Macro-Prudential Policy: Rationale and Key Issues

1. Macro-Prudential Policy:Rationale and Key Issues Rio de Janeiro 23 March 2012 Chief Economist Office Latin America and the Caribbean The World Bank 1

3. Structure of the presentation • Systemic oversight and macro-prudential policy • Macro-prudential policy (MPP): distinct objective, independent instrument? • The fundamental rationale for MPP • Lines of MPP defense • Issues in MPP design • Final thoughts • [Extra slides – the empirical case for MPP in LAC]

4. Systemic oversight and macro-prudential policy

5. Systemic oversight – key distinctions • Systemic oversight • “Macro-prudential” – the dynamic dimension of systemic regulation • “Micro-systemic” – the cross-section dimension of systemic regulation • “Systemic supervision” – the monitoring (and enforcement) dimension • “Micro-systemic” issues • Regulatory perimeter • Outer boundary – illuminating the shadows • Inner boundary – silos vs. universal banking license; conglomeration • The SIFI problem • Systemic supervision issues • New connections: parts to whole, through time, stability & development • Approach: top-down vs. bottom up; on-site & off-site; use of market discipline • New tools; institutional arrangements; skills

6. Macro-prudential policy Distinct objective? Independent instrument?

7. Distinct objective calls for independent instrument • Non-reducible, ultimate objective of macro-prudential policy (MPP) is to achieve sustainable financial system dynamics • Focus of MPP—enhance financial system resiliency to fluctuations (buffering) & mitigate financial-real amplification effects (dampening) • Objective of MPP is not perfectly correlated with that of monetary policy (MP) • MP objective is to coordinate and anchor agents expectations around a low and stable inflation target • The “divine coincidence” is a special (not a general) case • E.g., in the face of a negative aggregate demand shock, lowering the MP interest rate can also achieve MPP ad competitiveness objectives

8. Distinct objective  independent instrument (2) • MP can be a suboptimal tool achieve MPP objectives; conversely, MPP can overreach • Given an MPP objective, the i-rate can be inferior to an MPP instrument • An MPP instrument may be used to pursue non-MPP objectives (e.g., to deal with “fear of appreciation”), for which it is not the best tool • There is a fuzzy area where MPP and other macro objectives overlap; hence,identifying the best policy tool might not be easy • E.g., frothy capital inflows leading to excessive appreciation raise concerns about competitiveness as well as about financial system risks

9. The fundamental rationale for MPP

10. Market failure stories that justify MPP (1) • Agency and collective action frictions/failures that amplify exogenous shocks in models with rational agents • Typically modeled with rational expectations • Shock tightens constraint (say, collateral or information)  fire sales  asset/collateral prices fall  more fire sales … and so on • The un-internalized externalities of fire sales lead to socially excessive leverage & credit expansion (Jeanne & Korinek, 2011) • The amplified change in asset prices of fire sales ends up validated by changes in fundamentals, as price setting shifts • From the more to the less informed (Shleifer & Vishny, 1997) • From agents with better technologies to agents with worse ones (Kiyotaki and Moore, 1997) • From optimists to pessimists (Geanakoplos, 2009)

11. Market failure stories that justify MPP (2) • Endogenous adverse dynamics driven and amplified by cognition frictions/failures reflecting bounded rationality • Difficult to model mathematically (de Grauwe, 2009; Lo, 2009) • In the tradition of Keynes, Minsky, Kilderberger, and Shiller … • … supported by growing behavioral finance evidence (Kahneman & Tversky, 2002; Montague, 2007) • Focus is on non-reducible uncertainty, heuristically adjusted expectations, and the associated mood swings • “The market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning, yet in a sense legitimate … [because of uncertainty] … no solid basis exists for a reasonable calculation” (Keynes, 1936) • Up the cycle – exuberant euphoria, typically fueled by financial innovation • Down the cycle – panic and acute uncertainty aversion, fueled by socially costly flight to liquidity

12. Market failure stories that justify MPP (3) • The two market failure stories clearly justify MPP … • … and lead to similar policy implications, in many respects • But, in some important respects, they have very different policy implications • Buffers vs. dampeners: combating mood swings primarily implies dampening (rather than buffering) • Rules vs. discretion: mood swings are less predictable and less responsive to incentives, hence calling for more discretion • Price-based vs. quantity-based regulation: mood swings will be less responsive to price incentives such as capital charges

13. Lines of MPP defense

14. Lines of macro-prudential policy defense • Avoid contributing to amplification – don’t rock the boat • Remove pro-cyclicality in macro and traditional regulatory policy • Allow prudential buffers to be true buffers—i.e., to be used without penalty during downswings (Goodhart, 2010; Hellwig, 2010) • Remove deeper pro-cyclical factors, such as currency mismatches and social moral hazard (expectation of bailouts or “Greenspan put”) • Enhance financial system resiliency to cycle – build a better boat • Add more, cycle-dependentbuffers (liquidity and solvency) • Dampen the cycle – tame the (excess) amplitude of the waves • Emphasis on MMP instruments as dampeners • Nip the gestation of adverse amplifications in the bud • Induce the internalization of externalities (Pigovian taxes) • Prevent buildup of exuberance (approval protocols for innovations)

