Information about Asia and the Pacific Asia y el Pacífico
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Chapter 3: Implementing Macroprudential Policies

Steven Barnett, and Rodolfo Maino
Published Date:
April 2013
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Measuring and Monitoring Systemic Risk

Rodolfo Maino

Systemic risk has taken center stage in discussions about financial stability in the aftermath of the global financial and economic crisis of 2008–09. Until the crisis, risk monitoring and controls were mainly built around the safety and soundness of individual financial firms.

Crisis prevention proved to be inadequate as the risks kept mounting, particularly risks from advanced economies that had not been timely identified and unanticipated shock transmission channels and contagion across sectors. In addition, the connections between financial, fiscal, and macroeconomic stability were not well understood. And when warnings were made, they did not successfully trigger the needed policy reaction. The increased interconnectedness among banks, brokers, insurance companies, and hedge funds posed challenges to the way systemic risks were monitored because those interconnections amplify distress and other shocks in complex financial settings.

Contagion is the very essence of any definition of systemic risk because risk is largely driven by fluctuations in economic and financial cycles over time, including the degree of interconnectedness of financial institutions and markets, common exposures, and shadow banking conditions. Cyclical risks vary over time with financial and economic conditions reflected in asset valuations; market functioning; leverage of financial institutions, households, businesses, and governments; maturity transformation and risk information; innovation (new product and services); and the constant hazard of tail risks. Hence, any measure of systemic risk should be comprehensive enough to capture all linkages, associations, potential correlated defaults, and vulnerabilities beyond the banking system.

Data Dissemination and Collection

Data gaps become a critical obstacle for the timely and accurate assessment of key systemic risk components, including interlinkages and common exposures. Accurate measurement and efficient monitoring require reliable data. Pitfalls in the collection of data related to systemic risk are well known. Moreover, systemically important financial institutions (comprising not just large financial institutions but also those that are highly interconnected) and the exact boundaries of shadow banking systems (with a proliferation of institutions and markets outside regulatory boundaries) add to the present conundrum. Given that there is no available information on linkages and leverage of financial institutions—most especially information available in a manner sufficiently timely for risk assessment—the need to go beyond the mere collection of data points is evident. The implications of systemic risk are forward looking by nature; therefore, advances need to be made in econometric and statistical modeling to try to measure those implications.

Gathering and collecting data for identifying systemic risks involves microlevel and aggregate data. Data must be captured from the widest possible set of intermediaries to enable analysis of the balance sheets of interconnected and complex financial institutions. The implementation of macroprudential instruments and policies requires deep knowledge of all financial markets, including wholesale and insurance markets and savings and loan institutions prone to contagion. The measurement of interconnectedness is becoming an art, calling for a wide array of information and data to help identify systemic risks. In this context, the Bank for International Settlements is advancing work by expanding their consolidated and locational banking statistics. Also, the IMF Statistical Department is actively collaborating with the G-20 Data Gaps Initiative, which aims at closing information gaps highlighted by the crisis.

The sharing of data with external researchers is as important as is its timely collection. Hansen (2012, p. 12) emphasized that sharing data allows for replication of results and is necessary to “nurture innovative modeling and measurement.”

Ensuring Systemic Stability: Crisis Prevention

The global financial crisis has catalyzed critical changes in the international community’s efforts at crisis prevention and response. All crisis-hit areas have accelerated their efforts to cope with extreme pressures on financial systems and strengthen the international financial architecture on issues such as cross-border resolution, regulation and supervision of the shadow banking sector, lack of data and data-sharing arrangements, too-big-to-fail institutions, and over-the-counter derivatives.

The IMF has actively improved its role in crisis prevention and response. In particular, the IMF’s universal membership and legal surveillance mandate provide the institution with a unique responsibility to identify systemic risks and encourage remedial actions. In recent years, the IMF has become even more candid regarding surveillance and risk assessments, and new products have been developed to extend its existing country-specific and multilateral instruments, for example, spillover reports for the five largest economies. The IMF has also been actively engaged in strengthening macroprudential policy and discussing the feasibility of capital controls.

The Financial Stability Board (FSB) has taken decisive action to organize the multilateral effort to reform and strengthen regulatory and supervisory policies. In particular, the FSB has advanced a comprehensive framework to address the risks posed by systemically important financial institutions, including a capital surcharge and principles for the effective resolution of failing institutions. The FSB has also been working on issues related to the oversight and regulation of shadow banking systems.

Addressing Systemic Risks: Macroprudential Policies

A macroprudential policy approach allows countries to lessen risks to their financial system. Such an approach better accounts for other public policies with potential impacts on systemic financial stability. Macroprudential policy goes beyond limiting risks to individual financial institutions by aiming at containing systemic risk, including feedback between the financial sector, the real economy, and other policies. Swings in liquidity, credit, and asset-price cycles are well-known sources of systemic risk. However, the effects of those financial institutions and markets that are highly interconnected within, and across, national borders, must also be included.

Asia’s experience provides useful lessons on the application of macroprudential approaches, given the proactive use of macroprudential measures by many countries in the region. Asia’s effective use of macroprudential frameworks was built on certain notable elements:

  • Institutional arrangements should ensure a policymaker’s ability and willingness to act. This requires clear mandates, control over macroprudential policy instruments, safeguards for operational independence, transparency and other provisions to ensure accountability, and clear communication of decisions and decision-making processes. Recent IMF analysis suggests the following principles (IMF, 2011a):

    • Central banks should play an important role in macroprudential policymaking given that they have expertise in risk assessment and incentives to address systemic risk in a timely and effective manner.

    • The treasury should participate, but in a way that does not delay action in good times or that undermines the independence of monetary and prudential policies.

    • Effective coordination across policies and among agencies is crucial to reducing gaps and overlaps, but their independence must also be ensured.

  • Mechanisms for systemic risk monitoring and identification are needed that enable timely preventive action. This requires access to, and continuous monitoring of, data on business and financial cycles; on credit quantity and quality; on systemically important institutions, markets, and instruments; and on firms and activities that might be outside the perimeter of regulation. Systemic risk indicators are a useful tool, but the multidimensional nature of systemic risk means that a range of measures and qualitative information and judgment will also be necessary.

  • The policy toolkit, containing mostly prudential instruments, needs to be available to the macroprudential policymaker. IMF (2011b) illustrates the effectiveness of frequently used prudential tools and also concludes the following:

    • Emerging market economies have used macroprudential instruments more extensively than advanced economies have, both before and after the 2008–09 global financial crisis, but the crisis has prompted an increasing number of countries to use the instruments, and with greater frequency.

    • The effectiveness of the instruments does not appear to depend on the exchange rate regime or the size of the financial sector, but the type of shock seems to be a crucial factor, and different types of risk call for the use of different instruments. Whatever instruments are chosen, they need to be applied in a timely manner.

