William R White: Making macroprudential concerns operational
Speech by William R White, Economic Adviser, Bank for International Settlements, at a Financial
Stability Symposium organised by the Netherlands Bank, Amsterdam, 25-26 October 2004.
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Introduction
In recent years, we have witnessed many bouts of financial instability arising from a wide diversity of
proximate causes: operational problems, institutional failures, short-term problems in the functioning of
financial markets, mean revisions in overextended financial markets, and contagion across markets
and between countries.1 In this paper, I focus on problems arising from financial overextension or
systemic imbalances since they often lie at the heart of other observed problems.
As hypothesised in a recent paper,2 the increasing incidence of financial instability arises from the
coincidence of three secular trends. The first is liberalisation of global markets for goods and services.
Together with advances in technology, and technology transfer to such giants as China and India, this
has contributed to disinflationary pressures globally over an extended period. The second is the
liberalisation of financial markets, which, again together with advances in technology, has increased
the likelihood of justified optimism (favourably affecting credit and resource allocation) turning into
unjustified optimism which breeds boom-bust cycles. The principal manifestations of this have
historically been rates of growth of credit, asset prices and fixed investment well above historical
norms; in effect, imbalances. The third secular trend has been the narrowing focus of "independent"
central banks on the objective of constraining the rate of growth of prices of currently produced goods
and services, regardless of other short-term developments. Echoing insights from an earlier literature,3
the "elasticity" of the financial system has increased while at the same time policy resistance has
decreased. Rupture is commonly the end product of such overextensions.
The dynamics of cycles of this sort can vary widely, but they have three common features. First,
lending and debt levels rise sharply in the upturn. Second, credit originators tend in the upswings to
generate common exposures and thus all become vulnerable to the same shocks subsequently. Third,
the appetite for risk, the health of the financial system and the state of the real economy tend to
become endogenous. In the upswing, the appetite for risk rises, with initially positive effects on the real
economy and the financial system, which further stimulates risk-taking. In the downswing, this dynamic
process goes into reverse, with accumulated consumer and corporate debt loads weighing down the
economy even in cases where the financial system initially remains quite healthy.4 Whether a weak
financial system constrains the real economy, or whether a weak economy eventually threatens the
financial system, the central point is the endogeneity of all variables of interest. Evidently this makes
forecasting outturns particularly difficult, especially when we add in the non-linearities associated with
both interactive processes and discrete bankruptcy events.
What do we mean by macroprudential concerns? In effect, they have to do with avoiding the kind of
problems just described, with their attendant heavy costs in terms of output and employment. The
policy challenge is to find ways of reconciling the unquestioned benefits in efficiency arising from each
of the three secular trends with the occasional risks arising from their joint evolution over time.
How can we make these macroprudential concerns operational? Two things seem to be required.
First, there must be a convincing assessment that systemic imbalances are emerging which have the
potential to impose economic costs. This issue of "vulnerability indicators" is touched on in Section 1.
Second, given such an assessment, the incentives must be in place to allow the instruments of
macroprudential policy to be used appropriately.5 In Section 2 the core elements of an "idealised"
macroprudential framework to respond to systemic imbalances are laid out. They include the possible
use of prudential instruments as well as the use of monetary policy, and also the possible interaction
between these policy instruments. In this regard, some consideration is given to the kind of institutional
relationships that might best contribute to good macroprudential policy. In Section 3 a long list of
existing impediments (disincentives) to the suggested use of macroprudential instruments is surveyed.
Section 4 concludes with a consideration of some practical steps that might be taken to reduce these
disincentives.
In a recent paper, Houben et al6 distinguish between three states of the financial world: stability,
impending instability and actual instability. This paper deals only with the second state of affairs, and
thus has nothing to say about issues of crisis management and crisis resolution. However, the
recognition that eventual crises could have heavy fiscal costs would seem to imply that Treasury
officials might also be interested in both constructing and participating in a macroprudential framework
that operates effectively. Just as war is too important to be left to the generals, financial stability may
be too important to be left to the prudential authorities and the central bankers.
