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NEWS February 03 2019

Systemic Risk: The Effects of Implementing Macro-prudential Framework Tools

By Mohammed Assayed, Senior Associate, Corporate Department

 

Introduction

Since the 2007 - 2009 financial crisis, the talk and lengthy discussions about systemic risks and its implication on the stability of the global financial system has not ceased. Governments and international organizations showed increasing concerns of its serious implications,[1] “under which the world’s financial system can collapse like a row of diamonds” (Steven L. Schwarcz). In the United States, for instance, the congress held lengthy hearings discussing systemic risks and its impact on the financial markets.[2]

According to the International Monetary Fund (“IMF”), and to the Bank of International Settlements (“BIS”), systemic risk is defined as “a risk of disruption to financial services that is caused by an impairment of all or parts of the financial system and has the potential to have serious negative consequences for the real economy”.[3] However, it is hard to identify which type of risks are truly systemic to the economy[4] from the type of risks which are idiosyncratic. It is the negative externality and the contagion risk to the financial markets are the basis of systemic risk and therefore requiring an effective policy intervention and interaction.[5]

From the above definition of systemic risk, we can recognize that it has two main dimensions, cross-sectional and time-dimension.[6] The cross-sectional dimension, deals with common exposure in the financial systems, the level of interconnectedness, and how a specific shock can be amplified and goes on to become a real threat to the global economy. Thus, the main focus here is on the distribution of risk in the financial system.[7] On the other hand, the time- dimension deals with the pro-cyclicality accumulation of financial instability and how overall systemic risk progresses over time.[8]

Consequentially, the need to regulate such risk is essential, given its complexity and its different forms, however, previous macro polices that were entered to tackle systemic risks were not sufficient, they ,must be accompanied with other well established approaches such as micro-prudential, fiscal and monetary policies. In this article we will only discuss the design for macro-prudential approach framework, its implementation, and its potential impact on the financial stability and whether it will jeopardize the economic growth of the economy. 

 

The Design of Macro-Prudential Supervision Framework  

Previously, prior the crisis, the regulatory and supervisory approach was implicitly based on a philosophy which believed in three main principles.[9] First, markets are self-correcting, which means that market discipline is a more effective tool than setting up regulations and enacting laws. Second, the main responsibility in managing risks falls on the senior management and boards of the individual institutions, who are believed to be better positioned to evaluate risks that regulators. Lastly, customer protection can only be protected by unfettered and transparent market.[10] As a result of such philosophy, a micro-prudential supervisory approach (“Micropru”) has been implemented on the basis to focus on the administration of individual institutions instead of on the entire financial system, and the emphasis on ensuring the systems and processes were in place and correctly implemented rather than challenging business models and plans.[11] The Micropru, therefore, failed to address the risk of externalities on the financial system, such as, externalities related to strategic complementarities, interconnectedness, and fire sales.[12]

Consequentially, another complementary macro-prudential approach (“Macropru”) has to be in place, along with Micropru, to ensure financial stability and to control systemic risks.[13] Macropru can be defined as a policy that uses mainly prudential tools to control and mitigate systemic or system wide financial risk, thus limit the impact of disruption out if individual financial institutions that can have a severe negative results on the overall economy, including the probability of asset bubble formation[14], by first, targeting the accumulation of financial imbalances and establish effective defenses to keep the economy immune from any major sharp downswing.[15] Second, identifying the sources of contagion risks via identifying common exposures and the level of interconnectedness in the financial system.[16] From this definition, the underlying framework of Macropru can be outlined as follows,[17] we will discuss each in turn:

  • Objectives, of limiting systemic and system wide financial risk.[18]
  • Scope of analysis, of the overall financial system and its correlation with the economy.[19]
  • Set of tools and their governance, of prudential instruments which are particularly assigned to macro-prudential authorities.[20]

By looking at the objectives, we can notice that Macropru focuses on two essential dimensions of systemic risk, first, the buildup of systemic risk over time, called the “time dimension”, and second, the distribution of risk in the financial system at a particular time, called “cross-sectional dimension”.[21]

