Macroprudential policy: reforms on the horizon (Note)

Summary

• The expected reforms concern the instruments, institutional design, and scope of the macroprudential framework.
• With regard to instruments, the opinions received by the European Commission are in favor of simplifying activation procedures, revising the calibration of capital buffers for systemic institutions, and introducing additional tools.
• The governance of the European Systemic Risk Board and the division of tasks between macroprudential authorities should be modified.
• In the longer term, given the importance of the non-banking financial sector and the favorable context for its expansion, the macroprudential framework will probably be extended to the entire financial sector.

The framework governing macroprudential policy isrecent. Nevertheless, these few years of experience have given rise to an initial assessment. In 2016, the European Commission published a consultationwith a view to reforming macroprudential policy. In the supporting document, the Commission reports on practices in order to highlight the limitations of the framework and gather suggestions from the public. What are the weaknesses of the framework? What alternatives have been proposed? The proposals fall into three categories.

1. Achieving a better balance between flexibility and control

The objective of macroprudential authorities is to contain systemic risk. To this end, the instruments at their disposal are designed to strike a balance between flexibility and control. National authorities must be able to take measures tailored to the financial conditions and structure of their country’s financial system (flexibility). Furthermore, these measures must be transparent, harmonized, and validated by European institutions in order to promote the coordination of policies implemented in different EU member countries (control). This coordination is necessary to avoid the effects of regulatory arbitrage, unfair competition, or excessive risk-taking through cross-border activities. It is therefore on the basis of the balance between these two criteria that proposals for reforming macroprudential instrumentshave been made.

1.1 Simplifying the procedures for activating instruments

European regulation (CRR/CRD IV) establishes a hierarchy of prudential instruments. A new instrument can only be activated if those that take precedence over it have already been activated. Furthermore, the number of European institutions that must be notified for the measure to be validated, and the format of the notifications, vary greatly from one instrument to another.

In practice, these differences may encourage the macroprudential use of priority microprudential tools [1], which are more flexible but also less transparent, and whose implementation is not monitored at the European level. They may also affect the responsiveness of national authorities, leading them to choose less appropriate instruments or to refrain from taking action. A significant proportion of the responses received by the Commission, including that of the ESRB(European Systemic Risk Board, the supranational institution responsible for macroprudential policy at EU level), are in favor of abolishing the hierarchy of instruments and establishing a single activation procedure.

1.2 Reviewing the rules on capital ratios for systemic institutions

As shown in Figure 1, European regulations provide, among other things, for three capital buffers to combat the risks posed by systemic institutions: the G-SII and O-SII ratios [2], and the SRB (systemic risk buffer). The G-SII and O-SII ratios target in particular institutions that are considered « too big to fail, » i.e., the pillars of the international banking sector (G-SII) and/or the national and European banking sector (O-SII). They are limited to 3.5% and 2% of the total risk exposure of these institutions, respectively. The objective of the SRB is vague, its scope very broad, and it does not allow for a ceiling, which makes this instrument very flexible. Unlike the G-SII and O-SII ratios, the SRB does not specifically target systemic institutions, but can be applied to them.

In practice, the SRB has been used to circumvent the O-SII ratio cap, which is considered too low to cover the risks posed by the institutions concerned. In addition, a cap discount applies to foreign O-SII subsidiaries of O-SII or G-SII institutions, which may distort competition if identical institutions in the host country face stricter requirements. The main alternatives proposed are therefore to clearly define the objective of the SRB, raise the O-SII ratio cap, and remove the cap discount applied to these subsidiaries.

Figure 1: Capital requirements in CRR/CRD IV

1.3 Adding complementary instruments

The instruments currently available are not sufficient to combat excessive fluctuations in specific asset markets, with the exception of the real estate market [3]. The proposal to establish a countercyclical capital buffer for specific sectors [4] has been well received. It has also been suggested that three cycles should be targeted: real estate, credit, and asset prices.

Most macroprudential tools are capital ratios. Through these types of instruments, the authorities seek to rebalance the financial structure of banks in order to:

i. Increase their capacity to absorb losses;

ii. Reduce their incentive to take risks;

iii. Contain credit growth by making it more expensive [5].

In practice, several countries have also used measures targeting borrowers directly (such as loan-to-value, loan-to-income, and debt-service-to-income ratios) to avoid situations of over-indebtedness and thus improve credit quality. Given their effectiveness, it is to be expected that this type of measure will be made available to the national macroprudential authorities of all Member States and that their implementation will be harmonized at the European level.

Capital ratios are defined as a proportion of the total risk exposure of banking institutions. Risk exposure depends on parameters (probability of default, loss rate in the event of default, exposure at the time of default, maturity) that can be calculated by the banks themselves using their own models ( internal rating-based (IRB) approach ). These models are limited in that they only take into account known and quantifiable risks. There is also a problem of information asymmetry between banks and supervisory authorities, which may encourage banks to underestimate the risks they face [6]. More broadly, risk indicators are generally higher during slowdowns and lower during booms, which automatically affects capital requirements and can have a procyclical effect on credit cycle fluctuations. The ESRB strongly supports the introduction of macroprudential leverage ratios that are not dependent on banking models.

