Key Aspects of Macroprudential Policies:IMF frameworks and experiences

Chikako BabaMonetary and Capital Markets Department

International Monetary Fund

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November 2, 2017Joint IMF-FED-WB seminar for EM Senior Bank Supervisors

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Roadmap

I. Macroprudential policy framework IMF 2013 (Key Aspects of Macroprudential Policy);

IMF 2014 (Staff Guidance Note); and

IMF-FSB-BIS 2016 (Elements of Effective Macroprudential Policy)

II. Capital flows and macroprudential policies IMF 2012 (Institutional View);

IMF 2017 (Increasing Resilience to Large and Volatile Capital Flows: the Role of Macroprudential Policies)

III. Ongoing work

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I. Macroprudential Policy: IMF framework and experiences

1. Definition and rationale2. Challenges for effective macroprudential policy 3. The need for strong institutional foundations4. Operational considerations

Why macroprudential policy?4

Macro-

Financial Stability

Systemic Risk

Macroprudential

Policy

Price Stability

Economic Activity

Macroeconomic

Policies

(monetary/fiscal/

external)

Idiosyncratic Risk

Microprudential

Policy

Prudential

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Increasing use of macroprudential tools

Definition and Objectives6

DEFINITION

• Use of primarily prudential tools to limit systemic risk

SYSTEMIC RISK

• Risk of widespread disruption to the provision of financial services that can cause serious negative consequences for the real economy

Ultimate Objective

• Reduce the frequency and severity of financial crises

Intermediate Objectives

• Increase resilience of financial system to aggregate systemic shocks• Contain build-up of systemic vulnerabilities over time• Control structural vulnerabilities within the financial system

Scope

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Risks across the financial system as a whole Interactions within the system and with the real economy Focus: typically banks. Recently, non-bank financial sector too.

Complex boundaries and interactions with other policies Microprudential regulation and supervision, crisis

management and resolution, monetary and fiscal policies etc. Both complementarities and tensions

Macroprudential policies should not be overburdened

Potential overlaps with capital flow management measures (CFMs)

Challenge 1: Inaction bias8

Macroprudential policy is subject to biases that favor inaction or insufficiently forceful and timely action (IMF 2011, Nier 2011)

Because macroprudential policy manages a tail risk The benefits of action accrue in the future and are difficult to

measure

The costs of actions are more visible and felt immediately, by financial firms and borrowers.

Biases are compounded when macroprudential policy is subject to lobbying by the financial industry

political pressures

Challenge 2: Dynamic Evolution9

The financial system evolves dynamically; the level, source, and distribution of systemic risk are subject

to change.

…in response to financial innovations (technological innovations)

regulatory constraints (leakage problem)

distortions caused by other policies (e.g., fiscal distortions that favor debt)

Dynamic evolution can open up “policy gaps” and requires the coordination across policy fields. Need for coordination can reinforce inaction bias.

Principles for Effective Institutional Arrangements

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Institutional arrangements designed to: Foster willingness to act

Ensure ability to act

Promote effective cooperation in risk assessments and mitigation

Main elements 1. Mandate and governance

2. Transparency and accountability

3. Powers

Institutional foundations: Mandate and governance

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A clear mandate forms the basis of the assignment of responsibility for macroprudential policy

bank

Each institutional model has its own pros and cons…

… but they generally rely on the central bank having an important role, given its expertise, incentives to take action and independence

• Czech Republic, Ireland, New Zealand, Serbia, Singapore, ECB

Model 1.

Integrated

in the Central Bank

• UK, Malaysia, Thailand, RomaniaModel 2.

Dedicated committee within the central bank

• United States, Germany, TurkeyModel 3.

Committee outside the central bank

Institutional foundations:Transparency and accountability

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Clear objectives reduce the risk of inaction Transparency mechanisms can establish

legitimacy and create commitment to take action Important communications tools are

a policy strategy,

regular assessments of risk and effectiveness of measures taken,

records of the meetings of macroprudential policymakers.