1. Evaluating macroprudential risks
How can we best evaluate whether systemic imbalances are building up in such a way that they justify
a policy response? In principle, the task is to evaluate the expected loss arising from these
imbalances, where this is the multiple of the probability of financial stress times the loss given stress,
and to compare this to the costs associated with the use of policy instruments to avoid the problem.
No aspect of this calculus is easy. The probability of financial stress can be increased by many factors,
but can as well be reduced by other developments occurring simultaneously. Consider, for example,
how the capacity of time-varying risk weights to promote procyclicality under Basel II can be offset by
the spreading culture of risk management engendered by the same process. The costs associated
with a prospective "bust" (the loss given stress) will also depend on a myriad of factors, not least the
health at the time of the three principal components of the financial sector: financial institutions,
markets and the underlying infrastructure. This said, the historical record indicates quite clearly that
the economic costs of financial crises are very likely to be some multiple of percentage points of GDP.
Finally, the costs of using policy instruments to avert macroprudential risks must also be assessed.
Higher interest rates to lean against a boom might have the effect of driving inflation rates below
targeted levels. Moreover, from a Schumpeterian perspective, such a policy might stop out the
"creative" aspect in the process of creative destruction and put the economy on a permanently lower
growth path.
These difficulties admitted, many official agencies are paying increasing attention to data that might
throw some light on macroprudential vulnerabilities. The IMF has suggested a list of Financial
Soundness Indicators for individual countries, and uses them in the context of their Financial Sector
Assessment Programs. The Committee on the Global Financial System, which meets at the BIS, also
compiles statistics bearing on the evolution of balance sheets over time (especially debt positions) for
the major economies, and on the exposure to risks of various sorts (liquidity, credit and market) in
major financial markets. While welcome, none of these indicators in themselves give much of a flavour
of how vulnerabilities of various sorts might interact with systemic implications. In effect, they are micro
data grossed up to macroprudential dimensions. Accordingly, they provide information neither about
the distribution of risks nor about the interplay between market participants which can cause one kind
of risk to suddenly be transformed into another.7 A parallel might be drawn with the stress tests now
being conducted regularly by many of the larger financial institutions. These commonly indicate that
institutions are well prepared to meet most individual shocks, but they rarely consider a configuration
of shocks generated endogenously in the system. In particular, these stress tests rarely consider
circumstances in which other major players, some initially more vulnerable than others, are reacting
similarly and simultaneously to a shared set of exposures.
Some of my colleagues at the BIS have recently developed an interesting methodology for evaluating
the probability of financial stress, which also has the merit of being quite simple. Using only ex ante
information, Borio and Lowe (2002a) demonstrate econometrically that financial crises in industrial
countries are likely to be preceded by some combination of sustained above normal rates of growth of
credit, asset prices and investment. In a separate paper, Borio and Lowe8 show that the same pattern
applies for emerging market countries, with overvalued exchange rates also playing a role in predicting
crises. These models have the added advantage of producing a relatively low level of false positives.
Recent work by Morris Goldstein and Philip Turner (2004) puts the emphasis on currency mismatch
problems in emerging market economies, cases where borrowers have liabilities that must be serviced
in foreign currency whereas revenues are denominated in domestic currency. They conclude that the
loss given stress (in particular, currency depreciation) is positively related to the degree of currency
mismatch in the debtor economy. A similar calculus might reveal the exposure of creditor countries
today to a possible further depreciation of the US dollar, given that virtually all exposure to US
borrowers is in US dollars. Clearly, all of the work referred to in this paragraph is at an early stage of
development and further refinements could well pay big dividends.