2. Reforming the institutional framework of the macroprudential system

2.1 Strengthening the independence of the ESRB and the representation of different stakeholders

The majority of opinions gathered by the Commission are in favor of the ECB presidency being paired with that of the ESRB. Furthermore, there seems to be consensus on the establishment of a dual structure to strengthen the independence of the ESRB. This governance choice would include a president and a managing director. The former would continue to chair the meetings of the General Board, while the latter would chair the meetings of the Steering Committee.

Figure 2: ESRB organizational chart

European Commission, consultation (2016)

The main responsibilities for implementing macroprudential policy in the EU are entrusted to national macroprudential authorities. Furthermore, the effectiveness of the system depends on the coordination of all prudential regulatory authorities, including the microprudential regulatory authorities of the banking union, such as the resolution authority and the supervisory board. It is therefore to be expected that the composition of the ESRB bodies will be modified to include representatives of these institutions (national macroprudential authorities, resolution authority, and supervisory board of the banking union).

2.2 Clarifying the division of powers between the various macroprudential authorities

Macroprudential policy has two dimensions. A temporal dimension, which aims to smooth out fluctuations in the financial cycle through countercyclical action. A cross-cutting dimension, which aims to limit the concentration of risks in the EU, for example through action targeting systemic groups (as in the case of G-SII and O-SII ratios). A study published by the European Parliament proposed clarifying the distribution of powers. Given the heterogeneity of financial cycles across EU countries, responsibility for countercyclical policies would be left to national macroprudential authorities. The ESRB would then be responsible for coordinating them at the EU level. On the other hand, responsibility for the cross-border dimension would be entrusted directly to a supranational institution such as the ECB, in order to better cover all the risks arising from large groups with transnational activities. This division of responsibilities would, in particular, avoid duplication of tasks and simplify the procedures for activating instruments, which compromise the effectiveness of the system.

3. Extending the macroprudential framework beyond the banking sector

The question of extending the macroprudential framework to non-bank financial intermediaries (insurance companies, pension funds, and shadow banking, including investment funds and other financial intermediaries) arises because they are now, like banks, a major source of financing for the economy(at the end of the fourth quarter of 2016, shadow banking, insurance companies, and pension funds held 40% and 16.5% of total assets in the EU financial sector, respectively). Their expansion is expected to continue and accelerate with the entry into force of the Capital Markets Union, which aims in part to « develop and diversify the supply of financing, » and the current environment of low interest rates. Low interest rates tend to encourage risk-taking and balance sheet expansion. They favor financial intermediaries whose balance sheet expansion is not subject to regulatory constraints (this is the case for hedge funds and certain investment funds) and may increase competition between banks and non-banks, which are developing activities similar to banking services [7].

Furthermore, as shown in Figure 3, non-bank financial intermediaries are closely linked to banks. They include institutions created specifically by banks to hold the loans they grant, thereby avoiding the regulatory capital requirements associated with these loans. They also include institutions to which banks grant guarantees in the form of explicit and implicit credit lines (i.e., which are not subject to regulatory capital requirements). Finally, credit derivatives produced through securitization (generally highly rated and therefore perceived as risk-free assets) are assets in which banks invest heavily, as they serve as collateral for borrowing through repurchase agreements.

Chart 3: European banks’ exposures to shadow banking institutions (the green dots represent European banks, and all other dots represent the shadow banking institutions to which they are exposed)

ESRB, May 2017 report

Extending the macroprudential framework beyond the banking sector would therefore not only preserve the ability of non-bank financial intermediaries to finance the economy directly and indirectly (via banks), but also improve the effectiveness of the measures that apply to banks. The vast majority of opinions gathered by the commission were in favor of extending the framework. Certain measures have already been proposed by the ESRB, such as liquidity requirements for investment fund balance sheets [9] and margin and haircutrequirements appliedby lenders in securities and financial derivative transactions.

Conclusion

Before the crisis, the prevailing view was that prudential regulation had a single objective: to ensure the solvency of individual banking institutions. This is no longer the case. The macroprudential framework is currently being developed and will soon be reformed. The debate now focuses on defining the objectives, calibration, and activation procedures for the instruments, as well as the institutional design of the framework and its scope of application.

Notes

[1] The macroprudential use of microprudential instruments is permitted under Article 103 of CRD IV.

[2] G-SII and O-SII stand for « globally systemically important institutions » and « other systemically important institutions, » respectively.

[3] See Article 458 CRR

[4] A similar instrument has been available in Switzerland since 2012.

[5]Admati et al. (2013), Suarez (1998), Merton (1977), Jencen & Meckling (1976), Holmström & Tirole (1997)

[6]Prescott (2004), Mariathasan & Merrouche (2014)

[7]This is the case in the Netherlands, for example, where non-bank intermediaries grant a significant proportion of mortgage loans.

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