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«BIS Papers No 1 Marrying the macroand microprudential dimensions of financial stability Monetary and Economic Department March 2001 Papers in this ...»

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BIS Papers

No 1

Marrying the macroand microprudential

dimensions of financial


Monetary and Economic Department

March 2001

Papers in this volume were prepared for a meeting of senior officials from central banks held at the

Bank for International Settlements in October 2000. The views expressed are those of the authors and

do not necessarily reflect the views of the BIS or the central banks represented at the meeting.

Individual papers (or excerpts thereof) may be reproduced or translated with the authorisation of the authors concerned.

Requests for copies of publications, or for additions/changes to the mailing list, should be sent to:

Bank for International Settlements Information, Press & Library Services CH-4002 Basel, Switzerland E-mail: publications@bis.org Fax: (+41 61) 280 9100 and (+41 61) 280 8100 This publication is available on the BIS website (www.bis.org).

© Bank for International Settlements 2001. All rights reserved.

ISSN 1609-0381 ISBN 92-9131-615-6 Table of contents Foreword

Participants in the meeting

BIS background paper:

Claudio Borio, Craig Furfine and Philip Lowe: “Procyclicality of the financial system and financial stability: issues and policy options”

Papers presented:

Christopher Kent and Patrick D’Arcy (Reserve Bank of Australia): “Cyclical prudence credit cycles in Australia”

Markus Arpa, Irene Giulini, Andreas Ittner, Franz Pauer (Oesterreichische Nationalbank):

“The influence of macroeconomic developments on Austrian banks: implications for banking supervision”

Thierry Timmermans (National Bank of Belgium): “Monitoring the macroeconomic determinants of banking system stability”

Andrew G Haldane, Glenn Hoggarth and Victoria Saporta (Bank of England): “Assessing financial system stability, efficiency and structure at the Bank of England”

Benjamin Sahel and Jukka Vesala (European Central Bank): “Financial stability analysis using aggregated data”

Kimmo Virolainen (Bank of Finland): “Financial stability analysis at the Bank of Finland”........... 186 Laurent Clerc, Françoise Drumetz and Olivier Jaudoin (Bank of France): “To what extent are prudential and accounting arrangements pro- or countercyclical with respect to overall financial conditions?”

Christian Upper and Andreas Worms (Deutsche Bundesbank): “Estimating bilateral exposures in the German interbank market: is there a danger of contagion?”

Eddie Yue (Hong Kong Monetary Authority): “Marrying the micro- and macro-prudential dimensions of financial stability - the Hong Kong experience”

Massimo Sbracia and Andrea Zaghini (Bank of Italy): “Crises and contagion: the role of the banking system”

Shigenori Shiratsuka (Bank of Japan): “Asset prices, financial stability and monetary policy:

based on Japan’s experience of the asset price bubble”

Pascual O’Dogherty and Moisés J Schwartz (Bank of Mexico): “Prudential regulation of foreign exchange: the Mexican experience”

Henriëtte Prast and Marc de Vor (Netherlands Bank): “News filtering, financial instability and the euro”

Øyvind Eitrheim and Bjarne Gulbrandsen (Bank of Norway): “A model based approach to analysing financial stability”

Santiago Fernández de Lis, Jorge Martínez Pagés and Jesús Saurina (Bank of Spain):

“Credit growth, problem loans and credit risk provisioning in Spain”

Christian Braun (Swiss National Bank): “The cost of a guarantee for bank liabilities:

revisiting Merton”

William Nelson and Wayne Passmore (Federal Reserve System): “Pragmatic monitoring of financial stability”

BIS Papers No 1 Foreword

On 9-10 October 2000, the BIS hosted its annual autumn meeting of central bank economists. The topic of the meeting was “Marrying the macro- and microprudential dimensions of financial stability”.

With a view to stimulating debate on and study of this important topic, this volume makes available the

papers discussed at the meeting. These papers address three broad policy questions:

(i) How do central banks monitor the risk of financial instability?

(ii) What mechanisms amplify or dampen financial cycles?

(iii) How should policymakers respond to developments that pose a threat to the stability of the financial system?

Recent years have seen central banks pay increased attention to monitoring the risk of financial instability. As the papers in this volume illustrate, the approaches adopted by various central banks have much in common, although there are certain important differences. Some central banks rely mainly on aggregate macroeconomic and prudential data, while others make extensive use of supervisory data on individual financial institutions. Moreover, some central banks rely heavily on models of the financial sector, while others use a more eclectic approach. Overall, the work on indicators of financial stability has led to a more focussed analysis and a greater understanding of the aggregate risks to the financial system, even if it has not led to the development of a simple indicator of financial stability.

A theme that pervades a number of the papers in the volume is the recurrence of financial cycles.

These cycles are often characterised by rapid increases in credit and asset prices, and often end with some form of financial system stress. The papers discuss the factors driving these cycles, including the tendency for assessments of and attitudes to risk to be procyclical, incentive structures that encourage short-termism and the nature of regulatory arrangements. One important issue addressed in some of the papers is the tendency for bank provisioning to be backward looking. This tendency reflects both accounting rules and the methodologies that are used by banks to assess risk. Another important issue is the role of contagion in amplifying the downswing of the financial cycle.