A further reason for wishing to develop better measures of expected loss given financial stress is that
current measures can be seriously misleading.9 Consider first the currently available methodologies
for measuring credit risk. The risk assessments of rating agencies tend to rise more in recessions than
in the preceding upturn, a reaction more to the materialisation of risks than to their build-up. Banks'
internal ratings also tend to improve in good times, presumably because banks often look only a short
time ahead and simply extrapolate recent default experience. As for quantitative models for evaluating
credit risk, most do not incorporate macro variables and rely heavily on such market-determined
variables as equity prices and credit spreads. Unfortunately, these are precisely the variables that are
most likely to be biased by the market's excessive optimism during periods when serious imbalances
are emerging. Finally, it should be noted that, when calculating expected losses, none of the above
approaches recognises that the probability of default of a given credit tends in practice to be highly
correlated with the loss-given-default.10
2. Core elements of a macroprudential framework
The objective of a macroprudential framework is to limit system-wide financial excesses that could
feed back on the real economy with significant economic costs. The relevant authorities must use the
instruments at their disposal to limit the expected losses arising from such developments, recognising
that common exposures of financial institutions and market participants can exacerbate the financial
and economic cycle in both directions. Moreover, common exposures also mean that the authorities
face a significant problem of "fallacy of composition". That is, recommending what might be
appropriate for a single market participant could well exacerbate system-wide problems should
everyone do the same thing for the same "good" reason.
How can the insights above be translated into better operational policies? The first point to note is that
traditional microprudential standards and codes of good behaviour still need to be strongly
encouraged. If individual institutions are well managed, if markets function efficiently and if the
infrastructure supporting the financial system is strong, then incidents of financial stress are likely to be
less frequent and the associated costs reduced. The attention paid to such issues by the various
committees that meet at the BIS,11 the Financial Stability Forum and the Bretton Woods institutions
attests to their importance.
However, given a macroprudential focus, the nature of the monitoring of the components of the system
must change. Particular focus must be put on those parts of the system likely to have knock-on effects
elsewhere. From this perspective, banks, as suppliers of liquidity to the system, are more important
than insurance companies. By the same token, large financial firms should receive more careful
monitoring for imprudent behaviour than smaller firms whose failure might be more easily absorbed
without systemic implications. Indeed, their capital requirements might be calculated differently to
reflect such externalities. Finally, given the growing importance of markets - for the provision of credit,
the transfer of risk, and the management of risk by financial institutions - it is crucial that markets
continue to function properly under all circumstances. The implication is that market surveillance must
be strengthened under a macroprudential framework.
The most important guiding principle for a macroprudential framework would be that policies need to
be applied more symmetrically over the cycle - tightened as vigorously in the up phase as we observe
easing in the down phase. This has a number of implications for the conduct of prudential policy and
for monetary policy. As for the former, means must be found to ensure that the capital of financial
institutions is built up during cyclical upswings. This would have the dual merit of both restraining
excesses during the upswing and providing a cushion to moderate the downturn, when it does
eventually materialise. As for monetary policy, a tightening response in the face of growing imbalances
would again moderate the worst excesses and could obviate the need for subsequent radical easing.
In an environment of initially low inflation, a more symmetric policy over the cycle would also lower the
likelihood of policy rates ratcheting down over successive cycles to approach the zero lower bound.
This could become a significant problem if deflation were also to emerge in such an environment.
While this suggestion concerning symmetry might seem strange to some, it simply parallels the earlier
suggestion for more aggressive tightening of fiscal policy during upturns. More symmetry over the
cycle in the operation of fiscal policy is needed to help avoid the continuous ratcheting-up of debt
levels over time.
Implementing prudential policy in the manner suggested might be done in various ways. To the degree
that financial regulators felt sceptical about their capacity to evaluate the changing probability of
systemic stress, they might be inclined to eschew a discretionary response and to focus on some
simple rule-based procedures to govern private sector behaviour. Goodhart and Danielsson (2001)
suggest relating certain prudential norms to the rate of growth of loans or of asset prices. These
prudential norms might apply to the pricing of risk,12 to the accumulation of provisions for losses
(expected losses) or to the accumulation of capital (unexpected losses). Indeed, the Spanish
authorities have already implemented a system of "dynamic provisioning" which ensures that loan loss
provisions rise with loan levels, on the assumption that loss experience going forward will be the same
as the average loss experience based on historical experience over the full cycle.
