Summary:
– The recent financial crisis highlighted the shortcomings of the banking and financial system: a risky environment, systemic risk, and lax regulation are all factors that do not guarantee financial stability.
– Basel III is the first step toward strengthening the resilience of the financial system, but macroprudential policy must play a more important role in the coming years to maximize the effectiveness of regulation.
– Central banks will also have a major role to play in crisis forecasting: the Banking Union and the creation of the Single Supervisory Mechanism are steps in this direction, but conflicts of interest may arise.
On April 9, the Centre d’analyse stratégique (CAS), an institution providing expertise and decision-making support to the Prime Minister, presented its new analysis note on macroprudential policy against financial instability. At a press briefing, the CAS reviewed some aspects of this type of policy, discussing in particular the contributions of the new Basel III banking regulations, macroprudential policy, and the challenges of banking union. In this article, we will review the points presented in the note, providing additional interpretations and explanations in order to clearly identify the various issues surrounding the crucial challenge of financial stability.
A crisis that sounds the alarm
One of the lessons to be learned from the 2007-2009 crisis is that the financial system, in its pre-crisis state, was not robust enough to ensure its stability. Neither the prudential rules established by the Basel Committee nor the various financial institutions (banks, supervisory and regulatory institutions, and central banks) were able to anticipate and protect themselves from such a shock. Even now, despite the interventions (which were lifesaving but unfortunately came with certain painful constraints) by governments and central banks, financial stability is far from assured. However, it represents a major challenge for the years to come, given its close link with the real economy. Furthermore, as Reinhart and Rogoff demonstrated in their 2009 book [1], economic and financial cycles do not overlap, but for the past 20 years or so, banking and financial crises have tended to precede economic crises (in the context of the latest crisis, the spillover effects are clearly moving from finance to the real economy).
It is with this in mind that new standards (Basel III), new institutions (Single Supervisory Mechanism) and new tools (countercyclical buffers) have been organized and implemented in recent years to build and guarantee stability for the future. In its note, the CAS places macroprudential policy at the center of the financial regulatory framework. As its name suggests, this policy focuses on two key issues: the macro, i.e., the financial system as a whole and its interactions with the economic system, and the prudential, which has a more preventive aspect based on the study of cycles, imbalances, and financial bubbles. Macroprudential policy is therefore an essential element that complements microprudential policy (which focuses more on the supervision of individual institutions) in managing systemic risk.
Systemic risk, in all its forms
There is no official definition of systemic risk, but it can be likened to severe financial instability that disrupts the functioning of the financial system as a whole and significantly affects economic growth and well-being. Systemic risk is therefore a fairly broad concept, taking into account all interactions within the financial system; in this respect, it contrasts with individual or idiosyncratic risks [2]. According to economic literature, it has two dimensions: a temporal dimension, which takes into account financial imbalances through the study of economic and financial cycles, asset price bubbles, and credit booms; and an intersectoral dimension, which takes into account the financial interdependence between institutions, financial platforms, and the tools used.
Better supervision of systemic risk therefore seems to be a priority, and in its note, the CAS targets three major elements that it believes are at the root of systemic risk:
- Mimetic effects: in an environment where some agents take maximum risks, other agents have every interest in following the same trend because they know that if the sustainability of the system is called into question, they will necessarily be rescued. This moral hazard behavior can therefore lead to very dangerous momentum effects [3], contributing to a significant disconnect between risks and reality and increasing them [4]. This type of phenomenon is all the more significant in the presence of institutions that are too big to fail.
- Fire sales: a phenomenon of panic selling, leading to a sharp fall in asset values and causing a chain of bankruptcies among certain banking or financial institutions. This type of contagion through asset prices and the composition of financial institutions’ portfolios and balance sheets is all the more dangerous as it tends to affect liquidity, which gradually dries up before « disappearing » in a context of interbank confidence crisis.
- Banking interconnection: the banking world is particularly concentrated (which also raises issues of competition and « too big to fail« ), and the links between banks are often multiple, making it very difficult to identify the channels and risks of contagion in the event of a crisis or even beforehand in order to prevent any spread. Banks are not only Too Interconnected To Fail , butalso have links to the unregulated Shadow Banking System [5], whose exposures are difficult to measure.
