in the design of policy instruments - that is, the instruments must be
adjustable over the cycle. Counter-cyclical capital and liquidity requirements are thus
important tools.
Third, the real estate component in the financial cycle is of paramount importance.
This implies that instruments in the macroprudential policy toolkit should contain
borrowerside tools to influence the demand for credit, in addition to capital-related measures
conditioning bank credit supply. Financial asset prices are admittedly difficult to tame with
targeted policy intervention. However, regarding loans for housing, policy tools such as
Loanto-Value or Debt-Service-to-Income (LTV or DSTI) ratios, need to be part of the
macroprudential toolkit in order to effectively reign on or, at least, influence real estate asset
prices, as these are among the most important drivers of the financial cycle. The announced
revision of the CRDIV/CRR should provide an opportunity for the extension of the available
instruments, as LTVs and DSTIs are not included in the current EU regulation. Clearly,
measures addressing the credit supply side by banks - such as increased capital
requirements, counter-cyclical capital buffers or dynamic provisioning - can be easy to
activate but have proven to be of modest effectiveness. Furthermore, as non-banks play an
increasingly important role in the provision of credit, measures targeting only the banks could
just result in shadow-banks taking a considerable size of the mortgage business and fuelling
a boom in house-prices.
Fourth, stress tests of the banking and financial system must have a macroprudential
dimension. Such comprehensive assessments need to be embedded in a macro-financial
environment. They entail an assessment of the position of a specific economy in the financial
cycle since, for example, the adequate level of capital requirements cannot be dissociated
from a country's position on the cycle.
Fifth, macroprudential policy is complementary to monetary policy and should share
the same status as a policy area. Central banks must have responsibilities in both policy
areas even if they are not involved in microprudential supervision. Several reasons justify this
set-up. Both areas need to work in close co-operation; central banks are more sensitive to
macro-financial stabilisation goals; they possess more information about financial markets
and the economy. Finally, the alternative model of joining macroprudential policy with
microprudential supervision faces the problem that their supervisory objectives are focused
on avoiding individual banks' distress, for which they are accountable. In this perspective the
UK institutional framework is, in my view, the most adequate. In the European monetary
union, while monetary policy is designed for the euro area as a whole, macroprudential policy
should be country-specific, even if co-ordinated, since financial cycles are not fully
synchronised across countries.
Sixth, macroprudential policy should go beyond the banking sector and encompass
market-based finance institutions and products. As this sector continues to expand and
increase its role in lending to the real economy, as its interlinkages with the wider financial
sector deepen, and as the footprint of large institutions grows, non-banks are clearly gaining
in systemic importance. Moreover, the more policy-makers are effective in using
macroprudential tools to constrain excessive leverage and credit growth in the banking
sector, the more likely it becomes that there will be excessive adjustments in the non-bank
sector through leakages. For these reasons, the coverage of the macroprudential framework
needs to be extended to the shadow banking sector.
Let me elaborate on one principle: macroprudential stress tests of the banking sector and
their extension to non-banks.
Macroprudential Stress Tests
This year, the ECB is taking part in the EBA EU-wide Stress Testing in a fully-fledged
capacity as microprudential and macroprudential supervisor. This capacity is collectively
shared with the national competent institutions of the countries in the Single Supervisory
Mechanism.
The macroprudential policy responsibilities have added a new dimension to stress testing
that goes beyond the assessment of solvency of individual banks under a baseline and
adverse scenarios. Macroprudential stress tests should provide, in association with the
projected scenarios, indicators to measure and predict the overall level of systemic risk, the
position of the economy in the financial cycle and consequently the adequate stance of
macroprudential policies.
Differently from supervisory exercises where results are expressed in terms of capital
shortfalls or no additional capital requirements by bank, macroprudential stress tests might
show that capital positions are either insufficient to preserve financial stability of the system
or, in different circumstances, are excessive for the system as a whole requiring easing or
release of macroprudential measures. Only with this type of macro stress tests can we reach
conclusions about the stance of macroprudential policy.