    • To be effective, macroprudential policy needs to be complemented with strong regulation and supervision of individual financial institutions and policies to resolve failed institutions.

Many challenges remain in implementing effective macroprudential policy. Systemic risk is multidimensional and difficult to identify and measure, so effective macroprudential policymaking depends on filling information gaps and on effective coordination between macroprudential policy and other public policies. This coordination can be difficult in practice and needs to be coupled with mechanisms to prevent macroprudential policy from being used as an inappropriate substitute for other public policies, especially monetary policy. Because there will always be resistance to policy tightening before risks have been manifested, independence, accountability, and effective communication are also essential. In addition, the growing importance of cross-border systemic risks and regulatory arbitrage underscores the critical importance of effective international coordination.

Measuring Systemic Risk: The Toolkit

Based on supervisory research and data perspectives, Bisias and others (2012) gathered a thorough and complete survey of systemic risk analytics, providing 31 quantitative measures spanning key themes and issues in systemic risk measurement and management.1

There is no unique set of tools for all countries. The predictive ability of tools needs to be judged in context, because no tool is universally the best in all circumstances. Policymakers should look at all pressure points by adopting a wide range of tools to be used at any time. The objective is also to identify which tools (or combinations of tools) are among the best at measuring a specific dimension of systemic risk. Therefore, users are encouraged to calibrate their instruments to country-specific circumstances, and where appropriate, rules-of-thumb or thresholds based on cross-country analyses and research are provided. In sum, macrofinancial linkages and systemic risk are difficult to measure given the complexity and unpredictability of current financial scenarios and the scope for nonlinearities through illiquid markets or institutions and unstable correlation structures and behavioral relationships.

Billio and others (2010) grouped the literature on empirical systemic risk as follows: (1) bank contagion—based on the autocorrelation of banks’ defaults, returns, and fund withdrawals, and exposures among them;2 (2) macroeconomic fundamentals—focusing on bank capital ratios and liabilities, and on credit derivatives;3 and (3) joint crashes in financial markets—focusing on spillover effects on simple correlation, CoVaR (comovement of value at risk) measures, autoregressive conditional heteroskedasticity modeling, extreme dependence of securities market returns, and securities market comovements not explained by fundamentals.4 When data are available, tail dependence analysis becomes particularly useful. The analysis of codependence in the tails of equity returns to financial institutions is needed to distinguish the impact of the disturbances to the entire financial sector from firm-specific disturbances.5Acharya and others (2010) propose using tail-risk measures for assessing the solvency of the financial system based on a direct welfare calculation that produces a marginal expected shortfall.

Based on Billio and others’ (2010) classification, it was possible to devise five measures of systemic risk focusing on contagion and interconnectedness among hedge funds, brokers, banks, and insurers, including reverse contagion by adding estimation of causal relationships between financial institutions. These measures—which are aimed at capturing aspects of changes in liquidity, expected returns, and correlation—build on illiquidity, risk concentration, sensitivity (response) to market prices and economic conditions, and correlation among the holdings of financial institutions. See Box 3.1.

Building on the use of option pricing theory for firm financing—where there is an underlying stochastic process for the value of the firm assets—the contingent claims analysis of Gray and Jobst (2011) features risk adjustments to sectoral balance sheets with separate roles for debt and equity (equity is a call option on these assets and debt is a put option). Network models of the financial system are a different approach that complements these views by focusing on interconnectedness. Also, dynamic stochastic equilibrium models (Christiano, Eichenbaum, and Evans, 2005; Smets and Wouters, 2007) are built to deal with multiple shocks, explicitly modeling the time evolution of the mechanisms for those shocks. Still, much is needed to consolidate the integration of financial market constraints into these models.

Box 3.1.The Search for Systemic Risk Measures

Billio and others (2010) warned that any plausible indicator of systemic risk should capture issues related to the “four L’s” of systemic risk—liquidity, leverage, linkages, and losses. Some of the most used measures are the following:

Illiquidity and correlation. It is accepted that the more illiquid a portfolio, the larger the price impact of a forced liquidation, and the bigger the cascade effect on the rest of the economy when many investors are exposed to this shock at the same time (high correlation). The liquidity risk exposure of a given financial institution is given by the autocorrelation coefficient (ρk) of the institution’s monthly returns,

ρk=Cov[Rt,Rtk]Var[Rt], where k is the order of autocorrelation of {Rt} measuring the degree of correlation between month t’s return and month tk’s return.

Principal components analysis (PCA). PCA allows the decomposition of a covariance matrix of returns for banks, brokers, insurers, and hedge funds to help detect commonalities among them. If asset returns are driven by a linear K-factor model, the first K principal components should explain most of the time-series variation in returns, Rjt + αj + δ1F1t + … + δK FKt + εjt; where Ejt εjt] = 0 for any j ≠ j’ and hence the covariance matrix ∑ of the vector of returns Rt = [R1t …. Rjt]’ is expressed as,

where Θ contains the eigenvalues of the positive definite covariance matrix ∑ along its diagonal and Q is the matrix of corresponding eigenvalues. When normalized to sum to 1, each eigenvalue can be interpreted as the fraction of the total variance of turnover attributable to the corresponding principal component.

Regime-switching models. Sudden regime shifts in expected returns and volatilities can be captured by a simple Markov regime-switching model that compares the transition from a normal to a distressed scenario with returns Ri,t satisfying the following stochastic process: Ri,t = μi(Zi,t) + σi(Zi,t) μi,t; where Ri,t is the excess return of index i in period t, σi is the volatility of index i, μi,t is independently and identically distributed over time, and Zi,t is a two-state Markov chain with transition probability matrix Pz,i for index i. Hence, the joint probability of high-volatility regimes is given by the product of the univariate estimates,

Thus, the higher the joint probability of a high-volatility regime, the greater the interdependence among the sectors.

Granger causality tests. Beyond the degree of interconnectedness, the direction of the dynamic of propagation of systemic risks becomes critical. As Billio and others (2010) noted, in an informationally efficient market, price changes should not be related to other lagged variables; hence, a Granger causality test should not detect any causality. Nevertheless, the presence of market frictions—transaction costs, borrowing constraints, costs of managing information, institutional restrictions on short sales—permits the presence of spillovers among market participants.

CoVaR (comovement of value at risk) This measure uses market data to assess the contribution of an individual financial institution to systemic risk. Specifically, time-varying CoVaRs are derived by using quantile regressions—the contribution of a firm to systemic risk is the difference between the value at risk (VaR) of the financial system conditional on the distress of a particular financial institution i and the VaR of the financial system conditional on the median state of the institution i.

