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Comments on “Sources of Procyclicality in East Asian Financial Systems”

Author(s):
Stefan Gerlach, and Paul Gruenwald
Published Date:
July 2006
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The topic of managing procyclicality of the financial system is an important and challenging issue for central bankers and academics alike. Recurring episodes of financial sector crisis in the 1980s and 1990s, and its widely acknowledged role in exacerbating both cyclical upturns and downturns, requires us to contemplate practical countermeasures to mitigate procyclical tendencies in the financial sector.

In most emerging markets - including Thailand - managing procyclicality of the financial system is synonymous with managing procyclicality of the banking sector. Our banking system is by far the most significant element of our financial sector; and it is the means to channel funds to the real sector. Thus, for most emerging market central banks, our ability to properly control banking sector procyclicality has profound implications for the well-being of our real economy.

My remarks will focus on three main issues. First, I will briefly outline the causes of procyclicality in the banking sector. Second, I will propose some pre-emptive measures that we can adopt to counter procyclical tendencies. I will close by offering a few thoughts on the appropriate role of central banking authorities - particularly in emerging markets - in countering financial procyclicality.

Causes of procyclicality in the banking sector

Financial procyclicality arises whenever normal fluctuations in the business cycle are exacerbated by market participants’ tendency to behave in a uniform manner as business cycles change. There is also a propensity for regulatory policies, supervisory practices and governmental safety-net arrangements to reinforce and/or magnify this “herd-like” tendency of bank intermediaries.

A post-mortem evaluation of economic booms and busts in various parts of the world reveals that market participants’ understanding of, and appetite for, risk shifts with changes with the economic cycle. During an economic expansion, bankers are prone to excessive optimism and may be inclined to justify the feasibility of increasingly higher-risk or even otherwise “non-bankable” loan proposals, due in part to inflated collateral values, seemingly unlimited potential of their borrowers, and the intense competition among financial intermediaries. Against this background, even the most prudent lender may be tempted to relax its loan underwriting criteria and reduce its lending rates charged to high-risk borrowers or risk losing market share to its competitors. On the regulatory side, bank supervisors may also get caught up in this euphoria and thus are unable to identify and/or raise concerns, particularly since the banks’ financial condition are seemingly strong, with robust earnings and low levels of problem loans. Governmental safety net arrangements such as deposit insurance (and/or blanket guarantee regimes) - although designed to foster financial stability - further encourage the leveraging of the balance sheet by enabling banks to take on more risk with less capital, thereby contributing to rapid loan growth and the ensuing swings in loan quality.

When the economic downturn occurs, bankers’ optimism turns to pessimism; loan quality problems accumulate; and inadequate reserve levels become apparent. At this stage, bankers may significantly tighten lending standards and may become reluctant to lend even to creditworthy borrowers. Bank supervisors have a tendency to share in this pessimism and may demand significantly higher reserves due to known asset quality deterioration. They may also require additional capital based on a pessimistic view of banks’ overall risk profile and future prospects. Collectively, these factors lead to a contraction in bank lending to the real sector and an increase in the risk premia charged to otherwise creditworthy borrowers which, in turn, further exacerbates the economic downturn.

While the nuances of each financial sector crisis differ, one widespread problem is that both market participants and bank supervisors tend to underestimate risk during economic upturns - where there are seemingly no problems - and then become overly pessimistic during economic downturns - when everything becomes a problem. An interrelated issue is the procyclical bias of certain prudential requirements, such as asset classification and provisioning and capital adequacy rules, which serve to further accentuate economic booms and busts.

Policy options

Let me now turn to the difficult task of proposing practical suggestions on how we can modify our existing regulatory policies and supervisory practices so as to counter procyclical tendencies in the banking sector. In most emerging markets, a whole host of issues - such as the dominance of the banking sector, the lack of any other viable intermediary, the limitations of monetary policy instruments to fully counter procyclical imbalances, and the evolving nature of the risk management practices of our regulated banks - require policy-makers to use a more “activist” prudential agenda to combat procyclicality concerns. Simply put, the banking system is too important for emerging market economies to take a more subtle “wait and see” approach to this endeavor.