Communication can

establish and maintain a commitment to take action

create a political constituency for macroprudential action

create a narrative that prepares for additional action

Institutional foundations:Powers

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Powers needed to: Obtain information from other authorities Influence activation and calibration of regulatory tools Influence designation of systemically important institutions Initiate changes in regulatory perimeter to capture financial activities

that may give rise to financial stability risks

Strength of such powers

Effectiveness of policy framework may benefit from combination of these powers

Hard

• Direct control over tools or action

Semi-hard

• Formal recommendations to other regulatory authorities to take action, with a comply-or-explain mechanism

Soft

• Express opinion, warning, or recommendation not subject to comply-or-explain

Operational considerations: (1) Analyzing and monitoring systemic risk

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Typical areas to assess build-up of risks

Multiple early warning indicators considered useful to assess vulnerabilities before emergence of stress… Credit-to-GDP gap, mortgage debt, house prices etc. Can be combined with other indicators

… but none of these metrics can be used mechanically Part of broader risk assessment process (“guided discretion”)

Time dimension• Excessive growth in total credit or asset prices• Sectoral vulnerabilities (credit to household or corporate sector)• Maturity and foreign currency mismatches

Structural dimension • Linkages within and across intermediaries and market infrastructures

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Mapping assessment to policy tools

Broad-based(Capital) Tools

Sectoral Tools(Households,

Housing sector)

Sectoral Tools(Corporate)

Liquidity Tools

Core indicators

•Credit/GDP gap

• Increase in the share of mortgage loans to total credit

• Mortgage loan growth

• House price/income and rent

• Increase in the share of corporate loans to total credit

• Corporate loan growth

• Increase in loan-to-deposit ratio

• Increase in non-core-to-core funding ratio

Additional indicators

… … … …

Example: Indicators for Activation of CCB

Core and Additional Indicators

Core indicators

• Credit-to-GDP gap

Additional indicators

• Credit growth (m-o-m and y-o-y change)

• Debt levels and debt service ratios of households and corporates

• Asset price growth, house prices-to-income and rent

• Leverage on individual loans or at the asset level (e.g. loan-to-

value (LTV) - on average and the distribution across new loans

• Decomposition between core and non-core liabilities and the

wholesale funding ratio

• Current account deficits

Using multiple indicators17

Evaluation of core indicators should be com-plemented by additional indicators to support a judgment on the need for policy action. When multiple indicators are flashing “red”, there is a strong case

for activating measures, even if this decision should be based on judgment.

When some indicators are flashing “red,” and others “green,” consideration can also be given to alternative policy actions.

E.g., when house prices rise, but mortgage lending is subdued, this can point to supply constraints and the need for structural measures

When most indicators are yellow, this points to a gradual approach to the activation of measures, e.g., initial non-binding guidance or partial tightening of tools.

Where information to construct indicators is missing (“no light”), the emphasis is on the collection of the relevant data.

Operational consideration: (2) Identifying and establishing macroprudential policy tools

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A broad range of tools may be needed Access to comprehensive toolkit on ex-ante basis allows timely

application of relevant tools

Policies also being developed to address financial stability risks from outside the banking sector

Broad-based capital tools

e.g. dynamic provisioning,

countercyclical capital buffer, time-varying leverage ratio caps, macro-

supervisory stress tests

Sectoral capital and asset-side

tools

e.g. sector capital requirements/risk weight floors, caps

on share of exposures to

specific sectors, LTV/DSTI/LTI

ratios

Liquidity-related tools

e.g. differentiated reserve

requirements, LCR variants, core

funding ratio caps, levies on volatile

funding, LTD ratio caps

Structural risks

e.g. capital surcharges for

D/G-SIFIs, extra loss absorbency requirements, changes in risk

weights and large exposure limits

Operational consideration: (3) Operationalizing use of tools

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This involves translating the assessment of systemic risks to policy action by: Calibrating policy responses to risks