15. Issues in MPP design

16. Sweet spot vs. overkill • Financial cycles in part reflect fundamental factors that are themselves pro-cyclical • Investment opportunities and credit demand rise in the upswing and riskiness of borrowers truly decline • Schumpeterian creative destruction is intertwined with finance • Rapid financial expansion may just be sustainable catch-up growth—i.e., difficult to distinguish financial development trends vs. cycles • It thus makes no sense to aim at flattening the cycle altogether • The fact that only a small fraction (one in ten) of credit booms end up crashes is a warning against over-activism • The focus should be on containing the “excessive,” socially undesirable financial amplification effects and their implications

17. Buffers vs. dampeners • The focal point: stronger boats or smaller waves? • Buffers make the financial system more resilient to macro-financial turbulence (main concern of supervisors) • Dampeners limit the amplitude of macro-financial turbulence (main concern of central bankers) • The policy response • As one goes from agency frictions to externalities and to mood swings the MPP objective increasingly shifts from buffering to dampening • Buffers need to be usable in downswings  modify traditional focus on fixed, cycle-independent minimum requirements • Big research agenda to ascertain effectiveness of alternative tools • Balance sheet (capital, provisions, leverage, liquidity): primarily buffering? • Lending (LTV, DTI, RR): primarily dampening?

18. Rules vs. discretion • The focal point: automatic lower speeds or a vigilant captain • Rules limit regulatory uncertainty (hence the cost of regulation) and regulatory capture (hence the effectiveness of regulation) • But in view of uncertainties, a pure rules-based MPP can be insufficient or may introduce excessive deadweight costs • The policy response • Untested nature of instruments and mood swings stories argue for tilting the balance in favor of discretion, which is congenial to MPP dampeners • Rules are more congenial to buffers and to a world of rational agents • But discretion calls for a much bigger institutional reform agenda • Judgment-based MPP would require governance (transparency, accountability) arrangements akin to those for MP—a tall order indeed • Even more difficult for MPP compared to MP because policy costs of MPP are localized, hence are more likely to generate opposition and ill will

19. Price vs. quantities • State-dependent choices • Depend on uncertainty and the slope of the social marginal benefit curve relative to the private marginal cost curve (Weitzman 1974) • Steeper social marginal benefit => quantities (plays it safe) • Flatter social marginal benefit => prices (maximizes efficiency) • Depend on financial intermediaries’ response to incentives • Tightly-controlled system => prices (nip it in the bud) • Unsound or exuberant systems => quantities (too late for prices) • The policy response • In a world of pure agency frictions and rational agents a price-based MPP policy is likely to dominate • In a world marked by externalities and mood swings, quantities are likely to dominate, reflecting uncertainty and non-linearities at the tails

20. Specific vs. broad • Aggregate vs. institution-specific • Across the board (top-down) application based on aggregate triggers may have greater dampening effect … • … but (bottom-up) application that is differentiated by institution is less distortive – it does not punish the more prudent lenders • All types of lending vs. targeted types of lending • E.g., housing lending-focused (such as adjustable LTV and DTI ceilings) • Sector-specific interventions are better targeted to the epicenter of amplification but may be harder to calibrate, more vulnerable to circumvention, and more likely to distort credit allocation • Things are further complicated by the lack of well-defined, easy-to-agree indicators and levers for MPP • Implementation difficulties raise risk of doing more harm than good

21. Final thoughts

22. MPP – reminders as we move forward • Warnings • A strong case for MPP that is, to a significant extent, judgment-based • … but much uncertainty on effectiveness of MPP (big research agenda) • Benefits and costs of MPP materialize at different points in time • Deployment of MPP is not free of cost • Criteria • Gradual approach: use the four lines of defense in organizing strategy • Put in place a proper institutional framework for judgment-based MPP • Use MPP as a complement (not substitute) to fiscal & monetary policy • E-rate flexibility enhances MP and MPP independence • Tensions can arise: MPP can reduce the need for MP tightening and thus limit e-rate volatility, which can in turn reduce MPP independence

23. Thank you

24. Extra Slides The case for macro-prudential policy in LAC

25. Financial cycles in LAC’s history – stylized facts • Financial cycles in LAC have been quite frequent and more pronounced • Capital flow cycles more frequent, house price booms less, credit similar • Credit cycles of longer duration and greater amplitude than elsewhere • The median drop in credit per capita in peak-to-trough phases has been 18%, four time higher than in advanced countries • Credit cycles (at turning points) have tended to precede output cycles and follow asset (equity and even housing price) cycles • Unexpectedly, on average, capital flow bonanzas have been less likely to be followed by credit booms in LAC • LAC’s financial cycles have more often ended in crises • Frequency of banking crisis following credit booms has been higher • Credit booms as the best predictor of crisis, even after controls

26. The anatomy of LAC’s past financial cycles (1)

27. The anatomy of LAC’s past financial cycles (2)

28. The anatomy of LAC’s past financial cycles (3) Numbers in parenthesis represent robust standard errors. * (**) indicates that the coefficient is statistically significant at the 10 (5) percent level.

29. Financial cycles in LAC– past, present and future • What does the past say about the future for LAC? • In pre-crisis decades, the duration, amplitude and intensity of credit cycles declined across the world … • …. in LAC, accentuated by improved macro-financial “immune system” • Hence, a simple extrapolation of past macro-financial turbulence not the best guide to design future MPP for LAC … • … but the relative importance of credit cycles and the sequencing results will likely survive, given that financial structure changes slowly • What is the present adding? • “Double tailspin push” (commodity prices & capital inflows) stemming from world-wide cycle asynchronicity is interacting with still stimulative macro in LAC  credit boom formation (potential systemic risk buildup) • LAC macro constraints (fiscal rigidity, historically high i-rates, open capital account) and rising interconnectedness raise premium of MPP