Presuming that regulators did feel more confident in their prediction that systemic imbalances were
rising to dangerous levels, they might also have recourse to more discretionary action. In particular:
cash reserve ratios and secondary liquidity requirements might be increased. Loan-to-value ratios
might be tightened, repayment periods shortened, collateral requirements strengthened and margin
requirements for speculative trading increased. Such measures were very commonly used in industrial
countries 20 or 30 years ago and have been used more recently to good effect in both Hong Kong
SAR and Singapore. In the former case, the avowed purpose was not to stop the perceived property
boom, but rather to ensure that the banks would remain healthy even in the event of a subsequent
bust. Finally, and for the sake of completeness, it should be noted that fiscal measures might also
prove useful in some circumstances. Reducing the extent to which debt service charges (particularly
for housing) could be deducted from taxable income would probably have an effect. Other fiscal
changes (eg turnover taxes in the housing market) might also be thought useful.13
Implementing monetary policy as suggested above might also be done in a variety of ways. A more
rule-based approach might focus on the rates of growth of monetary aggregates or credit aggregates,
similar to the way policy tended to be conducted in some countries in the 1970s. The difference,
however, would be that the policy tightening would be as much directed to heading off incipient
financial excesses, with a potential for financial instability, as it would be to resisting inflationary
pressures. A two-pronged approach, a variation on the current approach of the European Central
Bank, might then have something to recommend it.14 Goodhart (2004) and a host of others have also
suggested ways in which credit growth and asset price increases might be linked more tightly to
subsequent movements in policy rates.
In contrast, monetary policy might rather be used in a highly discretionary way to respond to growing
imbalances that were judged by policymakers to threaten financial instability. Arguably, this is the
approach that has recently been taken by both the Bank of England and the Reserve Bank of
Australia. In the face of rapid increases in housing prices, and an associated rapid increase in both
household debt and household spending, both central banks raised policy rates even though actual (if
not necessarily projected) inflation was well under control. Similarly, in Sweden the monetary
authorities did not lower rates by as much as might have been expected given an undershoot of their
inflation target. They cited their concern about very rapid increases in house prices as the reason.
Cooperation among official agencies pursuing macroprudential objectives would ideally begin with
agreement that a problem was emerging. A first step in providing official resistance to emerging
imbalances might be statements of concern, presumably with one voice from different sources. Akin to
the "signalling" function of foreign exchange intervention, this might be sufficient to moderate the rate
of growth of credit, asset prices and investment. One possibility would be that market participants
might be prompted to question the inherent soundness of their current investment strategies. Another
might be that they would begin to develop concerns about more concrete policy measures which might
result in their current investment strategies becoming less profitable and/or more risky. The likelihood
of this happening would of course depend on the respect with which official views were regarded and,
more importantly, on the credibility of the implied threat of action.
In all likelihood, and this would certainly be true in the early days after the establishment of a
macroprudential framework, talk alone would not suffice to alter market sentiment. In the first instance,
the official community might turn to tighter prudential regulation. This has the advantage of directly
targeting an important source of concern; namely, the health of the financial system. Moreover, were
the excesses largely confined to certain sectors, regulatory guidance as to exposure levels might be
particularly useful. At a later stage, if required, the monetary authorities might begin tightening
monetary policy. The advantage of this instrument is the broad scope of its impact, which could help to
moderate a generalised tendency in the economy towards the development of imbalances. Perhaps
the conclusion to be drawn is that both prudential and monetary instruments might have to be used
jointly as described, recognising that over time the need to have recourse to the latter would decline as
the credibility of official threats became better established.
What kinds of processes and institutional arrangements between official agencies would best
contribute to the efficient pursuit of a macroprudential agenda? Perhaps the most serious problem to
avoid is that of macroprudential concerns falling between the cracks. That is, while each agency
recognises that a problem is emerging, it feels that it is the responsibility of some other agency to do
something about it. One possible answer would be to create a committee involving all those concerned
with systemic stability, but with a mandate to ensure macroprudential monitoring and the appropriate
policy response. In some countries, this would imply widening the mandate of already existing
committees set up to ensure a consistent official response to crisis resolution.15 The committee might
well be chaired by the central bank representative given that central banks have a more "top down"
perspective, focusing on the system as a whole,16 while prudential agencies (or central bank
supervisory departments for that matter) have traditionally approached issues from the "bottom up"
perspective of individual institutions.
