Macro-prudential Regulation: Cross-sectional and Time Dimension Approaches

1. BOK International Conference 2011 Comments on Macro-prudential Regulation: Where are we and Where do we need to go? 2011. 5. 26 Joon-Ho Hahm Yonsei University

2. Macro-prudential Approaches • Cross-sectional dimension • - focus on the ‘system as a whole’ • - TBTF and interconnectedness among financial institutions • - SIFI regulations: capital / liquidity surcharge, resolution, bail-in, etc. • Time dimension • - focus on the interaction between financial sector and real economy • - procyclicality • - countercyclical capital buffer, through-the-cycle risk parameters, • dynamic provisions, etc.

3. Major Points and Contributions (1) • This paper focuses on the cross-sectional dimension of macro-prudential • approach • - highlight endogenous, dynamic nature of financial risk • - Basel III approach (stronger Basel II + macro-prudential overlay) may • not be enough • - suggest a better framework: exploiting natural heterogeneity in risk • absorptive capacity of market participants • Micro-prudential approach leads to the fallacy of composition • making individuals safer may lead to a collectively riskier system • regulatory measures in micro-approach lead to endogenous risk • e.g.) risk measurement based on market prices creates procyclicality • as well as collective behaviour of financial institutions

4. Major Points and Contributions (2) • Risk is not static and depends on who holds the instrument • natural diversity of risks and market participants is a key source of • systemic resilience • ignoring and standardizing the heterogeneous risk capacity of financial • institutions may aggravate endogeneity and system instability • e.g.) mark-to-market valuation is relevant for institutions with limited risk • capacity due to short-term funding, but imposing this across the board • leads to the situation where all sell the same asset at the same time • - e.g.) too heavy credit risk measures and too little liquidity risk measures • for commercial banks while their risk absorptive capacity is the opposite • Making the system safer needs more than counter-cyclical measures

5. Major Points and Contributions (3) • Key suggestions for a better macro-prudential framework • - objective must be to minimize systemic risk subject to a given aggregate • level of individual risk-taking (required to promote economic growth) • - systemic risk can be reduced by reorganizing individual risks and • encouraging risks to flow to where there is absorptive capacity • - shift regulatory focus from risk sensitivity to risk capacity • - differentiate institutions in terms of risk capacity, and for this, need to • look more closely at the liability (funding) side • - encourage risk transfers by creating a system within which institutions • who can absorb risks have incentives to do so • e.g.) with mark-to-funding, firms with illiquid assets have incentives • to seek longer-term funding

6. Issues and Questions (1) • Agree in principle, but challenge is in actual implementation • How can we identify differential risk capacity of financial institutions? • - agree with the idea that we have to look at the liability side, namely, • the sources of funds, but may need more than this • - funding structure itself is endogenous and changing due to financial • innovation, disintermediation, and conglomeration • e.g.) wholesale and market funding of commercial banks • - risk is not static in the type of instruments but depends on ‘who holds • the claim’ (core vs. non-core liabilities) • - Korea’s experience illustrates this point (Hahm, Mishkin, Shin and • Shin 2010)

7. Bank Liabilities by Claim Holders households financial corporations non-financial corporations foreign sector Source : Joon-Ho Hahm, Frederic Mishkin, Hyun Song Shin and Kwanho Shin (2010.12) 7

8. Bank Securities held by Claim Holders financial corporations foreign sector households non-financial sector Source : Joon-Ho Hahm, Frederic Mishkin, Hyun Song Shin and Kwanho Shin (2010.12) 8

9. Issues and Questions (2) • Even more challenging task is, how can we incentivize financial firms • to better match risk-taking with their own risk absorptive capacity? • - partially reflected in Basel III global liquidity risk measures • - LCR is to promote the short-term resiliency of the liquidity risk profile of • institutions by ensuring that they have sufficient high quality liquid • resources to survive an acute stress scenario lasting for one month • - NSFR is to promote resiliency over longer-term time horizons by • creating additional incentives for banks to fund their activities with more • stable sources of funding on an ongoing structural basis • - These are liquidity risk measures, how about credit and market risks? • - macro-prudential levy or reserve requirement on non-core liabilities • can also help in this regard

10. Suggested Parameters for Liquidity Coverage Ratio (LCR)

11. Suggested Parameters for Net Stable Funding Ratio (NSFR)

12. Issues and Questions (3) • What are the implications for central bank in emerging market countries? • Central bank monetary policy can influence not only procyclicality but • also interconnectedness of the financial system • - influence risk appetite and distribution of risk by impacting profit and • net worth of financial firms, collateral value, leverage, and expectation • of bail-out (risk-taking channel of monetary policy) • - e.g.) low interest rate > money move > market funding of banks > asset • price inflation > herd behavior and concentration risk • - need to consider its impact on endogenous risk distribution when • formulating monetary policies • Central bank monetary policy and macroprudential regulations are • complementary and hence better coordination is required • - regardless of its macro-prudential mandate, central bank can bring • expertise and information in calibrating macroprudential measures

13. Issues and Questions (4) • Does emerging market country’ financial system has sufficient diversity • in risk absorptive capacity? • External liabilities of financial institutions are an important source of • interconnectedness and procyclicality in emerging market countries • raising systemic risk potential • - cause wide disparity between risk taking behavior and risk capacity • of emerging market financial institutions • - global liquidity flows also significantly undermine monetary policy • effectiveness of central bank in emerging market countries • - need a macro-prudential measure to mitigate its impact on systemic • risk • e.g.) Korea will introduce macroprudential bank levy on non-deposit • foreign currency debt of commercial banks from August 2011