Fundamentals of Macroprudential

Supervision
Bangladesh Bank Training Academy
October 2014

Glenn Tasky
Banking Supervision Advisor
(Supported by International Monetary Fund)
Bangladesh Bank
Mobile: 0175 978 4744 Email: [email protected]
 Backdrop: Global Financial Crisis, 2007-- 2014

• Beginning largely acknowledged to be 9 August 2007.

• BNP Paribas S.A., at the time France’s largest bank, stopped redemptions
from 3 investment funds it managed because it could no longer value the
holdings of mortgage-related securities that were 1/3 of the funds’ total
investments.

• Almost 7 years later, effects still being felt

– 490 banks have failed in the United States alone.
– Most expensive U.S. bank failure cost FDIC $13b to clean
up.

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 Backdrop: Global Financial Crisis, 2007-- 2014

• Total cost of cleaning up after bank failures in the United States will be
$100 billion.
• Cleaning up bank failures in some European countries pushed the national
debt up to unacceptable levels, contributing to the Eurozone crisis of 2010-
2013.
• The major problem in the crisis was LINKED failures of financial
institutions – global financial system is strongly INTERCONNECTED.

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 Backdrop: Global Financial Crisis, 2007-- 2014

• Some of the largest and most respected European and American financial
firms failed.
• Even more important, the financial crisis caused deep recessions in the
affected countries, with sharp increases in unemployment.
• Necessary to reduce the risk that a series of multiple failures of financial
institutions could occur and then affect the rest of the economy.

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 Response to Global Financial Crisis: Emphasis on
Macroprudential Supervision
The GFC was an extraordinary period of financial instability in the world
– requiring increased emphasis by regulatory authorities on financial
stability.

Definition: Financial stability – CONFIDENCE that

– Payment and clearing systems are reliable
– Repositories for safe money, such as depository institutions, are in fact
safe
– Qualified borrowers will receive credit on reasonable terms, and
– Failures among regulated financial institutions will be rare, small, and
managed in a fashion that does not create broader systemic problems.
Failures must not be linked!

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 Response to Global Financial Crisis: Emphasis on
Macroprudential Supervision
To promote financial stability, macroprudential supervision is used.
Definition: Macroprudential supervision is –
– A set of supervisory tools, and an institutional framework governing the
use of these tools, to promote SYSTEMIC financial stability and reduce
the risk of financial crises.
– These supervisory tools are often called macroprudential policies (MPP).
– The policies are aimed at limiting systemic
vulnerabilities, such as:
• Prolonged periods of substantial capital inflows
• Booming real estate markets
• Rapid credit growth

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 How is Macroprudential Supervision different from Risk-
Based (“Micro”) Prudential Supervision?

Risk-based prudential supervision (RBS) focuses on individual

institutions.
– Level and direction of various risks (capital, market, liquidity, etc.).
– Quality of risk management.
– Current and emerging threats to liquidity and capital adequacy on a
bank-by-bank basis.

Macroprudential policies (MPP) focus on the banking sector as a

whole.
– Monitor and discourage build-up of common risks.
– Monitor and discourage tight linkages.
 How is Macroprudential Supervision different from Risk-
Based (“Micro”) Prudential Supervision?

Both RBS and MPP are necessary, to promote the stability of

individual institutions, the banking (or broader financial system),
and the economy as a whole.
Sometimes the same tools are used for both. The tools are
complementary and reinforce each other.
 The Macroprudential Toolkit
These MPPs are actually in use in many Asian countries:
• Housing-related measures to “cool down” housing market, including lower caps
on loan-to-value ratios (LTVs) and debt-to- income ratios (DTIs); higher risk
weights on mortgage loans; housing- or land-related special taxes (stamp duties,
transaction taxes).
• Consumer loan measures, such as DTIs on credit cards or personal loans.
• Credit limits, such as explicit ceilings on bank credit growth or loan/deposit ratio.
 The Macroprudential Toolkit

These MPPs are actually in use in many Asian countries:

• Capital measures, such as the counter-cyclical capital buffer (CCB) and
restrictions on capital distributions.
• Dynamic provisioning, meaning an increase in the amount of required loan-loss
reserves during boom times in the economy Reserve requirements on deposits in
local currency (also a monetary policy tool)

• Other liquidity tools, such as minimum core

funding, minimum long-dated funding

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 The Macroprudential Toolkit

These MPPs are actually in use in many Asian countries:

• Measures to discourage transactions in foreign currency, such as broad limits
on liabilities denominated in FX, reserve requirements on FX deposits, higher risk
weights on FX-denominated loans
– Recognizes special risks in FX borrowing
• Increase in price of FX causes increase in total liabilities when expressed in
local $
• If deposits or borrowings by bank are owned by foreigners, risk of capital
flight

– And recognizes risk in FX lending:

• Borrowers may not be able to afford higher payments

if price of FX ↑↑

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 The Macroprudential Toolkit

Notice! We already use many of these tools in RBS. What makes them
different when used as MPP?
• In RBS, we select thresholds for these requirements and limits – LTV,
DTI, capital, liquidity, provisioning, etc. but don’t change these
thresholds.
• For MPP, we often change these thresholds, to discourage the buildup
of system wide risks.