The Republic of Korea: Implementing Macroprudential Policies

Jun Il Kim

The 2008–09 global economic and financial crisis has proved that ensuring the stability of individual financial institutions may not be enough to keep systemic risk under control. Systemic risk goes beyond the simple sum of the risks of individual institutions and involves considerations of dimensions deeper than the aggregate size of risk. For instance, how risks are distributed among financial institutions, and who holds them, matters a lot for systemic risk. Moreover, the real sector–financial sector linkages and cross-border linkages suggest that measurements of systemic risk should be able to capture the notion of interconnectedness and the complex interplay among market participants. The macroprudential policy framework (MPF) is widely discussed as an overarching framework to address the stability of the financial system as a whole. One of its key issues would be how to deal with correlated risks and risk mismatches at various levels.

The objective of MPF is to limit systemic risk in the financial system. The tools that can be employed to this end are prudential tools that are designed to target sources of systemic risk. Functionally, it may be useful to think of an effective macroprudential policy framework as consisting of three main elements: identification and measurement of systemic risk, timely use of policy tools, and effective coordination between macroprudential and other policies—for example, monetary policy (Figure 3.1). Some of these aspects will be discussed in this section.

Figure 3.1.Key Elements of a Macroprudential Policy Framework

Recently, important steps have been taken in the development of macroprudential policy instruments and in constructing the governance structure for MPF (FSB, IMF, and BIS, 2011). Progress has also been made in designing new macroprudential tools to deal with procyclicality and interconnectedness. Basel III has been introduced to reinforce Basel II (by way of introducing core capital, the liquidity coverage ratio, the net stable funding ratio, and so forth) and also to put a macroprudential overlay on the current framework by adopting measures to reduce systemic risks stemming from procyclicality and interconnectedness. The Financial Stability Board (FSB) has also come to an agreement on the framework to tackle risks posed by systemically important banks (SIBs).

Identification and Measurement of Systemic Risk

The identification of systemic risk is a vital component of an effective MPF. A key task is the development of quantitative measures of systemic risk that can be easily constructed and monitored. To be effective, those measures should capture both time and cross-sectional dimensions of systemic risk. In practice, various approaches have been used and tried, such as indicator-based monitoring, stress tests, calibrated metrics, and others. As yet, no framework has been agreed upon as best practice in identifying and monitoring systemic risk. Country-specific circumstances may need to be considered and the framework tailored accordingly. Also, in light of deepening cross-border interconnectedness, an international dimension to identifying systemic risk must be taken into account along with the accompanying need for international coordination.

Improving Data and Information

A first step toward improving the identification and monitoring of systemic risks would be to address the data and information gap. Although there are many facets to this critical issue, the governance structure of MPF is crucial. If macroprudential responsibilities are shared by multiple authorities, ensuring that relevant data and information are made readily available to the authorities that need it is particularly important.

More generally, best efforts should be geared toward greater and timely availability of relevant data and better use of acquired data for policy formulation. Regarding the first data issue, various efforts have been made, such as at the FSB Working Group on Data Gaps, but there is still a long road ahead. A useful option for improving data availability could be the establishment of an agency dedicated to data collection. For example, the Office of Financial Research, established by the Dodd-Frank Act in the United States, is dedicated to collecting and making available to regulators and to the public more and better financial data. The establishment of a similar group could be a worthwhile goal for countries where a data gap is a major constraint to building an effective MPF. The second issue is just as critical—the best food is useless without a good cook. Regulators may lack the capacity, incentive, or resources to use the flood of acquired data properly, and this is yet another gap that needs to be addressed.

Domestic and International Coordination: Institutional Arrangements and Governance Models

The institutional arrangement for macroprudential policy should facilitate effective control of systemic risk. This goal could be broken down into the following elements. The institutional arrangement must provide the institutions, and parties involved, with a clear objective; provide the right incentives and tools to the authorities so that they can act appropriately to achieve that objective; support accountability and transparency of decisions; and ensure effective coordination across policy areas.

To come to grips with this issue of institutional arrangement, the stylized models for MPF, suggested by IMF (2011c), has proved especially useful (Figure 3.2). The IMF classifies the macroprudential policy framework according to the degree of integration of authorities involved, roughly equating to full integration, partial integration, and separation models (as in Korea). Each model has its own pros and cons and it would ultimately come down to making the best out of the upsides and minimizing the downsides, according to the circumstances of each country. In each case, careful consideration should be given to making sure that the institutional arrangement ensures effective policy coordination across policy areas.

Figure 3.2.Three Stylized Macroprudential Policy Framework Models

Domestic Coordination

The boundaries of macroprudential policy are hard to define clearly; many other policies may also matter for financial stability. Of great interest is the relationship between monetary policy and macroprudential policy.

Conceptually, monetary policy and macroprudential policy are distinct. In light of the two-way causality between price and financial stability, however, monetary and macroprudential policies need to be coordinated so as to be complementary. The recent global financial crisis was preceded by a period of great moderation in the 1980s, a fact that raises the concern that monetary policy could become a victim of its own success. Although speculative, the global crisis might have been avoided if effective macroprudential oversight had been in place. Given that not all cases of asset-price appreciation are necessarily bubbles—for example, asset-price increases driven by productivity growth—an unduly simplistic and indiscriminate application of macroprudential policy could hamper the legitimate and productive allocation of credit and investment activities.

Ideally, macroprudential policy should be used as a complementary backstop to monetary and other macroeconomic policies. Inappropriate use of macroprudential policy as a substitute for monetary policy could do more harm than good. After all, chasing after financial stability through macroprudential policy while monetary policy keeps the interest rate too low may not only be futile but could potentially plant the seed for future financial instability. Broad-based credit booms and general asset-price appreciation would call for monetary policy responses. However, asset-price bubbles in an isolated market would likely be better addressed by macroprudential policy rather than monetary policy.

Meanwhile, attention must also be paid to the potential tension between macroprudential policy and the objectives of microprudential authorities (Figure 3.3). During the boom phase of the credit cycle, the macroprudential authority may be concerned with the potential buildup of systemic risk and would consider deployment of a countercyclical policy, such as strengthening capital requirements. Meanwhile, the microprudential authority, with no mandate for systemic risk, would not be worried about credit expansion, and may be reluctant to weaken financial institutions’ profitability by limiting risk origination. Conversely, during the downturn of the credit cycle, the macroprudential authority may loosen the capital buffer requirements to reduce the likelihood of system-wide deleveraging. But the microprudential authority is likely to be concerned with depletion of capital (because capital is less abundant when most needed) and may opt instead to strengthen the buffer requirement in response.

Figure 3.3.Potential Tension between Macro-and Microprudential Authorities

Source: Bank of Korea, Macroprudential Analysis Department.

International Cooperation

Macroprudential policy also involves an international dimension, particularly as related to cross-border capital flows. The trend toward global integration of capital markets and the subsequent possibility of cross-border spillovers and regulatory arbitrage has made this issue particularly important. Of course, the first best response would be to seek out a global solution, but lack of global jurisdiction makes this issue difficult. Similar difficulties may have resulted in international capital flows being underregulated, and left to exert excessive negative financial externalities as manifested in the form of boom-bust cycles. Although, in theory, flexible exchange rate adjustments should be able to largely resolve the problem to a large extent, in reality, such mechanisms are often limited in scope, especially in the context of emerging market economies where exchange rate appreciation is often a significant source of economic difficulties and worsening external balances. The lack of global jurisdiction also makes it difficult to deal directly and fundamentally with the source of risk, which would be a better and fairer solution to the externality problem.