It is notable that a committee of this type already exists at the international level - the Financial
Stability Forum - though not yet in most national jurisdictions. This committee brings together senior
Treasury, central bank and supervisory officials from systemically important countries, along with
representatives of the major international financial institutions and the standing committees of the BIS.
The committee routinely assesses financial vulnerabilities arising from conjunctural developments as
well as from ongoing structural change. While the committee as such has no powers - it is not a
super-regulator17 - the insights gained from its deliberations seem on occasion to have led to changes
in domestic prudential if not yet monetary policies. The Forum might also have a role to play in the
event of an international financial crisis needing management or resolution. Fortunately, this capacity
has not been tested to date.
3. Current impediments to effective macroprudential action
The previous section has set out an "idealised" framework for the implementation of macroprudential
policies. In addition to the many legitimate questions that might be raised about the desirability of the
suggestions made, there are a number of practical impediments to implementation of any sort of
macroprudential framework. Forbearance can be an issue at the systemic as well as the institutional
level. Some of these impediments are of a general nature, others affect prudential authorities in
particular, while still others affect the conduct of the monetary authorities. After identifying the nature of
these impediments, consideration is then given as to how they might be removed.
In addition to normal bureaucratic inertia, the principal impediment to implementing macroprudential
policies in practice is uncertainty as to the significance of potential systemic problems. The evaluation
problem mentioned above is serious. Moreover, it has probably become more so in recent years given
the massive structural changes under way in the financial industry, characterised above as
securitisation, consolidation and globalisation. Market mechanisms now allow the wholesale transfer of
risks, and the final resting place is more unclear than ever before. While no one really knows, the
common presumption is that these risks are now safely in the hands of those who can best bear them.
Consolidation is also viewed by some as a positive development, increasing the diversity of revenue
flows into financial firms and reducing risk. Others, however, point to an associated degree of
concentration in certain markets that is unprecedented, and the implications of which cannot thus far
be reliably assessed. Globalisation has likewise allowed a welcome dispersion of shocks, in the view
of some, while increasing the chance of contagion in the view of others. The central point is that
uncertainty about the seriousness of a problem, particularly if a number of agencies must be
convinced, is likely to be a significant impediment to action. As the French put it so well, "Dans le
doute, abstiens-toi".
A closely related problem is that policy action to curb excesses in the private sector is bound to be
resisted since private gains are at stake. At the intellectual level, the suggestion that the public sector
knows better than the collective wisdom of "the market" will be vigorously disputed. Those finding
themselves inside bubbles (ex post) are always unable to recognise it ex ante. At the practical level,
lobbyists, lawyers and enlisted media will be used to sell the idea that "this time it's different" and that
there need be no policy resistance to macroprudential concerns.
A final general concern is that policymakers will commonly have no clear idea of what effect their
policy actions might have. In part, this is for the same reasons that cast doubt on whether there is a
macroprudential problem in the first place. But, in addition, such uncertainty will be compounded by
the fact that financial imbalances may already be very well developed by the time agreement can be
forged on the need to act. An example of this kind of problem is being seen in the United States,
where policy rates are now being raised back towards more "normal" or "natural" levels after a long
period of exceptionally easy monetary policy. The reliance on "measured" policy moves, and the care
taken to communicate the Fed's policy intentions, attests to the delicate situation in which the
authorities now find themselves. Heavy debt accumulation by households and increased leverage by
financial firms raise the prospect of a different response to policy tightening than might earlier have
been expected. Growing suspicions as to the continued reliability of domestic measures of inflationary
pressures ("gaps") in an increasingly globalised real economy only add to the uncertainty.