This concept of macroprudential stress tests, which have to be top-down exercises, requires
that we go beyond the traditional approach of microprudential capital exercises.10 These
further requirements consist of an integrated approach between micro and macro
components which encompass primarily four main aspects: (i) a dynamic approach that
includes consideration of the bank's reaction to the scenarios; (ii) a comprehensive two-way
interaction between banks and the real economy; (iii) the assessment of contagion effects
stemming from interconnectedness among financial institutions, including non-banks in the
shadow banking sector; (iv) finally, the analysis of the interaction with other non-financial
sectors that are relevant for banks' risk management.
Let me dwell upon these four points, which are being addressed at the ECB.
Dynamic approach including the bank's reaction to the scenario: Going beyond the
static assessment of solvency of individual banks, macroprudential stress tests should
account for more realistic features, in particular banks' behavioural reaction to the stress
which could come in the form of deleveraging, straight capital increases or work-out of
nonperforming loans. To take that into account, the dynamic balance-sheet is implemented in
our framework by allowing banks to re-optimise their portfolio according to the risk-return
optimisation criterion.11
To account for two-way interactions of banks with the real economy we have developed
Dynamic Stochastic General Equilibrium (DSGE) models which are being calibrated at the
individual country level to assess these effects.12
Adequate levels of capital requirements, beyond regulatory minima, should depend on
structural and cyclical factors, notably the overall position of a country in the cycle. A general
equilibrium framework is thus needed to account for the overall impact of higher capital ratios
that can constrain banks' capacity to provide credit to the economy while, at the same time,
can bring down the cost of credit by reducing banks' default probability. The optimal level of
capital requirements is thus one that balances the costs linked to more expensive equity
funding with the benefits of a lower rate of bank defaults. Results from this model-based
approach can quantitatively assess the impact on overall GDP indicating that, as the capital
ratio increases, household consumption and borrowers' welfare first increase and then
decrease, thus highlighting the importance of correctly taking into account the starting point -
and the position in the cycle - when assessing the effects of a policy measure.
We have also assessed banks' response to capital shortfalls, using a GVAR model, also
used to examine the cross-border effects of deleveraging. This empirical work confirms
common wisdom that, in response to a negative shock to the leverage, banks tend to shed
assets instead of raising capital while keeping the leverage constant.13
The macro-feedback nexus is however not the only reason why an initial shock to an entity
can be amplified at the system-wide level. What I mean here, and this is my third point, are
the effects related to financial contagion emerging from interconnectedness and
resulting from dynamic interactions between the financial economic agents that can embed
non-linear features that could lead to fire-sales. Direct financial contagion via the interbank
channel has been one of the features of the ECB top-down stress tests for some years
already and we have been regularly publishing the results of the second round effects
(related to possible domino effects in the interbank market) in the ECB Financial Stability
Review. Yet, macroprudential stress tests should also consider the second round effects
from indirect contagion, most prominently due to possible fire-sales, which could also emerge
as an outcome of interactions between banks and shadow banks. We are developing agent
based models that could take account of these interactions and allow for endogenous asset
price determination.14 This implies that the macroprudential stress test framework should
encompass the direct stress test of shadow bank balance sheets.
Recent ECB research suggests that the shadow banking sector has a natural tendency to
grow until it becomes systemically important for the entire financial system and endangers
the stability of the banking sector.15 Stress testing shadow banks could unveil the
11
G. Hałaj, (2013), "Optimal asset structure of a bank - bank reactions to stressful market conditions", ECB
Working Paper Series No. 1533.
12
Darracq Paries, M., C. Kok, and D. Rodriguez Palenzuela (2011), "Macroeconomic propagation under
different regulatory regimes: evidence from an estimated DSGE model for the euro area", International Journal
of Central Banking, December. See also, Clerc, L., A. Derviz, C. Mendicino, S. Moyen, K. Nikolov, L. Stracca,
J. Suarez and A. P. Vardoulakis, (2015), "Capital regulation in a macroeconomic model with three layers of
default", International Journal of Central Banking, June.