International cooperation could fill in, at least in part, the gap left by the lack of global jurisdiction. However, the incentive for cooperation could be weak at the national level. This lack of enthusiasm is owing not only to myopia, but also to the one-way nature of financial cross-border externalities (running from North to South). Thus, a key prerequisite to international cooperation on macroprudential policy would be an institutional mechanism to promote a common understanding of threats to global financial stability; that is, it is in the interest of advanced economies as well to participate in a concerted endeavor to mitigate cross-border financial risk. In addition, international cooperation on macroprudential policy would also require steps to ensure that the MPFs of individual countries are mutually consistent. Such steps would help lessen regulatory arbitrage and would also obviate a situation wherein the policies implemented by individual countries work against each other.

Finally, the scope of international financial cooperation must also be broadened, particularly between advanced market economies and emerging markets. A good example of such cooperation would be information sharing between advanced and emerging market central banks. In this regard, the consultation with nonmembers of the FSB by the Regional Consultative Group for Asia of the FSB should be commended. Such outreach efforts would certainly reinforce international cooperation in macroprudential policy by facilitating communication and mutual understanding. Central bank currency swap lines, which proved useful in calming financial markets in emerging market economies during the 2008–09 global crisis, would also be a great avenue for further cooperation and contributions from advanced economies. In a similar vein, strengthening global or regional financial safety nets, such as provided by the IMF and the Chiang Mai Initiative, would be conducive to laying the groundwork for international cooperation.

Future Research

The remainder of this section puts forth policy questions that should be of interest for future research.

  • First, what could be done to minimize, if not prevent, the unintended consequences of strengthening macroprudential oversight? The recent experience in the euro area is suggestive of the risk of unintended consequences of macroprudential policy. Specifically, anecdotal evidence indicates that strengthened capital requirements intended to ring fence European banks from contagion have forced many European banks to deleverage in the midst of financial distress. Another concern would be that strengthened MPF could stifle the economy by discouraging appropriate risk-taking for growth or even undermine the legitimate intermediation function of the financial sector. Stronger rules for liquidity coverage and capital buffers will certainly contribute to financial stability but may also weaken the growth potential of the financial industry and the broader economy as well.

  • Second, what would be the implications of a stronger MPF on funding costs faced by nonfinancial borrowers—particularly those in emerging market economies? Because international claims typically carry high risk weights in the calculation of capital requirements for banks, under strengthened macroprudential regulations, global banks in advanced economies are likely to have less incentive to maintain exposure to emerging markets than otherwise. This could lead to reduced funding opportunities or higher funding costs for emerging markets.

  • Third, what would be the long-run response of financial institutions to strengthened MPFs? This question also has an important bearing on how to address the previous two policy questions. The efficacy and effectiveness of an MPF would depend on the endogenous response of financial institutions. If banks and the entire financial system become safer under the new macroprudential regulations, economic theory suggests that they should perhaps be ready to live with low returns. But it would not be unreasonable to predict that banks would change their business models to circumvent macroprudential regulations if profitability falls too low. Policymakers would face a difficult choice between financial safety and profitability, both of which matter for financial stability.

  • Fourth, would stronger MPFs offer better opportunities and incentives for emerging markets to engage in financial integration to a greater depth? If international capital markets become safer with reduced volatility in capital flows, emerging market economies may opt for more capital account liberalization and further integration into global financial markets. Thus, stronger MFPs could result in safer international capital markets, making it easier for emerging markets to reap the benefit of financial liberalization and integration, bearing minimum risk.

  • Fifth, how should the line be drawn between capital controls and macroprudential policy? A key difference between capital controls and macroprudential policy is whether the policy discriminates by residency. However, despite such conceptual differences, de facto effects may be similar, making such a distinction less effective in practice. For example, if macroprudential policy constraints fall disproportionately on foreigners—perhaps by being more binding on foreign banks than on domestic banks—the line between capital controls and macroprudential policy can become blurry.

  • Last, how would macroprudential policy affect central bank independence? There have been claims that central banks’ expanded responsibility for financial stability may undermine central bank independence in conducting monetary policy by subjecting them to political (or market) pressures. To what degree is this true, and how would central bank independence considerations affect domestic macroprudential policy coordination?

India’s Experience with Macroprudential Policies

Rabi N. Mishra

The Indian Financial System and the Role of the Reserve Bank

The Indian financial system is dominated by the banking system, in particular by commercial banks (Figure 3.4). Public sector banks, in turn, comprise the largest segment of the banking system in the country, accounting for 65 percent of total banking system assets.

Figure 3.4.Segments of the Indian Financial System

Source: Reserve Bank of India Financial Stability Report, December 2011. Note: NBFC = nonbanking financial company.

The country has a well-defined regulatory architecture that extends its perimeter around the entire financial system, banking as well as nonbank financial institutions. The Reserve Bank of India regulates the banking sector and nonbanking financial companies (NBFCs), as well as the money, foreign exchange, and government securities markets. Sectoral regulators oversee capital markets (the Securities and Exchange Board of India), the insurance sector (the Insurance Regulatory and Development Authority), and for pension funds (the Pension Funds Regulatory and Development Authority).

Cooperation between regulators is ensured through a Financial Stability and Development Council, headed by the finance minister, which deals with issues relating to financial stability, financial sector development, interregulatory coordination, macroprudential supervision of the economy, financial inclusion, and financial literacy, among others. A subcommittee of the council, headed by the governor of the reserve bank, has emerged as the primary steering arm of the council, since its establishment in 2010.

The reserve bank is not explicitly mandated to pursue financial stability by its statute. It does, however, enjoy a mandate that is larger than is typical of many central banks. The reserve bank is the issuer of currency and is the monetary authority. It is the banker and debt manager for the government and the gatekeeper of the external sector. It regulates and supervises the payment and settlement system. Together, these roles have implicitly entrusted the reserve bank with the principal responsibility for financial stability—a responsibility the bank has taken on, given that financial stability has been one of its three principal policy objectives, along with price stability and growth, since 2004.

The Evolution of Macroprudential Policymaking in India

Because the banking sector dominates the Indian financial system, the reserve bank’s macroprudential policy measures have been aimed primarily at addressing risks in the banking system. Some measures aimed at addressing the cross-sectoral dimensions of systemic risks, especially measures to address the risks arising from interconnectedness, also encompass the nonbank financial sector. The application of countercyclical policies to the shadow banking system poses challenges, as has also been the experience internationally. The policies have aimed at increasing the resilience of the banking system.