There are particular impediments to prudential authorities behaving as suggested above. First, and
perhaps most important, they do not have a macroprudential culture. It is a big leap for supervisors, in
large part lawyers and accountants by training, and used to evaluating the health of single institutions,
to think systemically. Shocking systems of simultaneous equations to see the effects on market
clearing conditions is not their natural pastime. Moreover, it is an even bigger leap for prudential
authorities to be convinced that action is needed when the financial system seems healthy, and only
the corporate and household sectors seem overextended. Surely, they would argue, this is someone
else's responsibility. A second very practical concern is that, in most jurisdictions, the prudential
authorities do not have the power to use prudential instruments in the way recommended. Acquiring
such rights would probably involve a long and difficult political process. Consider, for example, the
strong opposition already being mounted by the accounting profession and the tax authorities to the
idea of forward-looking provisioning for expected losses. How the use of such instruments, effectively
imposed from outside, might be reconciled with the current trend to relying more on financial firms'
internal assessments of the risks they are bearing is a closely related question.
Third, there is the fallacy of composition problem referred to above. How could the prudential
authorities convince individuals to behave in ways that seemed to conflict with their own best
interests? They would have to be persuaded both that it was in the common good of all to do so,18 and
that other providers of credit would not be "free riders" gaining new customers even as they practiced
restraint. Finally, and closely related, prudential policies to reduce "excesses" in the financial system
would have to be quite comprehensive, or else the demand for credit would simply shift to unregulated
sectors and new sources of such credit would arise. Indeed, a large and growing proportion of credit is
already provided directly through markets rather than regulated financial institutions. Considerations
such as these imply that the use of monetary policy might also have to be contemplated19 if
imbalances in the financial system are to be effectively constrained.
Unfortunately, along with the general impediments against the use of policy for macroprudential
purposes, other considerations militate against the specific use of monetary policy. The first of these is
that monetary policy is generally committed to the objective of domestic price stability, whether in the
context of a formal "inflation targeting framework" or not. If rates must be raised for macroprudential
reasons when inflation is under control, then the inflation target may be undershot. Some worry that
this could undermine the credibility of the whole regime. At the very least, there is an inconsistency
that will need to be publicly and convincingly explained. Moreover, in a world of liberalised capital
flows, there is the problem that higher interest rates might serve to draw in foreign capital in significant
ways. A stronger exchange rate might lower domestic prices and increase the undershoot of the target
inflation rate. Conversely, actions taken to prevent the exchange rate from rising (intervention) might
conceivably result in an increase in domestic liquidity that would fuel imbalances rather than moderate
them.
Finally, it may prove (indeed has proved) difficult to get policymakers to focus on the simultaneous
occurrence of a number of developments as the only reliable indicator that imbalances are building up.
Rather, there has been a tendency to suggest that the macroprudential approach comes down to
"targeting asset prices", and various well known objections can be raised to this. Which of many asset
prices should be targeted? What should be the targeted level? Would interest rates high enough to
"burst the asset price bubble" not cause enormous damage elsewhere in the economy? This narrow
focus on asset prices as the core of the problem will have to be replaced by a broader conceptual
framework if anything practical is to be done about macroprudential concerns using monetary policy.
4. Can current impediments be removed?
Given enough conviction that a macroprudential framework is needed, steps could be taken to deal
with some of the above impediments to its effectiveness. The phrase "given enough conviction" is,
however, crucial since there will clearly be both costs and risks involved with changing the status quo.
In this spirit, what follows are less recommendations than possibilities to be evaluated.
It was suggested above that uncertainty as to whether macroprudential imbalances were approaching
dangerous levels would militate against a policy reaction. That is because tighter policy would clearly
have costs in terms of either economic efficiency or lost output. The assumption underlying this
reaction, however, is that policymakers have an objective function that they are trying to maximise.
The question that should be asked is whether policymakers ought not rather to be following a minimax
strategy that focuses on avoiding truly bad outcomes. With such an approach, uncertainty about the
possible build-up of financial imbalances that could led to heavy costs would in fact tilt the balance
more towards preventive action by the official sector. The bias to inaction could be reduced even more
by research studies. One objective would be to indicate the extent to which internal governance and
market discipline could be shown historically to have promoted rather than impeded procyclicality in
the financial system. Another might simply be to improve further the reliability of the promising
i