The main focus in the time dimension is to control or minimize pro-cyclicality in the financial system, by measuring how systemic risk interacts with the financial system, and therefore assess its stability, i.e. in booming economy, financial system tends to add on more risk, through plenty of credit and money supply (this is shows the interlink between Macropru and monetary policy), rapid increase in asset valuation and prices, and through a remarkable increase in leverage and maturity mismatch,[22] mainly due to the fact when short term debt is cheaper form of financing than equity, banks and other financial institutions will tend to take on more debt that they should be.[23] In contrast, in a downturn economy, the lack of sufficient buffers can impose financial distress which can be amplified by pressing deleveraging, and by suddenly cutting the credit tab.[24]

In the cross sectional, on the other hand, the prime focus is to reduce concentration risk, which can arise from having similar exposure among banks and other financial institutions,[25] and the high interconnectedness level among them, resulted mainly from their interbank money market operation and payment & settlement systems.[26]

Before discussing the tools for Macropru, the effective assessment of systemic risk should be highlighted as it is one of the essential elements for a stronger Macropru framework.[27] This requires upgrading the current financial statistics and the analytical toolkit to cover all potential sources of systemic risk and its buildup.[28] Improved quality of information in this area will assist the regulators and supervisors to better understand interconnections in the financial system, and consequentially developing the right analytical tools to limit the possibility and consequences of the general reaction to shocks that can jeopardize the stability of the whole financial system.[29] However, as long as financial markets will keep growing and creating innovative investment tools, the likelihood of noticeable information gaps will definitely emerges.[30] Therefore, one of the priorities of a successful Macropru policy is ensuring the financial statistical framework are dynamic and responsive to keep the pace with the development in the financial markets.[31] Nonetheless, such a development will increase the burden on adopting Macropru, as it will increase the underlying costs significantly.

Since the last financial crisis, and the regulators and international institutions are trying to identify the right tools for an effective Macropru framework. For example, “Goodhart  Kashyap” suggested five Macropru policy tools in order to mitigate the defaults in the housing markets which may lead to serious impairment to the banking and financial system.[32] These are: a) caps on loan to value ratio, b) higher capital requirements for banks, c) clear and strict loan loss provisioning for banks, d) increased the bank’s liquidity requirements via higher liquidity coverage ratios, e) margin requirements on repurchase transactions by shadow banks.[33]

In spite of the challenges of identifying the right tools for implementing Macropru, a set of tools have been proposed to address the both pillars of Macropru framework: time dimension and cross-sectional dimension.[34]  

 

I. Basel III 

The previous Basel standards (Basel I and Basel II) were entirely based on Micropru measures, which as explained above, considers risk as exogenous, caused as result of individual behavior,[35] by focusing on the balance sheet insolvency of financial institutions and ignoring insolvencies related to cash flows i.e. liquidity measures.

Basel III was first introduced by the Basel committee in 2010, as immediate response to the financial crisis.[36] In 2017 Basel III got amended to cover the following comprehensive features:[37] First, increasing the level and upgrading the quality of capital, by increasing the requirements of Tier 1 capital from 4% to 6%, with a minimum of three quarters must be the highest quality (common shares and retained earnings). Second, enhance methods of capturing risk, by enhancing risk sensitivity and reducing the reliance on external credit ratings. Third, higher leverage ratio requirements. Fourth, improving liquidity, by asking banks to hold sufficient liquid assets to keep them operational for at least 30 days. Finally, limiting pro-cyclicality, by requesting banks to retain earnings to build up capital buffers during expansionary high growth periods.[38]

The above Basel III framework contains a number of provisions that should control pro cyclicality and limit financial imbalances.[39] In addition, it addresses interconnectedness among financial institutions via managing the risks arising from the firm exposure i.e. derivatives transactions, securitizations and off-balance sheet exposure.[40] On the lights of the above, Basel III combines both Macropru and Micropru tools to tackle systemic risk. 