Countercyclical Measures

The Investment Fluctuation Reserve (IFR)

In the early years of the first decade of the 2000s, the macroeconomic and monetary policy environment was accommodative and banks in India were enjoying the benefit of marked-to-market profits. At the same time, a market risk charge on capital had yet to be prescribed for commercial banks in India. To enable banks to deal with the impact of a less benign interest rate environment when the cycle turned, an Investment Fluctuation Reserve (IFR) was introduced in 2002 as a countercyclical measure. Accordingly, banks were advised to build up an IFR to a minimum of 5.0 percent of their investment portfolios by transferring the gains realized on the sale of investments within five years. Therefore, these gains could not be distributed and the reserve thus created enabled banks to absorb losses when interest rates rose beginning in late 2004 (Figure 3.5, panel a). The measure also ensured that the capital adequacy ratios of the banking system remained stable despite the introduction of a capital charge for market risk and falling income due to an increase in yields (Figure 3.5, panel b). The prescription was withdrawn once the capital charge for market risk was applied.

Figure 3.5.India: Effect of the Investment Fluctuation Reserve (IFR)

Source: Reserve Bank of India.

Time-Varying Risk Weights and Provisioning Norms

Traditionally, banks’ loans and advances portfolio is procyclical, tending to grow quickly during an expansionary phase and slowly during a recessionary phase. During times of expansion and accelerated credit growth, there is a tendency to underestimate the level of inherent risk and the converse holds true during times of recession. This tendency is not effectively addressed by the prudential specific provisioning requirements for impaired assets because they capture risk ex post but not ex ante.6 To reduce the element of procyclicality, calibrated risk weights and provisioning norms at different stages of the economic and credit cycles are used.

The use of time-varying risk weights and provisions in India was largely sectoral. As stated in BIS (2010, p. 10), “the most widely used macroprudential instruments have been measures to limit credit supply to specific sectors that are seen as prone to excessive credit growth.” In India, time-varying risk weights and provisioning norms were extensively used in response to a macrofinancial backdrop that pointed to disproportionately high rates of growth of credit to specific sectors like housing, commercial real estate, and the retail segment. When the correction did set in, in the wake of the global crisis, some of these measures were relaxed to enable banks to cope with the adverse macrofinancial conditions.

The tightening and build-up phase

In the early years of the new millennium, GDP grew at about 9 percent, inflation was high, and a huge flow of foreign capital entered the country. While overall bank credit growth accelerated considerably (about 30 percent), credit growth to certain sectors, such as real estate, accelerated much more sharply (about 100 percent).

Against this backdrop, in July 2005 the risk weights on banks’ exposures to commercial real estate were increased to 125 percent from 100 percent. The increase in risk weights and in the standard asset provisioning requirement in 2005 scaled back the credit growth rate in real estate to about 9 percent by March 2006. However, the credit growth rate increased again, requiring further action. In May 2006, the risk weight was further increased to 150 percent and the standard asset provisioning requirement was raised to 1 percent (Table 3.1 and Figure 3.6).

Table 3.1.Banks’ Exposure to Commercial Real Estate
DateRisk weight (percent)Provisioning requirement for standard assets (percent)
December 20041000.25
July 20051250.25
November 20051250.40
May 20061501.00
January 20071502.00
November 20081000.40
Source: Reserve Bank of India, Annual Reports.
Source: Reserve Bank of India, Annual Reports.

Figure 3.6.India: Build-Up Phase—Commercial Real Estate

Source: Reserve Bank of India.

Similarly, given the evidence of sharply rising housing prices and a heightened growth rate of credit to the housing sector (about 40 percent), the risk weights on housing loans extended by banks to individuals were increased to 75 percent from 50 percent in December 2004. Subsequently, the risk weights on smaller housing loans (priority sector) were reduced to 50 percent from 75 percent, while the risk weights on larger loans and those with a loan-to-value ratio exceeding 75 percent were increased to 100 percent (Tables 3.2 and 3.3). These measures helped bring down the growth rate in credit to the retail housing sector from greater than 16 percent in March 2005 to about 6 percent by March 2008 (Figure 3.7).

Table 3.2.Banks’ Exposure to Retail Housing Loans
PeriodRisk weight (percent)Provisioning requirement for standard assets (percent)
December 2004750.25
November 2005750.40
May 2006751.00
May 200750–751.00
May 200850–1001.00
November 200850–1000.40
Source: Reserve Bank of India, Annual Reports.
Source: Reserve Bank of India, Annual Reports.
Table 3.3.Differential Risk Weight for Retail Housing Loans
Loan amountLoan-to-value ratio (percent)Risk weight (percent)
Up to Rs 3 million≤ 75 percent50
> 75 percent100
Rs 3 million to Rs 7.5 million≤ 75 percent75
> 75 percent100
Rs 7.5 million and above125
Source: Reserve Bank of India, Annual Reports.Note: Overall cap on loan-to-value ratio of 80 percent for loans above Rs 2 million and 90 percent for loans up to Rs 2 million. Rs = Indian rupee.
Source: Reserve Bank of India, Annual Reports.Note: Overall cap on loan-to-value ratio of 80 percent for loans above Rs 2 million and 90 percent for loans up to Rs 2 million. Rs = Indian rupee.

Figure 3.7.India: Build-Up Phase—Retail Housing Loans

Source: Reserve Bank of India.

Risk weights on consumer credit and capital market exposures were also increased to 125 percent from 100 percent. The provisions for standard assets were revised progressively upward in November 2005, May 2006, and January 2007, in view of the continued high credit growth in personal loans, credit card receivables, loans and advances qualifying as capital market exposures, and loans and advances to the nonbank financial sector.

The release phase

When the headwinds from the global financial crisis started having an impact on the domestic macroeconomy and the domestic financial system, the Reserve Bank of India responded by easing the risk weights and the standard asset provisioning norms for these sectors (Figure 3.8).

Figure 3.8.India: Release Phase—Commercial Real Estate

Source: Reserve Bank of India.

Back to the build-up phase

By 2009, the domestic economy could come out from the clutches of the global meltdown, and the expansionary measures adopted during the recessionary phase had to be exited. The primary concern was about the asset quality of banks, on account of the exuberant lending during the boom period followed by the reserve bank’s relaxation of norms for restructuring advances during the crisis. Subsequently, banks were prescribed to achieve a provisioning coverage ratio of 70 percent of gross nonperforming advances by September 2010 as a macroprudential measure, with a view to augmenting provisioning buffers in a countercyclical manner.

Unique Dimensions of the Reserve Bank’s Countercyclical Policies

The reserve bank’s approach to countercyclical macroprudential policies has been based on the exercise of judgment, though empirical and anecdotal evidence were used to confirm policy judgments. The decisions were based on information such as a clear trend in significant year-to-year increases in aggregate bank credit; evidence from on-site inspections of banks; emerging signs of the underpricing of risks; a growing trend of residential mortgages for investment purposes; and a visibly steep increase in land prices evidenced by auction results. Thus, the approach to countercyclical policy was not rule bound and was based on the possibility rather than the certainty of asset-price bubbles.