It is noteworthy that any regulatory and supervisory policy modifications that are driven by procyclicality considerations should also seek to preserve the fundamental integrity of the “safety and soundness” component of the prudential framework.

Against this background, I have separated the proposed procyclical countermeasures into two broad categories: (1) enhance risk-based supervision; and (2) proactive use of prudential tools. The proper implementation of a risk-based supervisory framework combined with the flexible use of “blunt” prudential requirements, provides a promising approach to countering procyclicality in emerging market economies.

Enhance risk-based supervision

Let me first spend a few moments outlining the importance of risk-based supervision and its critical role in countering banking sector procyclicality during good times, and minimizing procyclical tendencies during bad times. The concept of risk-based supervision and its counter-cyclical virtue - is easier to digest within the context of economic booms. One of the primary objectives of risk-based supervision is to identify gaps in risk management policies and practices before such weaknesses adversely affect earnings and capital. Therefore, if risk-based supervision is properly implemented, it has the potential to address the “preventive leg” of the financial procyclicality debate - e.g. the inability of banks and bank supervisors to properly identify risks during boom times.

In addition to enhanced supervisory oversight, the risk-based framework also encourages banks to enhance their own risk management capabilities. The risk-based philosophy entails a shift away from a rigid, rules-based approach to regulation and supervision, and towards what economists refer to as “incentive compatible” prudential standards. By “incentive compatible,” I am referring to broad principle-based standards that encourage banks to develop and continuously update their internal risk management systems to ensure that they are commensurate with the scope and complexity of their operations.

Interestingly, the proper implementation of risk-based supervision can also play an important role in minimizing procyclical behavior during economic downturns. How is this possible? It is because the fundamentals of risk-based supervision are deeply rooted in the notion of following an evenhanded course that is premised on sound judgement and critical analysis. In other words, the risk-based philosophy requires bank supervisors to be skeptical of conventional wisdom - in good and bad times - and never be excessively optimistic or pessimistic.

At the end of the day, risk-based supervision can be a powerful tool to counter procyclical tendencies due to its focus on steering a balanced course, with a particular emphasis on a forward-looking, longer-term analytical framework, rather than solely a point-in-time evaluation.

Of course, the requisite knowledge, skills and abilities needed to properly implement risk-based supervision can only be achieved with time. At the Bank of Thailand, we have steadily embraced the risk-based philosophy during the past several years. We have revamped our supervisory framework to provide a more structured and risk-oriented approach to the on- and off-site examination process, while encouraging our front-line supervisors to think analytically and in a balanced manner - rather than simply rely on rules-based compliance criteria. Nevertheless, we are fully aware that it remains a work in progress.

Proactive use of prudential tools

As we move into our discussion of using flexible prudential requirements to counter procyclical tendencies, it is critical to keep in mind that its effectiveness hinges upon the quality of risk-based supervision. This is primarily because it is easy for banks to get around any rules-based prudential requirements, regardless of whether they are used for safety and soundness purposes or designed to counter procyclicality concerns. Thus, the quality of day-to-day supervision is inextricably linked to the reliability of prudential requirements used to counter procyclicality concerns.

Numerous prudential requirements may be used to counter pro-cyclical behavior in the banking sector. Obviously, the proactive use of prudential measures works best when there is close interaction and two-way exchange of information between supervisory and monetary authorities. Let me briefly highlight a few of these prudential requirements.