Considering costs and benefits (ex-ante)

Assessing and addressing leakages

Evaluating effectiveness (ex-post)

Considering the potential for tools to be relaxed

Improving the information base

Implementing and tightening20

The implementation of tools should aim to ensure the effective and efficient use of macroprudential policy. The aim is for benefits to be realized in a manner that considers adjustment costs to the financial industry;

balance sheet constraints require phase-in; should be tightened in “good times”

efficiency costs for borrowers from a reduction in the provision of financial services; can be minimized by well-targeted approaches (e.g., tighter LTV limits for

speculative buyers)

costs to output growth; effects of some tools on output can be large (esp. LTV and DSTI); a gradual

approach can mitigate the costs.

Well-tailored design and a gradual approach to the tightening of tools can help achieve benefits while avoiding costs.

Implementing and tightening (ctd.)21

Use of multiple tools can increase effectiveness.

The marginal benefit of tightening any one tool will eventually decrease due to increased distortions and incentives for circumvention.

The use of complementary tools can mitigate such effects, increasing the desired impact of macroprudential action.

Effects of tools on indicators should be monitored in real time, to gauge effectiveness and need for recalibration.

Assessing and addressing leakages22

Whenever prudential tools are binding, financial activity tends to migrate (“leak”) out of the regulated sector (“boundary problem”).

In principle, both domestic leakages (to non-banks) and cross-border leakage can be addressed by expanding the scope of macroprudential intervention. To non-bank providers of credit (by expanding the perimeter of

macroprudential intervention) To foreign providers of credit (e.g. “reciprocity”, greater “host

control” of branches, targeted CFMs)

The scope for and strategies to address leakages can differ across macroprudential tools. E.g. cross-border leakage less of an issue for retail loans (and LTV

type measures), but more likely for corporate credit.

Relaxing macroprudential tools23

Macroprudential policy tools can be relaxed when financial risks dissipate. A relaxation of macroprudential tools should be considered when the

costs of keeping them in place outweigh their benefits.

A relaxation of time-varying tools can also be called forin periods of financial stress. To help avoid a vicious feedback between deteriorating economic and

financial conditions that depresses economic activity

especially when macroprudential constraints are binding on the supply of credit.

A relaxation needs to respect prudential minima that can ensure an appropriate degree of resilience against future shocks.

Buffers need to be built-up in good times.

Relaxing macroprudential tools (ctd)24

A softening of aggregate demand is not sufficient to justify a relaxation of macroprudential tools. Financial imbalances can keep growing through an episode of a cyclical

downturn in aggregate demand

A relaxation of macroprudential policy tools should be considered if systemic risk materializes. As financial conditions tighten, this can drag down real economic activity

with it, creating a vicious feedback, with financial and real cycles moving in lock-step.

Business cycle

Financial cycle

Not a time for relaxation

Time for relaxation

Time

Cycle

Relaxing macroprudential tools (ctd)25

Gauging the case for relaxation requires judgment.

Indicators for relaxation can differ across tools. Liquidity tools:

Early signs of liquidity stress within the system that may lead to fire-sales:

increases in the price of wholesale funding, increased access to central bank lending facilities

Broad-based and sector-specific capital tools: Early signs of an incipient credit crunch:

sharply slowing credit growth, market indicators, incipient increases in NPLs.