One extremely important factor in the conduct of countercyclical policy by the reserve bank was the coordinated approach to implementation of monetary and macroprudential policy, as illustrated by Table 3.4. Whereas the interest rate measures were aimed at dealing with the inflation scenario, the countercyclical policies were aimed at “leaning against the wind” with a view to curbing procyclicality. The use of the policy mix was critical, because during the build-up phase in a growing economy like India’s, the use of blunt instruments such as interest rates to moderate sectoral exuberance could have inflicted significant collateral damage in the form of a reduced flow of credit to the entire economy. Such coordination was rendered possible in India as a result of the multiple roles of the reserve bank—as the monetary authority, the regulator and supervisor of the banking sector and a major portion of the nonbanking financial sector, and as the implicit macroprudential authority.

Table 3.4.Coordinated Policy Response
Monetary tightening phaseMonetary easing phaseMonetary tightening phase
Measure(September 2004–August 2008)(October 2008–April 2009)(October 2009 to date)
Monetary Measures (basis points)
Repo rate300−425250
Reverse repo rate125−275300
Cash reserve ratio450−400100
Provisioning Norms (basis points)
Capital market exposures175−1600
Housing loans75−601601
Retail loans other than housing loans175−1600
Commercial real estate loans175−16060
Non-deposit-taking systemically important nonfinancial companies175−1600
Risk Weights (percent)
Capital market exposures2500
Housing loans−25 to 25200 – 253
Retail loans other than housing loans2500
Commercial real estate loans50−500
Non-deposit-taking systemically important nonfinancial companies25−250
Source: “Macroprudential Policies: Indian Experience,” an address by Mr. Anand Sinha, Deputy Governor, Reserve Bank of India, at the Eleventh Annual International Seminar on Policy Challenges for the Financial Sector on “Seeing Both the Forest and the Trees—Supervising Systemic Risk,” co-hosted by the Board of Governors of the Federal Reserve System, the International Monetary Fund, and the World Bank, Washington, DC, June 1–3, 2011.

Provisioning requirement for housing loans with teaser interest rates was increased to 2.0 percent in December 2010.

Risk weight on housing loans of relatively smaller size classified as priority sector was reduced from 75 percent to 50 percent in May 2007, which was not a countercyclical measure but rather an attempt to align the risk weights on secured mortgages with the provisions of Basel II, which was to be implemented with an effective date of March 2008. For larger loans and those with loan-to-value ratios exceeding 75 percent, the risk weight was increased to 100 percent from 75 percent.

The risk weight on loans above 7.5 million rupees was increased to 125 percent.

Source: “Macroprudential Policies: Indian Experience,” an address by Mr. Anand Sinha, Deputy Governor, Reserve Bank of India, at the Eleventh Annual International Seminar on Policy Challenges for the Financial Sector on “Seeing Both the Forest and the Trees—Supervising Systemic Risk,” co-hosted by the Board of Governors of the Federal Reserve System, the International Monetary Fund, and the World Bank, Washington, DC, June 1–3, 2011.

Provisioning requirement for housing loans with teaser interest rates was increased to 2.0 percent in December 2010.

Risk weight on housing loans of relatively smaller size classified as priority sector was reduced from 75 percent to 50 percent in May 2007, which was not a countercyclical measure but rather an attempt to align the risk weights on secured mortgages with the provisions of Basel II, which was to be implemented with an effective date of March 2008. For larger loans and those with loan-to-value ratios exceeding 75 percent, the risk weight was increased to 100 percent from 75 percent.

The risk weight on loans above 7.5 million rupees was increased to 125 percent.

Other Macroprudential Measures

Interconnectedness between Banks

Cross-holding of capital among banks and financial institutions

  • Banks’ and financial institutions’ investments in instruments issued by other banks and financial institutions that are eligible for capital status for the investee bank or financial institution should not exceed 10 percent of the investing bank’s capital funds (Tier 1 plus Tier 2).

  • Banks and financial institutions should not acquire any fresh stake in a bank’s equity shares, if by such acquisition, the investing bank’s or financial institution’s holding exceeds 5 percent of the investee bank’s equity capital.

  • Banks’ and financial institutions’ investments in the equity capital of subsidiaries are at present deducted from their Tier 1 capital for capital adequacy purposes. Investments in the instruments issued by banks and financial institutions that are listed, which are not deducted from Tier 1 capital of the investing bank or financial institution, will attract 100 percent risk weight for credit risk for capital adequacy purposes.

Interbank liability limits

  • The interbank liability of a bank should not exceed 200 percent of its net worth as of March 31 of the previous year. However, individual banks may, with the approval of their boards of directors, fix a lower limit for their interbank liabilities, in view of their business models. Banks whose capital-to-risk-weighted-assets ratio is at least 25 percent more than the minimum of such ratio (9 percent), that is, 11.25 percent, as of March 31 of the previous year, are allowed to have an interbank liability of up to 300 percent of net worth. The prescribed limit will include only fund-based interbank liabilities within India (including interbank liabilities in foreign currency to banks operating within India).

Call money market. To ensure nondisruptive functioning of the interbank markets, access to the uncollateralized funding market (the call money market) is restricted to banks and primary dealers and there are caps on both lending and borrowing:

  • Call money borrowing limit. At present, on a fortnightly average basis, such borrowings should not exceed 100 percent of a bank’s capital funds. However, banks are allowed to borrow a maximum of 125 percent of their capital funds on any day, during a fortnight.

  • Call money lending limit. At present, on a fortnightly average basis, banks’ lending in the call money market should not exceed 25 percent of their capital funds. However, banks are allowed to lend a maximum of 50 percent of their capital funds on any day, during a fortnight.

Interconnectedness between Banks and Other Entities in the Financial Sector

  • Banks exposures to NBFCs. The exposure (both lending and investment, including off–balance sheet exposures) of a bank to a single NBFC or NBFC-AFC (asset financing company) should not exceed 10 percent or 15 percent, respectively, of the bank’s capital funds on its last audited balance sheet. Banks may, however, assume exposures to a single NBFC or NBFC-AFC up to 15 percent or 20 percent, respectively, of their capital funds, provided the exposure in excess of 10 percent or 15 percent, respectively, is the result of funds on-lent by the NBFC or NBFC-AFC to the infrastructure sector. Exposure of a bank to infrastructure finance companies should not exceed 15 percent of its capital funds on its last audited balance sheet, with a provision to increase the exposure to 20 percent if it is the result of funds on-lent by the infrastructure finance company to the infrastructure sector.