Vary capital buffer with changes in economic cycle. The main concept here is that banks should be required to hold capital in excess of regulatory minimum during good times, so that it can be drawn down, if needed, during bad times. Although conceptually appealing, the determination of how much “buffer” capital is enough is a matter of judgement and can lead to disagreements between bank management and bank supervisors. In emerging markets, the most practical solution, perhaps, is to explicitly require two sets of ratios: (a) a minimum capital ratio; and (b) a minimum targeted capital ratio that is set at a pre-defined level above the regulatory minimum. During good times, all banks may be expected to adhere to the targeted capital ratio; and in economic downturns, bank supervisors may exercise some discretion on how much “buffer” capital is needed.

Increase the regulatory credit risk-weights assigned to certain high-risk assets/sectors. If bank supervisors see a rapid accumulation of credit concentrations in certain high-risk sectors during boom times, consideration may be given to increase the Basel I risk-weights from 100 percent to a higher risk-weight function (say 150 percent or 200 percent). While the risk-based capital ratios would remain unchanged, the methodology used to calculate risk-based capital would be altered, resulting in an increase in the actual level of capital held by banking organizations.

Adopt forward-looking provisioning requirements. Provisioning requirements should strike the proper balance between establishing minimum regulatory safeguards versus principles-based concepts that require banks to assess, and supervisors to review, the adequacy of provisions based on debtors’ ability to repay over an appropriate time horizon. In addition, forward-looking provisioning requirements should also consider qualitative issues, such the extent of loan concentrations, the quality of loan underwriting standards, and the quality, type and marketability of collateral. If supervisory and monetary authorities raise concerns about inflated asset values, the minimum haircuts assigned to collateral (if considered during the provisioning process) can be increased.

Prescribe loan-to-value (LTV) ratios for the property sector. Another rules-based, but less interventionist tool, is to provide supervisory prescribed LTV guidelines for the property sector, particularly in situations where supervisors are concerned about rapid increases in property values. At the Bank of Thailand, we introduced maximum LTV ratios for the high-end residential real estate market beginning in December, 2003.

Conclusion

Countering procyclicality in the banking sector is indeed a formidable and a particularly important challenge. Developing practical solutions to counter procyclical imbalances necessarily requires close policy coordination and two-way flow of information between the monetary and supervisory functions. There is scope to use proactive prudential tools, in conjunction with traditional monetary policy instruments, for macroeconomic stabilization. This is especially true in an emerging market context where the banking sector dominates the financial system. Moreover, as recent experiences in many countries suggest, traditional monetary tools are not effective in tackling sectoral imbalances - such as an overheated property market - that could eventually lead to broader macroeconomic instability. In this case, the void could be filled by our menu of prudential tools targeted at that particular sector. The fundamental issue is that we must have a deep understanding of broader macro-economic data and trends, together with nuanced insights on the health of the banking sector in general, and individual banks in particular. Central banks, in their twin role of ensuring monetary and financial stability, are uniquely positioned to tackle these profound challenges.

We should keep in mind, however, that the linkages between bank supervision and macroeconomic policy go far beyond the issue of countering procyclicality. In emerging market economies, the sheer size of our banking systems and the lack of any other viable credit intermediary, implies that without a safe and sound banking system, our real economies - and macroeconomic stability - will be severely damaged. Second, our ability to properly implement monetary policy operations - particularly since the banking sector is the mechanism through which monetary policy operates - necessarily requires practical, hands-on knowledge of individual banks and the banking system. This in-depth knowledge is only possible through our regulatory and supervisory responsibilities.

Finally, while our supervisory responsibilities enhance our macro-economic capacity, I firmly believe that our oversight of macro-economic affairs strengthens and provides context to our supervisory responsibilities. For example, in designing regulatory policy, we need to balance safety and soundness elements with the potential detrimental effects of excessively conservative regulations to the overall economy.

In closing, I must note that some academics have argued that there are certain potential conflicts of interest between the monetary and supervisory side of our business. However, these concerns can be alleviated through well-defined rules and processes. In the final analysis, there are simply too many compelling reasons for emerging market central banks to maintain oversight role of the banking system. The stakes are simply too high to think otherwise.

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