Tools specific to the residential property market (such as LTV and DSTI): Early signs of a vicious cycle between falling house prices, falling credit and

rising defaults:

falling prices, sharply slowing credit, and deteriorating borrower balance sheets

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II. Increasing Resilience to Large and Volatile Capital Flows:

The Role of Macroprudential Policies

Capital Flows and Systemic Risk: Transmission Channels

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Effects on Credit Growth and Asset Prices28

Capital inflow surges may fund credit booms Surges dominated by debt (especially bank) inflows

more likely to end in financial crises than other inflow surges (Calderon and Kubota, 2012)

Inflow surges can exert upward pressure on asset prices

Increases in asset prices magnify credit booms via financial accelerator effects

Portfolio debt flows depress yields and lead to risk-taking incentives

But weaker effect on credit growth for portfolio equity flows and weak or negative effects from FDI flows

Capital Flows and Credit Growth29

Co-movement between capital (in particular debt) flows and credit growth in both AEs and EMs

Especially strong for gross (rather than net) capital flows

-10

-5

0

5

10

15

20

-2

-1

0

1

2

3

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

Net inflows (in percent of GDP)

Change in credit in percent of GDP (rhs)

Net Capital Inflows vs Changes in Credit

-10

-5

0

5

10

15

20

-10

-5

0

5

10

15

20

25

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

Gross inflows (in percent of GDP)

Change in credit in percent of GDP (rhs)

Gross Capital Inflows vs Changes in Credit

Effects through Exchange Rates30

Credit risks from unhedged FX loans may build up Interest rate differentials and/or expected currency appreciation can

incentivize household and corporate FX borrowing from local banks

Strong correlation between capital flows and the share of foreign currency lending (Basso et al 2007, Ostry et al 2012).

Risks may materialize when capital flows reverse and the exchange rate depreciates A sharp depreciation may leave unhedged borrowers unable to service their

FX loans.

Even if intermediaries are fully hedged, unhedged final debtors can create credit risk for intermediaries

Effects on Non-core and FX Funding 31

Under favorable external conditions, domestic banks may raise funding through “non-core” (wholesale) liabilities – including funding in FX

This gives banks further room to extend credit, leading to increases in loans to deposits

May also increase maturity mismatches, making banks vulnerable to funding risks, especially when funding is in FX (e.g. Korea).

Rollover risk may materialize when external conditions worsen

Macroprudential policy: objectives32

Intermediate objectives:

Increase the resilience of the financial system

Contain the build-up of systemic risk over time

Macroprudential policies can help countries better weather capital flow volatility if and when it arises.

Policy approach should be well calibrated to contain systemic vulnerabilities.

Macroprudential Policy Tools and Transmissions

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• e.g. countercyclical capital buffer, leverage ratio caps, macroprudential stress tests

Broad based tools

• e.g. LTV, DTI, sectoral capital requirement (including tighter req. for unhedged FX credit)

Sectoral tools (household and corporate)

• e.g. NSFR, LCR, liquidity charges• Including currency differentiated

tools (e.g. LCR, NSFR, reserve req.)

Liquidity tools

• e.g. Caps on interbank exposures, changes to market structure

Structural MPP

Reduce interconnectedness

More resilient funding structure

Increase resilience to shocks Contain excessive credit growth

Lower currency or maturity mismatches

Resilience

Procyclicality

Effectiveness - Synopsis34

Growing evidence that macroprudential policy tools can increase resilience (IMF-FSB-BIS 2016), across all macroprudential tools (capital buffers, LTV/DTI, liquidity

tools)

Ability to contain procyclical dynamics between asset prices and credit differs across tools. Borrower-based tools (LTV/DTI) more effective at containing

excessive credit than capital tools

Effectiveness of some tools limited by

Domestic leakage (provision of credit by non-banks)

Cross-border leakage (provision of credit from abroad)

Shift from bank-based towards market-based funding

Especially when corporates are able to borrow from abroad and through markets

Strategies to Increase Effectiveness 35

Reciprocity arrangements

under Basel III, home authorities of cross-border banks impose the same capital buffer on cross-border exposures

Source country policies

policies to reduce redemption risks from investment funds, as proposed by the FSB

policies to limit large exposures to individual counterparties, and thereby risks from interconnectedness including across borders

Role of MPMs in Mitigating Systemic Risks Associated with Outflows

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Capital outflows should be handled primarily with macroeconomic, structural, and financial sector policies

Outflow controls a last resort: only in crisis situations or when a crisis is imminent

The potential to relax MPMs can give countries an additional set of tools to respond to outflow-related risks, although decisions on relaxation needs to recognize trade-offs.

