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To insert your company logo on this slide • From the Insert Menu • Select “Picture” • Locate your logo file • Click OK • To resize the logo • Click anywhere inside the logo. The boxes that appear outside the logo are known as “resize handles.” • Use these to resize the object. • If you hold down the shift key before using the resize handles, you will maintain the proportions of the object you wish to resize. Macro-prudential Approach (Regulation and Supervision) Bam Bahadur Mishra Deputy Director, NRB
Disease Identification With the failure of Lehman Brothers in US, and Northern Rock in the UK, the financial system in the US and the EU came close to a complete meltdown and raised the question on the current financial regulations and supervision. • This has initiated focus on discussing macro-prudential regulation and supervision commonly known as macro-prudential surveillance approach in reforming the present incumbent regulations.
Disease Identification • Micro-prudential refers to the Basel II type of regulation that focuses on risk-taking behavior of individual financial institutions. After the crisis, some adepts have criticized, "Basel II is based on a flawed sophism of composition: promoting the soundness of individual banks in disseminating the “best practices” of optimal risk management is supposed to ensure ipso factooverall financial stability
Symptoms of Disease • We cannot make the financial system safe merely by making specific financial institution and product safe. We have spent many years tightening up micro-prudential regulation and yet financial crashes are still prevailing. Financial crisis do not occur randomly, but always follow booms. The cycle of financial boom and crash implies there is something “macro” going on; and needs to address separately.
Report from the Pathology Lab • A common source of macro-prudential risk is common behavior by financial firms; often because of close adherence to micro-prudential rules. During booms, asset prices rise and measured risks appear to fall. Acting prudently, financial firms will feel it is safe to expand lending. All financial firms expanding together will lead to a increase for assets price that will lead to unsustainable valuations and lending .
Report from the Pathology lab A. Persaud, in his paper “Sending the herd off the cliff edge” has mentioned how all financial firms responding to common, prudential, market-based risk controls would lead them all to want to sell the same assets at the same time, creating a liquidity black hole i.e. massive crisis in the system".
Macro-prudential Vs Micro-prudential • Basel II is a purely micro-prudential device, which became unable to address the systemic risks in financial sector resulting in collapse of banks. Basel II has created a new risk of “false sense of security” that has been widespread and all supervisors round the globe have been perplexed • Macro-prudential regulation concerns itself with the stability of the financial system as a whole whereas, micro-prudential regulation, consisting of measures as the certification of those working in the financial sector (regulators and supervisors) on how financial institutions operate, concerns itself with the stability of individual entity and the protection of individual only.
Macro-prudential Vs Micro-prudential • Micro-prudential regulation concerns itself with the stability of individual institutions. Micro-prudential regulation examines the responses of an individual bank to exogenous risks. • By construction it does not incorporate endogenous risk. It also ignores the systemic importance of individual institutions such as size, degree of leverage and interconnectedness with the rest of the system.
All but not the whole • In trying to make themselves safer, banks, and other highly leveraged financial intermediaries, can behave in a way that collectively undermines the system. (Fallacy of Composition) • Selling an asset when it appears to berisky may be considered a prudent response foran individual bank and is supported by muchcurrent regulation. • But if many banks do this,the asset price will collapse, forcing risk-averseinstitutions to sell more and leading to generaldeclines in asset prices, higher correlations andvolatility across markets, spiraling losses, andcollapsing liquidity. Micro-prudential behaviorcan cause or worsen systemic risks. As a result, risk is endogenous.
Need of Macro-prudential Approach Monetary policy and micro-prudential regulation are limited in their ability to control the credit supply at the systemic level and to translate systemic risk warnings into policy actions. The adoption of a macro-prudential approach would offer the authorities a means of better protecting the economy against the consequences of financial instability so as to maintain the essential services banks provide to the real economy through otherwise severe economic disturbances.
Need of Macro-prudential Approach • The need for a macro-prudential regime should not, however, obscure the fact that it is not sufficient in itself. Without a holistic approach, which recognizes shortcomings in monetary policy, fundamental economic imbalances, the need for sustainable fiscal policy and effective micro supervision, macro-prudential regulation, however well designed, intentioned and implemented is unlikely to prevent a future crisis occurring.