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 The Macroprudential Toolkit – Example of Hong Kong
and Singapore -- Housing

Sometimes necessary to “cool down” housing booms:

– Between 2009 and 2011, real house prices in Singapore increased by 40%.
– Between early 2009 and late 2013, real house prices in Hong Kong rose by
90%.
– Rising house prices can cause problems:
• Banks may relax credit-granting standards, thinking that rising property values
will protect them if borrowers default (subprime crisis).
• Credit grows rapidly while credit quality drops.
• Housing becomes unaffordable for many people.
• Prices can quickly turn around and decline sharply.

Proverb: Markets go up by the stairs, down by the lift!

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 The Macroprudential Toolkit – Example of Hong
Kong and Singapore -- Housing
To “cool down” the housing booms, HKG and SIN:
– Singapore lowered LTV limits on second mortgages and very long-term
mortgages.
– Hong Kong lowered LTV limits on luxury properties, investment
properties, and borrowers with income from abroad.
– Singapore adopted DTI limit in 2013.
– Hong Kong lowered DTI limit that had been in effect since 1997.
– Hong Kong also raised risk weights on mortgages.

The measures were effective in slowing down price ↑

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 How and When to Apply MPP: The
Countercyclical Capital Buffer
How do we know when the train is going too fast, and we should apply
the “brakes”?
Important: MPP are not intended to slow down the overall economy,
although they may have that unintended effect.

Regulators look for unusually fast increases in some indicator – house

prices, ratio of credit to GDP.

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 How and When to Apply MPP: The
Countercyclical Capital Buffer
Definition: Countercyclical capital buffer is an additional number of
percentage points of required Common Equity Tier 1 (usually 2.5),
imposed during times of excessively rapid credit growth or asset price
acceleration.

• Can be activated when growth in

credit as % of GDP exceeds trend
growth, “released” when growth
falls short.
• Capital buffer is built up in good
times, protecting banks against
losses when times turn bad.

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Example of New Policy that is both RBS and MPP:
Designation of SIBs

Question: Which are the most important banks in the world? Which
ones are “Too Big to Fail”?
Answer: Banks can be ranked by a methodology that considers size,
complexity, and interconnectedness. The goal is not to rank them by
risk of failure, but by their systemic impact IF they fail. That is, which
banks would be most likely to set off a generalized financial crisis if
they failed?

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 Example of New Policy that is both RBS and MPP:
Designation of SIBs
Global Systemically Important Banks (GSIBs) as of November 2013, rank-ordered (Financial
Stability Board)

1. HSBC (UK) 12. Morgan Stanley (US) 23. Santander (Spain)

2. JP Morgan Chase (US) 13. Royal Bank of Scotland (UK) 24. Societe Generale (Fr.)

3. Barclays (UK) 14. UBS (Switz.) 25. Standard Chartered (UK)

4. BNP Paribas (France) 15. Bank of China (China) 26. State Street (US)

5. Citigroup (US) 16. Bank of New York Mellon (US) 27. Sumitomo Mitsui Financial Group (Jp.)

6. Deutsche Bank (Ger.) 17. Banco Bilbao Vizcaya Argentaria (Sp.) 28. Unicredit Group (It.)

7. Bank of America (US) 18. Banques Populaires and Caisses d’Epargne 29. Wells Fargo (US)
(Fr.)
8. Credit Suisse (Switz.) 19. Industrial and Commercial Bank of China
Ltd. (China)
9. Goldman Sachs (US) 20. ING Bank (Neth.) 8 US, 4 UK, 4 Fr., 3 Jp.,

10. Group Credit Agricole (Fr.) 21. Mizuho Financial Group (Jp.) 2 Switz., 2 China, 2 Sp.,

11. Mitsubishi Tokyo FG and UFJ (Jp.) 22. Nordea (Sweden) 1 Gr., 1 Sw., 1 It.

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 Implications of SIB designation

Just as the FSB can denote a “G-SIB,” individual regulatory authorities

should denote “D-SIBs” –domestic systemically important banks.

D-SIBs can be subject to:

– Higher capital requirements.
– More than the normal amount of
supervision (more frequent exams,
more detailed off-site monitoring, more
frequent meetings with bank
management).
– Goal is to lower the risk of failure of D-
SIB, which could cause failure of other
banks or disrupt economy.

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Take steps to lower the risk of crisis!