Role of MPMs in Mitigating Systemic Risks Associated with Outflows

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Relaxation of MPMs can be considered when (IMF 2014): Buffers are in place

Outflows are generating financial stress

Expectation that releasing the available buffer(s) will work to relieve financial stress and support provision of credit

Trade-offs needs to be considered carefully, as relaxation can reduce resilience to future shocks, and should consider the need to maintain confidence and regulatory minima Building larger buffers ex ante can create policy space

What is the Role of Macroprudential Policy in the Process of Liberalization?

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Greater capital flow liberalization should be supported by a progressive strengthening of capacity to deploy macroprudential tools. along the sequence of steps envisaged under the integrated approach.

in particular, in the context of the liberalization of banking and portfolio debt flows

The capacity to deploy tools effectively requires adequate institutional arrangements and toolkits, as well as information to assess risks and calibrate policy tools appropriately.

Where supervisory capacity or relevant data to operationalize macroprudential policy are lacking, this would argue for caution with further liberalization.

The Integrated Approach to Capital Account Liberalization (IMF, 2012)

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LiberalizeFDI inflows

Greater

liberalization Cap

ital

Flo

w

Lib

eral

izat

ion

Support

ing

Ref

orm

s

Greater Liberalization

Revise legal framework

Improve accounting and statistics

Strengthen systemic liquidity arrangements,

related monetary and exchange operations

Strengthen prudential regulation

and supervision, risk management

Restructure financial and corporate sectors

Develop capital markets, including

pension funds

Liberalize

FDI outflows,

other LT and

some ST flows

Including macroprudential policy capacity

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III. Ongoing work

Closing information gaps41

Information gaps can hinder all of: detection of risks; design of measures; monitoring of migration of

activity.

Examples of common information gaps: House price data

Granular data on household indebtedness (actual LTV/ LTI)

FX exposures of the corporate sector

Exposures and funding links within the financial system

in particular between the regulated and unregulated sectors

Activities of non-bank institutions

Macroprudential authorities need to close data gaps that impede analysis and mitigation of risks. Supervisory data, survey data, credit registers

Macroprudential database42

IMF-FSB-BIS 2016 stocktaking of experiences and lessons

But: no consistent and regularly updated source of information on macroprudential measures

No such database at all on institutional setups

G20: important data gap also for policymakers and researchers

IMF: to develop an annual and global survey, in collaboration with FSB and BIS. Building on 2013 IMF (GMPI) database

To be sent to all (189) members every year, as part of the AREAER updates

Database publicly available in Q1 2018

Benefits43

For policymakers:

as experience accumulates, policymakers can learn about policy measures taken elsewhere

For researchers:

database can be used to analyze domestic effects (on credit and asset prices) and spillovers to other countries

For IMF staff:

can be a useful source of information on measures taken by a country and measures taken elsewhere

But: survey is not formally part of mandatory surveillance:

Survey is voluntary

Database: scope and design44

Framing: macroprudential policy? “use of primarily prudential tools to contain systemic risk”,

IMF 2013, IMF-FSB-BIS 2016

Granular list of measures, covering designs discussed in IMF 2014. Respondents asked to “tick” yes/ no

Respondents to provide more detailed description of design, calibration and timing (announcement and effective dates)

Back data on measures taken since 2011

Also basic information on institutional arrangements

Database: process and next steps45

Aligned with process for AREAER:

Survey was sent to all (189) members from mid-April

Responses are being received

Dialogue with members, to ensure consistency

Database to become publicly available in Q1 2018

Separate website within the AREAER site

G20:

IMF is planning summary note for G20 (Q1 2018), showing basic descriptive statistics/ distributions

G20 having welcomed initiative in March (Baden Baden)

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Thank you