Identifying the sources and channels of systemic risk propagation is the first step in establishing the tools of tomorrow that will best combat the risks associated with financial instability. However, we must not confuse causes and consequences if we want the exercise to be as effective as possible. It is undeniable that points 1 and 3 above are two essential elements for understanding the origins of systemic risk, but point 2 on fire sales is not one of them and is more of a consequence. The cause of this type of phenomenon lies in the other two conditions, but also and above all in the leverage of banks (their asset-to-equity ratio). An excellent article by Adrian and Shin discusses the systemic nature of bank leverage and describes the risks to interbank liquidity.[6]. Another key factor in understanding the crisis and what should be the areas of concern in the coming years is the pro-cyclical role of credit (enabled by securitization, the failure of rating agencies, and the underestimation of the risk channel by central banks), the mechanisms of which are accurately described in a 2011 report by the French Economic Analysis Council (CAE) [7].
Basel III and macroprudential policy
Firstly, it is important to note that most of the measures taken under Basel III [8] are not macroprudential in nature, but essentially microprudential.This distinction is clearly noted in the CAS memo, where the increase in capital and liquidity requirements under Basel III are clearly equated with a microprudential capital constraint for banks, even though they also have a macroeconomic impact.
Countercyclical buffers, on the other hand, are more macroprudential in nature than capital ratios. These buffers allow for the accumulation of up to an additional 2.5% of capital per type of ratio. This increase in requirements should take place during periods of growth and economic expansion. In times of crisis, the buffers may be reduced to 0%, and the funds mobilized during good times will be invaluable in dealing with a potential crisis. The decision to permanently introduce a leverage ratio is also a significant step forward in banking regulation, given its role in crises. It is also important to note that stricter conditions (an additional increase of 1% to 2.5% in requirements per ratio) are imposed on large banks considered to be « highly » systemic [9] (15 in Europe and 29 worldwide) and that the creation of a European Systemic Risk Board should provide a more robust framework for regulating it.
What other macroprudential policy tools are there? The CAS note attempts to provide an overview of these instruments, but few of them are currently in force. As bank credit plays a decisive role in financial crises, regulating it in the form of a loan-to-value ratio ( the ratio between the loan and the market value of the asset it finances) or a debt-to-income ratio ( the ratio between the credit taken out and the borrower’s income) would be a decisive step towards greater stability. Other elements such as the Volcker Rule ( limiting proprietary trading and prohibiting banks from investing in hedge funds), the recommendations of the Vickers and Liikanen Commissions (focusing more on competition and the separation of banks’ commercial and investment activities), taxing banks according to their contribution to systemic risk [10] also appear to be plausible arguments for strengthening macroprudential policy, as do increasing the frequency of stress tests and raising requirements for monitoring banks to determine whether they are sufficiently capitalized.
Much work remains to be done, and macroprudential policy is currently far from being fully recognized as an essential element in promoting financial stability, given the timidity of the measures taken. Basel III is certainly a positive step, but it is not enough and has several limitations: its pro-cyclical nature, the lack of enthusiasm among Americans to comply with the timetable, the absence of sanctions for banks with multiple links to shadow banking institutions , and its limitation to the banking sector alone. It would appear that, in terms of both financial regulation and supervision, central banks will have to play an increasingly important role in ensuring financial stability.
Monetary policy and banking union: what are the benefits?
Banking regulation in Europe seems inevitably to require a banking union, at least at the European level. In principle, this should be based on the following three pillars: a single supervisory mechanism for banks, a standardized deposit guarantee scheme, and the establishment of a crisis resolution mechanism.
The European Central Bank (ECB) has been assigned the task of implementing the single supervisory mechanism (SSM), in conjunction with the European Banking Authority (EBA). The ECB will take up its new duties on March 1, 2014 (for more information on this subject, please refer to our previous article on the single supervisory mechanism). It should be noted that not all banks will be subject to supervision, as only those with total assets exceeding €30 billion will be directly supervised by the SSM. However, the ECB will have oversight of other institutions when they find themselves in difficult situations. Given what we have seen previously, where all banks are affected and may inherently pose systemic risk, the decision not to supervise all banks could run counter to the desire to ensure financial stability, even though it is undeniable that the SSM already represents a decisive step forward.
Only this first component of the banking union is the most developed, with the other two still at the discussion stage. Following the recent crisis in Cypriot banks, everything suggests that the issue of deposit guarantee management is likely to become central. Currently in Europe, all accounts up to €100,000 are guaranteed, even though, as things stand, this type of system is not sustainable: it is highly unlikely, if not impossible, that this type of guarantee system could be implemented if too many bank account holders were to resort to it [12]. According to the CAS, pending progress on this issue, the creation of a national authority to force insolvent banks to make their (junior) creditors contribute via a bail-in, as recently happened in Cyprus, could help to supplement the current system. Encouraging the bankruptcy of certain financial institutions in difficulty and the creation of bad banks are also interesting ways of managing, ex ante , certain situations that could lead to crises. In addition, this type of mechanism could also be part of the logic of setting up a crisis resolution mechanism.