  • Banks’ exposures to mutual funds. Banks’ total investments in liquid or short-term debt schemes (by whatever name) of mutual funds with a weighted average maturity of portfolio of not more than one year will be subject to a prudential cap of 10 percent of their net worth as of March 31 of the previous year. The weighted average maturity would be calculated as the average of the remaining period of maturity of securities weighted by the sums invested.

Common and Large Exposures

  • Single and group exposure ceilings. The exposure ceiling limits are stipulated as 15 percent of capital funds for a single borrower and 40 percent of capital funds for a borrower group. The capital funds for the purpose of this ceiling will comprise of Tier 1 and Tier 2 capital as defined under capital adequacy standards.

  • Capital market exposures. Banks’ exposures to the capital market are subject to a regulatory limit of 40 percent of their net worth on a solo as well as a group basis.

  • Exposure to sensitive and other sectors. Banks’ exposures to sensitive sectors, such as real estate, systemically important NBFCs, and the commodity sector, are closely monitored. Banks are encouraged to place internal sectoral limits on other segments as well to ensure that their aggregate exposures are well dispersed.

Measures for Managing Capital Outflows by Encouraging Inflows

  • Inflows for External Commercial Borrowings maturing in three to five years. The cap on costs was increased from London interbank offered rate (Libor) + 300 basis points to Libor + 350 basis points in November 2011.

  • Non-Resident (External) Rupee interest rates were deregulated to attract capital flows from expatriate Indians.

Measures for Managing Excessive Capital Inflows

  • Mutual funds are permitted to invest abroad up to US$7 billion currently (increased from US$500 million at the end of the 1990s).

  • Similarly, corporates currently can invest abroad through joint ventures and wholly owned subsidiaries up to 400 percent of their net worth. This is an increase from an earlier limit of 100 percent. Reserve bank approval is required for an investment abroad greater than this limit.

  • Inflows to India are subject to a hierarchy of preferences with direct investment preferred to portfolio flows, rupee-denominated debt preferred to foreign currency debt, and medium- and long-term debt preferred to short-term debt.


The assessment of the impact of macroprudential measures in India, as in any jurisdiction, is challenging. Where macroprudential policy and monetary policy measures are implemented in tandem, as in India, further challenges arise in isolating the impact of the macroprudential policy measures from that of the monetary policy measures. Notwithstanding these limitations, reasonable evidence indicates that the measures taken by the Reserve Bank of India to curb exuberance in select sectors met with a reasonable degree of success in moderating credit flow toward the targeted sectors, because of both the resulting higher cost of credit to these sectors and the signaling impact of the central bank measures. However, as a result of the predominant risk-averse sentiment prevailing in the banking sector in the release phase, the countercyclical measures adopted during the period were relatively less effective in arresting the slowdown in credit growth.

Macroprudential Policy in New Zealand

Chris Hunt

This section provides a brief overview of the framework for macrofinancial analysis at the Reserve Bank of New Zealand (RBNZ), and more particularly, the development of new macroprudential instruments. The lesson for prudential policy from the 2008–09 global financial crisis has been clear: regulatory authorities must take more account of macrofinancial risk, in addition to the traditional the microfinancial risks specific to individual banks and other financial institutions. The RBNZ’s policy work in this area reflects a broader global effort to bolster the macroprudential framework.

The first part of this section outlines the New Zealand economic and institutional context for prudential policy and is followed by a short discussion of the tools that the RBNZ is currently exploring, which could be helpful in mitigating the effects of financial system risk. Focus is given to our core funding ratio (CFR), which is the New Zealand variant of the Basel Committee’s net stable funding and is designed to address the funding-liquidity risks to the New Zealand banking system. The section concludes by outlining the further work that is necessary to fully implement a suite of new macroprudential instruments.

At present, there is no compelling case for using any new macroprudential tool to address the buildup in systemic risk or emerging financial vulnerabilities in New Zealand. Credit growth has been virtually zero since the start of the financial crisis. as households and firms have been deleveraging or restructuring their balance sheets, given the accumulation of debt in the period before 2007.7 Nevertheless, it is important to prepare the groundwork for macroprudential policy and to pre-position the new instruments for when the next credit and asset-price boom materializes.

Economic and Institutional Context

New Zealand has a small open economy and its financial system is well integrated into the international financial system. So, not surprisingly, New Zealand was heavily affected by the global financial crisis and the global recession that followed. In the real economy, New Zealand’s export prices tumbled and GDP growth remained negative or flat through most of 2008–09. The recovery in activity to date has been reasonably subdued, with real GDP yet to surpass the 2007 peak.

The New Zealand financial system is small by international standards, about 250 percent of GDP. However, the banking system is very large relative to total financial system assets, at 80 percent. The banking system is also highly concentrated, with the four largest banks—all of which are Australian owned—accounting for nearly 90 percent of total bank assets. Only 4 out of a total of 21 registered banks are New Zealand owned; these 4 together account for just 6 percent of bank assets.

New Zealand’s banking system did not experience a major deterioration in asset quality, and nonperforming loans remained low by international standards. However, when global debt markets froze, the banks were unable to access offshore funding for a number of months other than for very short terms. The funding shortage was alleviated through reserve bank liquidity support, and a government guarantee on wholesale bank debt assisted banks in issuing debt when markets reopened. The nonbank lending sector (credit unions, building societies, and finance companies) experienced a string of company failures. These failures were related more to the domestic property sector downturn and weak internal governance than to international developments. However, increasing investor caution and competition for funding in the wake of the global financial crisis did increase the funding pressures on financial sector companies.

The pool of domestic savings to fund investment is limited, given the level of indebtedness of New Zealand households. As a consequence, New Zealand has run ongoing current account deficits and accumulated a large net external liability position with the rest of the world. Much of this debt is linked to overseas borrowing by the New Zealand banking system (Figure 3.9), essentially to fund lending to households and firms.

Figure 3.9.New Zealand: Net External Liabilities

Source: Statistics New Zealand.

Note: The reinsurance effect refers to the flows from global insurers as a result of the Canterbury earthquakes in late 2010 and early 2011.

During the expansion of economic activity up until 2007, lending to households, agriculture, and much of the business sector expanded significantly. Credit growth averaged 15 percent per year at its peak between 2004 and 2006 (Figure 3.10). In funding this credit, banks increasingly relied on short-term debt raised primarily from the U.S. commercial paper market. It was this funding-liquidity risk (rollover risk) that provided the key concern for New Zealand policymakers during the financial crisis.

Figure 3.10.New Zealand: Credit Growth by Sector

(contribution to total credit growth)

Source: Reserve Bank of New Zealand Standard Statistical Return.

Note: Credit refers to private sector credit intermediated by financial institutions.