The papers identify a number of policy options for dealing with the build up of systemic risk. The first is public discussion by the official sector of the nature of risks facing the financial system. The second is to use regulatory and supervisory policies in a countercyclical fashion or, less ambitiously, to make the financial system more robust to financial shocks. The third is to use monetary policy in an effort to constrain the development of financial imbalances that have the potential to cause financial and macroeconomic instability. The various papers discuss the advantages and disadvantages of each of these types of policies. One common consideration is the ability of policymakers to identify changes in risk sufficiently well to be able to respond. Another is the possible creation of moral hazard if the authorities systematically respond to changes in risk over time. A third important issue is the need to coordinate policy responses amongst authorities with different responsibilities.

–  –  –

1. Introduction

In recent decades, developments in the financial sector have played a major role in shaping macroeconomic outcomes in a wide range of countries. Financial developments have reinforced the momentum of underlying economic cycles, and in some cases have led to extreme swings in economic activity and a complete breakdown in the normal linkages between savers and investors.

These experiences have led to concerns that the financial system is excessively procyclical, unnecessarily amplifying swings in the real economy. In turn, these concerns have prompted calls for changes in prudential regulation, accounting standards, risk measurement practices and the conduct of monetary policy in an attempt to enhance both financial system and macroeconomic stability.

In this paper, we examine these concerns and discuss possible options for policy responses. It is not our intention to formally model the complex interactions between the financial system, the macroeconomy and economic policy. Rather, we have the more modest goal of stimulating discussion on some of the key linkages between developments in the financial system and the business cycle.

Our main focus is on the intrinsically difficult issues of how risk moves over the course of a business cycle and on how policymakers might respond to reduce the risk of financial instability, and attendant macroeconomic costs, that can arise from the financial system’s procyclicality.

A common explanation for the procyclicality of the financial system has its roots in information asymmetries between borrowers and lenders. When economic conditions are depressed and collateral values are low, information asymmetries can mean that even borrowers with profitable projects find it difficult to obtain funding. When economic conditions improve and collateral values rise, these firms are able to gain access to external finance and this adds to the economic stimulus. This explanation of economic and financial cycles is often known as the “financial accelerator”.

While the financial accelerator presumably plays a role in all business cycles, it is not sufficient to generate the widespread financial instability that periodically leads to very large swings in economic activity. In this paper, we argue that an additional material source of financial procyclicality is the inappropriate responses by financial market participants to changes in risk over time. These inappropriate responses are caused mainly by difficulties in measuring the time dimension of risk, but they also derive from market participants having incentives to react to risk, even if correctly measured, in ways that are socially suboptimal.

The measurement difficulties often lead to risk being underestimated in booms and overestimated in recessions. In a boom, this contributes to excessively rapid credit growth, to inflated collateral values, to artificially low lending spreads, and to financial institutions holding relatively low capital and provisions. In recessions, when risk and loan defaults are assessed to be high, the reverse tends to be the case. In some, although not all, business cycles these financial developments are powerful amplifying factors, playing perhaps the major role in extending the boom and increasing the severity and length of the downturn. We argue that the worst excesses of these financial cycles could be We would like to thank Joe Bisignano, Bill Coen, Renato Filosa, Stefan Gerlach, Bengt Mettinger, Bill White and, in particular, Kostas Tsatsaronis for their helpful comments. We are also grateful to the central banks that provided us with data and comments. Thanks are also due to Philippe Hainaut and Marc Klau for valuable research assistance. The views expressed are those of the authors and do not necessarily reflect those of the BIS.

It has a long history, reaching back at least to Fisher (1933), and has recently been subject to extensive theoretical modelling by, amongst others, Bernanke and Gertler (1995) and Kiyotaki and Moore (1997). For a recent survey, see Bernanke et al (1999).

In recent times, although from a somewhat different perspective, the role of financial excesses has been stressed by, amongst others, Kindleberger (1996) and (1995) and Minsky (1982).

BIS Papers No 1 1 mitigated by increased recognition of the build up of risk in economic booms and the recognition that the materialisation of bad loans in recessions need not imply an increase in risk.

These measurement biases, which we argue go hand in hand with economic agents being better at measuring relative than absolute risk, can arise from a variety of sources. One such source is difficulties in forecasting overall economic activity and the link with credit losses; difficulties in assessing how correlations of credit losses across borrowers and, more generally, across institutions in the financial system change over time are part and parcel of the same problem. This tends to contribute to excessively short horizons and to an extrapolation of current conditions into the future.

The short-term focus is also encouraged by incentive structures that reward short-term performance, and by certain aspects of accounting and regulatory arrangements. We argue that good risk management requires both a horizon for measuring risk that is longer than one year – the typical industry practice – and a consideration of system-wide developments. Not only would such an approach contribute to the soundness of individual institutions, it would also reduce the financial amplification of economic cycles.

Looking forward, proposed changes to the way in which bank capital is regulated are likely to increase the importance of accurately measuring changes in the absolute level of risk. The proposed changes are primarily designed to rectify current problems with relative capital charges. They represent a major step forward in aligning regulatory capital charges with the relative riskiness of banks’ credit exposures (eg public sector versus private sector, high- versus low-risk corporates). As such, they significantly strengthen the soundness of individual institutions. At the same time, the proposed changes will naturally result in capital requirements on a given portfolio changing over time, as the assessed risk of that portfolio evolves. If risk is measured accurately, this has the potential to further enhance banks’ soundness and reduce the procyclicality of the financial system. However, exploiting this additional potential arguably calls for improvements in current risk measurement practices and/or greater reliance on the supervisory review process. The New Basel Capital Accord, which proposes a strengthening of the supervisory review process, could provide a sounder basis for such increased reliance.

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