 

II. Countercyclical Variations in Margins or Collateral Haircuts [41]
 

This tool aims to upgrade common margining practices to become more dynamic and stable during the economy life cycle, thus capping financial markets pro-cyclicality.[42] It can be achieved by applying haircuts and mark-to-market practices on collaterals, and that specifically includes collateral on over-the-counter (OTC) derivatives.[43]

 

III. Sectoral Capital Requirements
 

This tool provides an important mechanism to address the cross-sectional dimension of systemic risk and therefore managing concentration and interconnectedness exposure, by temporarily increase individual firm’s capital requirements on their exposure to specific sectors.[44]

 

A good example for such a tool would be the Bank of England Act 1998 (Macro-prudential Measures) Order 2013/644, in which the regulator has the authority to ask financial firms to maintain additional funds to three main sectors:[45] a) Residential property, which includes mortgages, b) Commercial property, and c) financial sector, which allows the regulator to target exposures to loans, derivatives and bonds to all financial participants. In addition, the regulator can impose specific requirements on firms if they fail to keep the additional capital, and applying stress tests on individual firms to consider certain financial, property exposure as if gave rise to their overall risk.[46]

 

III. Identifying Systemically Important Financial Institutions ("SIFI")

          

It is a tool that labels major financial institutions as “too big to fail”, as their default will carry a serious systemic risk to the economy.[47] In turn, regulators are required to impose on them extra layer of regulatory requirements.[48] The US enactment of the 2010 “Dodd-Frank Act” is a good example of SIFI, by the authority of the Dodd-Frank Act the Financial Stability Oversight Council (“FSOC”) has been established with the power to label banks and other financial institutions as SIFI. Such label will impose extra regulatory burdens and intensified scrutiny, including strict oversight by the Federal Reserve, higher capital requirements, and stress tests.[49] Which in turn, will add another layer of cost on both regulators and financial institutions.

 

Challenges in Implementing Macrupro framework

Obviously, the road of implementing the Macrupro framework entails significant challenges.[50] First, the use of time varying Macropru techniques requires a significant amount of judgement, as it requires accurate targeting and timing. In order to deploy such tools, regulators must locate the relevant point of risk progression, i.e. “distinguishing between overheating asset boom from secular growth in demand, and then pick the tool that suppresses the boom without imposing constraints on other economic growth”.[51] Practical evidences suggested that such tools are more influential at tightening credit than easing, and have a counter-effect of growing consumer credit than bank credit.[52]

Second, by requiring targeted banks and financial firms to internalize systemic cost of stability, the cross-sectional Macropru techniques will most likely raise the cost of their credit intermediation, which in turn motivates them (banks and financial firms) to participate in credit intermediation through non-target firms, outside the umbrella of regulatory perimeter. In addition, this may have an extended impact of shifting significant amount of financial intermediaries outside the financial sector.[53] As a result systemic risk will be amplified instead of being mitigated and controlled.

Third, politicians and industry practitioners will resist implementing such measures, in fact, they might fight it and lobby against it, mainly because both groups have shorter time horizon than the period which systemic risk will be build up and eventually burst.[54] For example, holding dividends distribution to shareholders when the economy is growing will not be accepted from short-term investors and traders.    

 

The Impact of Macropru Framework on Economic Growth:

Before discussing the relationship between Macropru and economic growth and whether it will enhance or mute growth, I would like to briefly define a very important risk in the financial market, “Regulatory Risk”, it is the risk that a change in laws and regulations will negatively influence the growth of a certain sector or market.[55] This will lead us to the topic of over-regulation risk. Over-regulation can halt economic growth by capping innovation, muting banking productivity, and by limiting credit growth.[56]

As explained earlier, Macropru framework aims to enhance financial system stability and resilience, by mainly mitigating systemic risk. Nevertheless, there is a strong argument that Macropru may be efficient at the cost of curbing long-term economic growth, which signaling a trade-off relationship.[57] On the other hand, it can be argued that a more regulated supervised economy could better stand economic growth.[58] To elaborate more on this point, we will test two scenarios, first, Macropru framework may support long-term economic growth, and second, Macropru may halt long-term economic growth. 

