Macro-prudential policy, bank systemic risk and …

1 OECD Journal: Financial Market Trends 2014 Volume 2013/2 OECD 20141 Macro-prudential policy , bank systemic riskand capital controlsbyAdrian Blundell-WignallandCaroline Roulet*The paper explores the issue of Macro-prudential policies in the light of empiricalevidence on the determinants of bank systemic risk, and the effectiveness of capitalcontrols. In many ways this reflects a step back in time towards sector approachesto monetary policy that were so prevalent in the 1960s, 1970s and early and interdependence is such that proposals on these issues should betreated with care until much more is understood about the Classification: C23, C25, F21, F43, : Macro-prudential policies, capital controls, economic growth, emergingeconomies, financial crisis.

2 * Adrian Blundell-Wignall is the Special Advisor to the OECD Secretary-General on Financial Markets andDeputy Director of the OECD Directorate of Financial and Enterprise Affairs ( ).Caroline Roulet is an OECD economist and policy analyst in the same work is publishedon the responsibility of the Secretary-General of the OECD. The opinions expressed and argumentsemployed herein are those of the author and do not necessarily reflect the official views of theOrganisation or of the governments of its member policy , bank systemic RISK AND CAPITAL CONTROLSOECD JOURNAL: FINANCIAL MARKET TRENDS VOLUME 2013/2 OECD 20142I. IntroductionThe first references to Macro-prudential policy were in closed meetings, such as in theCooke Committee in 1979,1which was the forerunner of the Basel Committee of BankingSupervision (BCBS).

3 The chairman noted that micro- prudential issues were beinginterfaced with Macro-prudential issues. The concern was about bank lending globally inthe face of high oil prices. He attempted to draw the boundary of supervisory interest asnot in the macroeconomic problems per se, but how the latter had (and could) lead to bankproblems not treatable with micro regulation. Lamfalussy around the same time explainedthat Macro-prudential issues are problems that bear on the market as a whole, and maynot be obvious in individual banks at the micro prudential level. The first publicappearances of the term were in the Euro-currency Standing Committee (ECSC) report, andin the Cross Report (BIS, 1986) where it merits an entire chapter.

4 The introduction to thereport launches into bank risks that are related to innovations, capital markets banking,derivatives, securitisation, large bank off-balance-sheet responses to investment banks,liquidity risk, and the under-pricing of risk. These developments might cause concerns such as technology failures, the evaporation of liquidity in a crisis situation, and problemswith counterparty risk that could have macro consequences and negative feedback loopson the macro economy. In short, the Cross Report sets on the table all the topics that werenever adequately dealt with in subsequent years, and which resulted in the global financialcrisis (GFC) of 2008 until the term Macro-prudential has taken on new meanings in more recent years.

5 In thelate 1990s, following the Asia crisis, the IMF focused more on the term and includedindicators for it in their Financial Sector Assessment Program (FSAP) reports. The senseappears to be for a need to monitor financial developments that might lead tomacroeconomic problems. A clearer definition of the Macro-prudential term appears inCrockett (2000), who saw two strands to it:i)the pro-cyclicality of the financial cycle, whichcalled for a build-up of cushions in good times that could be run down in bad times(stabilisers); andii)institutions having similar exposures being interconnected with eachother, which calls for the calibration of prudential tools with respect to the systemicimportance of individual institutions.

6 Crockett sees the distinction between macro - andmicro- prudential not in terms of the type of instruments, but rather in the objective of thetasks and the conception of the mechanisms influencing economic outcomes. This seems areasonable goal, but a decade or so later the FSB conceptualises it more narrowly. Inits 2011 paper on Macro-prudential policy tools and frameworks the FSB defines Macro-prudential policy as one that uses prudential tools to limit systemic or system-widefinancial risk (FSB, 2011).This is precisely where the problems start. If prudential tools are to be used for microand macro policy objectives then governance problems are going to become still, there may be conflicts in policy objectives whereby governments are lured intothe belief that if it is not politically popular to get internal and external balanceMACRO- prudential policy , bank systemic RISK AND CAPITAL CONTROLSOECD JOURNAL: FINANCIAL MARKET TRENDS VOLUME 2013/2 OECD 20143fundamentals right, then somehow these policy tools might be able to act as a way tosquare the circle.

7 There are two broad strands to these thoughts: Monetary and fiscal policy failed to prevent the financial crisis at the systemic level, sonow they are to be augmented by some prudential tools in the expectation that togetherthey can succeed. The financial crisis and policies to deal with it in advanced economies, including lowrates and quantitative easing, have had spill-over effects in emerging market economies(EMEs), and it has become fashionable to believe that perhaps capital controls can beused to resolve these paper looks first at the concept of Macro-prudential policy and the requirementsfor its successful use in Section II: identification, calibration, tools, the potential conflictsin objectives and the governance issues.

8 Section III then provides some empirical evidencepertaining to the efficacy of Macro-prudential policy to contain systemic risk in advancedeconomies, focusing on complexity and interdependence. The paper then explores theusefulness of capital controls in emerging economies as a Macro-prudential tool. Finally,some concluding remarks are provided in Section Macro-prudential tools to counter systemic OverviewThere is enormous support for the idea that asset prices and the credit cycle havestrong implications for systemic stability, and that there are limits to what inflation-focused monetary policy can achieve on its own. White (2012) focuses on the currentmonetary ease, which could have unintended consequences.

9 macro policy needs to leanmore heavily into the wind and governments should use whatever tools they have in thecurrent crisis to help restore macro equilibrium given the limits to what central banks cando. Borio (2012) reviews a wide range of literature and events and asks what we havelearned from boom bust financial cycles. He focuses particularly on the interactionbetween credit and property prices: these are associated with cycles of wide amplitude andlong duration compared to GDP, and they are inextricably linked with financial crises. Boriosuggests modelling this with new approaches to the cycle in risk attitudes which are onlyloosely linked to underlying values and fundamentals (as opposed to model-consistentexpectations in models).

10 This fits nicely with the idea of Macro-prudential policy , and theneed to build buffers in good times and to run them down in bad process of financial deregulation recognised that monetary policy cannot operatevia regulations and controls affecting sector behaviour, as used to be the case prior to theearly 1980s. This combination of interest rate policy combined with a number of the oldtools now being revived in the Macro-prudential lists, and some new ones, is in some sensea step back in time. The new Macro-prudential advocates appear to want to influencesector behaviour again, as such behaviour has been associated with systemic risks . Insome sense the belief appears to be that the old tools and re-regulation, perhaps if used ina more intelligent way, may help better to achieve macro stability objectives in the main causes of systemic risk are financial institutions that engage in three broadactivities:i)credit intermediation;ii)maturity transformation; andiii)leverage.