For some economists [13], monetary policy and its conduct by central banks could contribute directly to maintaining financial stability while also playing a preventive role. The objective of price stability alone is no longer sufficient to ensure the stability of markets or the real economy. The principle of separation, whereby central banks only respond to financial tensions if they pose a threat to price stability, is therefore called into question. From the underestimation of the risk channel [14] to the ECB’s overly restrictive mandate and the remuneration of excess reserves, there is ample evidence that monetary policy has a major role to play in the years ahead. Should we introduce a Taylor rule augmented by expectations or observations on asset prices, or introduce credit ceilings? Isn’t there a risk of creating conflicts of interest for central banks, with the danger that they will lose their credibility? Should we redefine the conditions for access to central liquidity [15] and rethink the organization of the lender of last resort [16]?
Conclusion
The road to financial stability is still long, given the many conditions that must be met to ensure it. Bank regulation seems to be on the right track, even if global disagreements on certain aspects (such as the US’s non-alignment with the Basel III timetable) could slow down the overall process and thus the effectiveness of the measures taken by countries that are more willing to act.
Macroprudential policy is still in its infancy, but it is to be hoped that it will not stop there and that tools will actually be put in place quickly. Central banks, in terms of supervision and regulation as well as monetary policy, should be at the center of the system, and it is to be hoped that they will be able to combine these new objectives as effectively as possible without losing credibility. The involvement of countries, international institutions (G20, International Monetary Fund) and various financial institutions (not just banks) is also a key condition for ensuring financial stability.
Notes and References:
[1] C.M Reinhart and K. Rogoff « This Time is Different: Eight Centuries of Financial Folly » (2009)
[2] An idiosyncratic shock is a shock affecting a particular institution, which finds itself in difficulty due to the reaction of its own characteristics to its environment. This shock does not affect other institutions.
[3] This effect is defined as the tendency for securities that have performed well (poorly) in the past to perform well (poorly) in the future.
[4] This type of phenomenon can also be likened to the « paradox of tranquility » highlighted by H. Minsky (1982 and 1986): during periods of economic and financial stability, risk aversion decreases and financial agents take excessive risks.
[5] All financial intermediaries providing the same services as certain banks but which are not subject to regulation and whose activities or operating methods remain very opaque. Examples of such institutions include hedge funds and money market funds.
[6] T. Adrian and H. S. Shin, « Liquidity and Leverage , » Federal Reserve Bank of New York Staff Reports (2010).
[7] J-P. Betbèze, C. Bordes, J. Couppey-Soubeyran, and D. Plihon (2011), « Central Banks and Financial Stability, » Economic Analysis Council.
[8] We have already discussed these measures in an article, which we recommend reading for further information on the subject: http://www.bs-initiative.org/index.php/analyses-economiques/item/104-la-regulation-des-banques-en-europe-ou-en-sommes-nous)
[9] It is often said that only large banks are systemic, but this is not true: while it is undeniable that the largest banks are systemic, all banks are systemic, whether they are universal or not, large or small, especially given the degree of banking interconnection. The Spanish banking crisis, with the collapse of small regional banks, is a perfect example of this, with the contagion gradually spreading to the entire banking system.
[10] V. Acharya, L. Pedersen, T. Philippon, and M. Richardson, « Measuring Systemic Risk, » NYU Working Paper (2010).
[11] For more information on the causes of the Cypriot crisis and its implications, read Arthur Jurus’ article on our website: http://bs-initiative.org/index.php/analyses-economiques/item/97-financement-de-la-sortie-de-crise-a-chypre-quelles-perspectives.
[12] A. Demirgüç-Kunt, E. J. Kane & L. Laeven, “Deposit Insurance Design and Implementation: Policy Lessons from Research and Practice” (2006)
[13]C. Borio and H. Zhu, “Capital regulation, risk taking and monetary policy: A missing link in the transmission mechanism?” Journal of Financial Stability (2012) or C. Borio and P. Lowe
[14] Low interest rates can fuel yield appetite behavior , whereby certain investors embark on highly profitable but very risky projects.
[15] Notably through the contribution of central clearing houses, see J-C. Rochet (2010), « Systemic risk: an alternative approach, » Revue de Stabilité Financière, Banque de France (2010).
[16] To fully understand the issue of PDR, read Julien Pinter’s article: http://bs-initiative.org/index.php/notes-de-recherche/item/77-preteur-de-dernier-ressort-ce-que-nous-dit-goodhart.