Implementing Macropru framework can limit the severance of financial shocks, which are generally followed by periods of low productivity and negative growth.[59] This means by having Macropru tools in place, we will certainly have better economic growth and productivity during periods of financial shocks. In addition, as macroeconomic volatility reduces growth, and that Macropru framework aiming to reduce macroeconomics volatility (by enhancing stability), Macropru framework, therefore, should positively support long-term growth by diminishing economic volatility.[60]

On the other hand, Macropru can halt growth by limiting the ability of the market to allocate financial resources freely. In addition, by requiring financial institutions to keep countercyclical buffer to counter the cyclicality of the economy, might reduce the flow of credit to the economy, which in turn, it may negatively impact economic growth.[61]

Despite of several arguments against it, one of the approaches to resolve such trade-off and conflict, is to include economic growth to the objectives of Macropru policy. This objective was in fact included in the Financial Policy Committee (FPC) mandate pursuant to S.9C.(1) of the Financial Services Act 2012:

 

“9C Objectives of the Financial Policy Committee

(1) The Financial Policy Committee is to exercise its functions with a view to—

(a) Contributing to the achievement by the Bank of the Financial Stability Objective, and

(b) Subject to that, supporting the economic policy of Her Majesty’s Government, including its objectives for growth and employment”.  

Thus, it is clear that the FPC has a Macropru mandate with a prioritization of objectives, where ensuring financial stability as a primary objective and maintaining economic growth as a secondary.  

 

Conclusion

In summary, there is no doubt that Macropru policy is an essential pillar of financial stability, however, it is not as effective and efficient should it be implemented in isolation, there must be close coordination with other policies i.e. Micropru, fiscal and monetary policy, at the international level, in order to achieve the desired outcome.  

Similarly, given it complexity and the significant cost involved, I believe implementing it will never be a straightforward and easy process,[62] especially that verifying its effectiveness requires another financial shock, which may be not anytime soon.

 

Bibliography

Journals:

·         Baker A, 'Political Economy And The Paradoxes Of Macroprudential Regulation'

·         Caruana J, 'Systemic Risk: How To Deal With It?' [2010] BIS

·         De Nicolo G, G FavaraL Ratnovski, 'Externalities And Macroprudential Policy' [2012] SSRN Electronic Journal

·         'Finalising Basel III' [2017] Basel Committee on Banking Supervision

·         'FPC Macro-Prudential Tools' [2018] Practical Law Financial Services

·         'IMF-FSB-BIS – Elements Of Effective Macroprudential Policies' [2016] IMF-FSB-BIS

·         Llewellyn D, 'The Economic Rationale For Financial Regulation' [1999] Financial Services Authority

·         'Macroprudential Policy Tools And Frameworks' [2011] FSB, IMF, BIS

·         'Macroprudential Policy: An Organizing Framework' [2011] INTERNATIONAL MONETARY FUND

·         Mcguirk DF Abrams, 'GOVERNMENT OVER-REGULATION HAS A NEGATIVE IMPACT ON THE GLOBAL COMPETITIVENESS OF U.S. MANUFACTURERS'

·         Settlements B, 'Marrying The Macro- And Micro-Prudential Dimensions Of Financial Stability' [2001] SSRN Electronic Journal

·         'Systemic Risk' (2008) 97:193 THE GEORGETOWN LAW JOURNAL

·         Thimann C, 'How Insurers Differ From Banks: A Primer In Systemic Regulation' [2014] SSRN Electronic Journal

·         'The Turner Review - A Regulatory Response To The Global Banking Crisis' [2009] The Financial Services Authority

·         Boar C and others, 'What Are The Effects Of Macroprudential Policies On Macroeconomic Performance?' [2017] BIS Quarterly Review

Books:

·         Cranston & Avgouleas R and others, Principles Of Banking Law (Oxford University Press)

·         Armour J, Principles Of Financial Regulation

 

Websites:

·         'UK Home | Investopedia' (Investopedia, 2018) <https://www.investopedia.com/> accessed 13 December 2018

Statutes:

·         Financial Service Act 2012

·         Dodd Frank Act 2010

·         Bank of England Act 1998

 


[1] 'Systemic Risk' (2008) 97:193 THE GEORGETOWN LAW JOURNAL.