Objectives of Macro-prudential Approach • The objectives of macro-prudential policy can be broadly or narrowly defined along a continuum at one end of which lies the stability of individual financial institutions and, at the other, the prevention of asset bubble emerging. Our view is that there is a balance to be struck between the two. The objective should be more ambitious than simply increasing the resilience of firms; the targeting of asset prices bubbles should be part of the regime but not its overriding objective. A part of its role should be to 'join up the dots' of micro supervision as well as look at wider macroeconomic risks.
Definition • C. Borio defines macro-prudential surveillance as: “Policy that focuses on the financial system as a whole, and also treats aggregate risk as endogenous with regard to collective behavior of institutions. It aims to limit system-wide distress so as to avoid output costs associated with financial instability”. This definition focuses on monitoring of conjuncture and structural trends in financial markets so as to give warning of any proximity of financial instability and this should become a core activity for the apex body of financial sector.
Fundamentals • Macro-prudential approach is about encouraging different behavior than a prudent firm would follow. The prudential behavior followed by a firm is that it will follow what others are doing in the existing market and market condition. Macro-prudential regulation is different from what prudent firms are doing in general condition. It contradicts following the bullish behavior in any stock market.
Fundamentals Goodhart mentions that “A classic macro-prudential tool is to raise capital adequacy requirements, not for all times, but specifically when aggregate borrowing in an economy or a sector is above average in an attempt to put sand in the systemically dangerous spiral of rising asset prices leading to rising borrowing to buy assets, leading to rising asset prices.”This will not end boom-bust cycles, but it will help to reduce their magnitude.
Mechanism • Another macro-prudential Mechanism would be to take a holistic approach to financial regulation and encourage certain risks to flow to places with a capacity for that risk. When the crash comes, firms that can absorb short-term liquidity risks (with long term funding), are not forced to join the selling frenzy in the name of common prudential rules, but are more able to buy and diversify liquidity risks across time. This would forestall the implosion of the financial system that would occur if there are no buyers, only sellers
Naked Swimming. • Warren Buffett says, “you see who is swimming naked only when the tide runs out”. He probably means that while fraud and unethical practices are going on all the time, they become visible only when the veil of rising market prices is removed. They are not the cause of the tide going out; they are merely revealed by it. We must continue to clamp down on fraud and ethical abuses and promote transparency, but this is not enough to avoid crises. We cannot avoid crises without avoiding the booms.
Naked Swimming • Booms are always underpinned by a good story explaining why it is prudent for individual institutions to lend more. Micro-prudential regulation is not enough; it must be supplemented by macro-prudential regulation that catches the systemic consequences of all institutions acting in a similar manner. While we cannot hope to prevent crises, we can perhaps make them fewer and milder by adopting and implementing better regulation; in particular, more macro-prudential regulation.
Tools • The tools to implement a macro-prudential regime will be dependant upon its objectives. Tools can be broadly divided into those which impact the asset and the liability sides of the balance sheet. The decision on which to adopt should be based upon thorough analysis and an understanding of the trade-offs involved in terms of the impact on individual businesses, households and the economy overall. It is critical that the debate is conducted internationally.There are many precedents from round the globe where specific macro-prudential measures have been employed. Lessons can be learnt from these. • Perhaps more fundamentally, the quality of economic statistics needs to be improved so that policy decisions are based on an accurate picture of what is really going on.
Tools • The regulatory tools may be familiar, butmacro-prudential policy applies themdifferently. • For example, regulatory capital requirements would rise with aninstitution’s contribution to systemic risk. That contribution depends on anintermediary’s interconnectedness and the riskiness of its balance sheet, and isoften correlated with its size. • To be effective in limiting systemic threats, aregulatory capital surcharge probably would rise more than proportionally to afirm’s systemic risk contribution.
References • Macro-Prudential Regulation, ECMI Commentary No. 25/4 August 2009; Avinash Persaud • A Framework for Macroprudential Banking Regulation September 2005 : Jean-Charles Rochet • Why the micro-prudential regulation fails? The impact on systemic risk by imposing a capital requirement: DNB working paper July 2010. • Macro-prudential and micro-prudential regulation: The Warwick Commission • A systemic approach to financial regulation – European perspective.2009 • Rethinking Micro and macro-prudential supervision, Financial services Research 2009; Christopher Finger. • A possible Macro-prudential approach, July 2010; British Bankers’ Association.