13
Gross, M., C. Kok and D. Żochowski, (2016), "The impact of bank capital on economic activity: Evidence from
a Mixed-Cross-Section GVAR model", ECB Working Paper Series No. 1888, March.
14
Calimani, S., G. Hałaj, D. Żochowski, "Fire-sales in an ABM of banks and shadow banks", mimeo.
15
Ari, A., C. Kok, M. Darracq Paries and D. Żochowski, (2015), "Shadow banking in general equilibrium", mimeo,
European Central Bank.
vulnerabilities in this sector and help assessing the potential for spillover of the stress in that
sector to the rest of the financial sector.
This brings me to my fourth point. Interaction between banks and the non-financial
sectors: a macroprudential stress test framework should integrate, to the extent possible, all
sectors of the economy to properly account for vulnerabilities that may emerge from any of
them. Chiefly important are the household and corporate sectors. At the ECB, work is well
underway with the view to extend the stress testing framework to the household sector16,
using data from the ECB Household Finance and Consumption Survey.17
The model combines a macro part - capturing macro variables that shape household
balance sheets over time - and a micro part - built around a household member level logistic
model for its employment status - in a fully integrated manner. The framework allows us to
compute probability of default (PDs) and loss given default (LGDs) for mortgage exposures
directly at the household sector level and link them to macroeconomic stress scenarios. The
model-framework offers, for example, insights into how borrower-based instruments - such
as LTV and DSTI ratio caps - influence the economy Intuitively, the effect of LTV caps
derives primarily from reducing loss given default (LGD) parameters, as the LTV ratio is
directly related to the value of the underlying collateral in a mortgage loan. The effect of DSTI
caps, on the other hand, stems mainly from the reduction in household capacity to serve the
debt, thus their probability of default (PD). These results are confirmed by the model.
This module is being integrated in the ECB top-down stress testing framework to account for
a consistent stress scenario and for dynamic adjustments of individual households' balance
sheets in response to shocks and related second round effects.
Finally, as just illustrated, enhancements to the ECB macroprudential toolkit go beyond
stress testing as the complete set of models also provide a tool for impact assessment of
macroprudential policy instruments. As policy instruments are targeted to address systemic
risk, assessing macroprudential measures in a consistent manner requires accounting for
spillovers, including to the real economy, also taking account of their impact on various
sectors as well as layers of interaction between those sectors.
Conclusion
Let me conclude. The ECB has been working hard on developing analytical tools for the
effective implementation of macroprudential policy. The ECB's new legal competences in
macroprudential policy relate primarily to the power to top-up measures adopted by national
authorities and the assessment of possible spillovers to other countries in connection with
the reciprocity principle laid down in the legislation. In this vein, the ECB has been analysing
the numerous macroprudential measures adopted by member states that, so far, we have
decided not to aggravate.
Concerning the governance framework, we have created an internal Macroprudential
Coordination Group and established the Macroprudential Forum - integrating the Governing
Council and the Supervisory Board - to discuss all matters related to financial stability and
macroprudential policy. We are taking our new responsibilities very seriously. The
robustness of our assessments is key and, for this reason, analytical and research work in
the macroprudential policy area has been stimulated and has been fruitful, as evident in my
remarks. Since March this year, the ECB started publishing a Macroprudential Bulletin18 that
will inform about the analytical work being done, the policy decisions adopted and assessed,
as well as analysis of relevant regulatory developments. This will further contribute to
enhance transparency in our assessments. We look forward to maintaining a lively dialogue
with the community of people in official institutions, in the financial sector and in academia
who are interested in the new important field of macroprudential policy.
Thank you for your attention.
This is the full text of a speech delivered in abridged form at the ECB on 26 April.