[2] Ibid

[3] Jaime Caruana, 'Systemic Risk: How To Deal With It?' [2010] BIS.

[4] 'Systemic Risk' (2008) 97:193 THE GEORGETOWN LAW JOURNAL.

[5] Jaime Caruana, 'Systemic Risk: How To Deal With It?' [2010] BIS.

[6] Ibid

[7] Jaime Caruana, 'Systemic Risk: How To Deal With It?' [2010] BIS.

[8] Ibid

[9] 'The Turner Review - A Regulatory Response To The Global Banking Crisis' [2009] The Financial Services Authority.

[10] Ibid

[11] Ibid

[12] Gianni De Nicolo, Giovanni Favara and Lev Ratnovski, 'Externalities And Macroprudential Policy' [2012] SSRN Electronic Journal.

[13] Ross Cranston & Avgouleas and others, Principles Of Banking Law (Oxford University Press).

[14] Ibid

[15] 'Macroprudential Policy Tools And Frameworks' [2011] FSB, IMF, BIS.

[16] Ibid

[17] Ibid

[18] Ibid

[19] Ibid

[20] Ibid

[21] Ibid

[22] Ibid

[23] Ross Cranston & Avgouleas and others, Principles Of Banking Law (Oxford University Press).

[24] 'Macroprudential Policy Tools And Frameworks' [2011] FSB, IMF, BIS.

[25] Ibid

[26] David Llewellyn, 'The Economic Rationale For Financial Regulation' [1999] Financial Services Authority.

[27] 'Macroprudential Policy Tools And Frameworks' [2011] FSB, IMF, BIS.

[28] 'Macroprudential Policy: An Organizing Framework' [2011] INTERNATIONAL MONETARY FUND.

[29] 'Macroprudential Policy Tools And Frameworks' [2011] FSB, IMF, BIS.

[30] Ibid

[31] Ibid

[32] Ross Cranston & Avgouleas and others, Principles Of Banking Law (Oxford University Press).

[33] Ibid

[34] Ibid

[35] Ibid

[36] 'Finalising Basel III' [2017] Basel Committee on Banking Supervision.

[37] Ibid

[38] 'Finalising Basel III' [2017] Basel Committee on Banking Supervision.

[39] 'Macroprudential Policy Tools And Frameworks' [2011] FSB, IMF, BIS.

[40] Ibid

[41] 'Macroprudential Policy: An Organizing Framework' [2011] INTERNATIONAL MONETARY FUND.

[42] 'Macroprudential Policy Tools And Frameworks' [2011] FSB, IMF, BIS.

[43] Ibid

[44] 'FPC Macro-Prudential Tools' [2018] Practical Law Financial Services.

[45] 'FPC Macro-Prudential Tools' [2018] Practical Law Financial Services.

[46] Ibid

[47] 'UK Home | Investopedia' (Investopedia, 2018) <https://www.investopedia.com/> accessed 13 December 2018.

[48] Ibid

[49] Ibid

[50] John Armour, Principles Of Financial Regulation.

[51] John Armour, Principles Of Financial Regulation.

[52] Ibid

[53] Ibid

[54] Ibid

[55] 'UK Home | Investopedia' (Investopedia, 2018) <https://www.investopedia.com/> accessed 13 December 2018.

[56] Dennis Mcguirk and Fern Abrams, 'GOVERNMENT OVER-REGULATION HAS A NEGATIVE IMPACT ON THE GLOBAL COMPETITIVENESS OF U.S. MANUFACTURERS'.

[57] Codruta Boar and others, 'What Are The Effects Of Macroprudential Policies On Macroeconomic Performance?' [2017] BIS Quarterly Review.

[58] Ibid

[59] Ibid

[60] Ibid

[61] Ibid

[62] Ross Cranston & Avgouleas and others, Principles Of Banking Law (Oxford University Press).

 

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