Macrofinancial Analysis at the RBNZ

The RBNZ is a “full service” central bank with legislative responsibilities covering both price and financial stability. The bank is also the prudential regulator of banks, nonbank deposit-taking institutions, and most recently, the insurance sector.8 No explicit macrofinancial stability objective is set out in RBNZ’s enabling legislation aside from a general requirement to promote the soundness and efficiency of the financial system. These powers do, however, enable the bank to develop or modify prudential tools with a macroprudential objective in mind. This new macroprudential framework is being developed in consultation with the treasury, and an explicit macroprudential governance framework will be agreed on with the minister of finance as a basis for policy decisions in the future.

Attention to macrofinancial stability issues was first developed within the RBNZ in response to the Asian financial crisis of the late 1990s. In 2000, a team was set up to monitor financial system risks and their relationship to the macroeconomy. In 2004, this team began publishing the semiannual Financial Stability Report, which summarizes the health of the New Zealand financial system and the associated risks and vulnerabilities. During the 2008–09 global financial crisis a new committee was established, the Macro-financial Committee (MFC), to focus explicitly on macrofinancial stability issues. The MFC complements the other two main decision-making bodies concerned with monetary policy and microprudential regulation, respectively. MFC is the body within the RBNZ that is currently considering the development of new macroprudential tools to address systemic risk.

However, the focus on macroprudential tools is not an entirely new development. In the past the RBNZ, in concert with the treasury, has considered a number of prudential instruments as part of an investigation into supplementary tools that could potentially help monetary policy combat inflation pressures arising mainly from the housing sector and allow less reliance to be placed on the policy interest rate. In an inflation targeting regime with a floating exchange rate, increasing the policy rate to combat inflation pressures can put upward pressure on the exchange rate by way of the carry trade and can negatively affect industries in the tradables-producing sector.

The RBNZ and treasury released a report in 2006 that concluded there was no easy way of solving this policy dilemma for a small open economy like New Zealand, but that several tools might help at the margin, including some instruments that are now considered macroprudential in nature (RBNZ and Treasury, 2006). However, none of the instruments identified at this time were subsequently adopted, with most appearing to entail significant costs or likely to be of limited effectiveness.

The global financial crisis has reactivated interest in the role of macroprudential tools and the work program has broadened from its earlier focus. Although still cautious about what can be achieved through macroprudential policy, it may have a role to play in addressing systemic risks in the financial system in a way that both microprudential settings and monetary policy before the crisis did not.

The reserve bank has followed the international debate with interest—a debate that has greatly increased the understanding of the two main dimensions of systemic risk: how systemic risk is distributed across the financial system at any time (the cross-sectional dimension), and how systemic risk builds up over time and helps drive the broader economic cycle (the time-varying dimension). The view at the RBNZ is that the primary objective or role of any new macroprudential tool should be to build up financial system resilience so that financial institutions are better able to weather adverse shocks. It is possible that some tools could also have a role to play in successfully reducing the amplitude of the credit cycle and broader macrostabilization, though this remains to be seen.

Expanding the Macroprudential Toolkit

The RBNZ’s focus in relation to developing macroprudential tools has been on addressing the effects of financial system procyclicality and the time-varying dimension of systemic risk. Four tools have been examined in this regard:9

  • the Basel Committee’s countercyclical capital buffer;

  • the RBNZ’s own core funding ratio;

  • loan-to-value ratio restrictions; and

  • overlays to sectoral capital risk weights.

To supplement the development of new tools, an early warning system that is necessary for calibrating the implementation of any tool is in the early stages of development. A robust framework is required that tells the policymaker—subject to the usual levels of uncertainty—when vulnerabilities and imbalances are emerging, and when they are reaching potentially critical levels that might warrant macroprudential intervention.

As an aside, the RBNZ is also in the process of implementing the Basel III capital regime for the banking system. Most of the new capital standards are expected to be adopted, but will be tailored to suit the New Zealand conditions. This regime is expected to be implemented well ahead of the Basel timetable. The RBNZ is also implementing a bank resolution policy designed to reduce the adverse consequences of a bank failure and the cost to the taxpayer if this event were to occur (Hoskin and Woolford, 2011). By requiring banks to pre-position their systems for the Open Bank Resolution policy, the policy might have an effect on ex ante risk taking, thereby helping to reduce overall systemic risk. One aim of the policy is to remove the perception that there is a “too-big-to-fail” subsidy or guarantee offered by the government.

The Core Funding Ratio as a Macroprudential Instrument

The key risk to the banking system during the crisis was the unavailability of funding, given the banking system’s reliance on short-term debt raised in offshore markets to help fund balance sheet growth during the boom period. In April 2010, the RBNZ introduced a new liquidity policy to address this risk and improve the maturity profile of bank funding (Hoskin, Nield, and Richardson, 2009).

The core funding ratio, which, along with one-week and one-month liquidity mismatch ratios, forms the policy, defining a minimum level of stable funding to which banks must adhere. Stable funding is defined as retail funding and wholesale funding greater than one year to maturity as a share of total loans and advances. Tier 1 capital is also included. The core funding ratio was initially set at 65 percent and was increased in mid-2011 to 70 percent. The RBNZ plans to increase the core funding ratio further to 75 percent early in 2013. This increase was originally planned to occur in July 2012 but was deferred in response to the European sovereign debt crisis, which saw term debt markets effectively closed during much of 2011.

As a result of both the policy and banks’ own efforts (core funding started to increase before the formal implementation of the liquidity policy), the core funding of the New Zealand banking system has improved since late 2008 (Figure 3.11).

Figure 3.11.New Zealand: Core Funding Ratio

Source: RBNZ Prudential Liquidity Report and Standard Statistical Return.

The core funding ratio is viewed primarily as a microprudential tool, albeit a tool that might also have important macroprudential properties. For example, there is reason to believe that a fixed core funding ratio (e.g., set at 75 percent) could have some stabilization effect during a credit boom. Banks would have to rely on more expensive sources of funding—retail deposits or long-term wholesale funding—to fund balance sheet growth. This result could serve to dampen credit growth by raising the banks’ costs of funds at the margin.

The RBNZ has undertaken simulations examining this cost-of-funding effect, and the size of such an impact depends crucially on what happens to credit spreads over the cycle (Ha and Hodgetts, 2011). Typically, credit spreads contract during a boom as risk aversion declines. Therefore, any automatic stabilization property may depend on how aligned the New Zealand credit cycle is with the global business cycle and the extent of any contraction in term debt spreads.

In addition to this cost of funding channel, a “sand in the wheels” effect may also be operating with a fixed core funding ratio. Banks cannot easily and quickly increase the level of core funding even in benign financial market conditions. The placement of term debt, for example, has to be planned ahead and marketed. The pool of domestic and global investors that would potentially purchase such bonds is much smaller than for short-term debt, so there may be saturation effects. Moreover, in periods of market stress as witnessed since mid-2011, the window of opportunity for New Zealand banks to issue long-term debt can be quite narrow or nonexistent.

Any automatic stabilization impact of the core funding ratio would arguably be magnified if the tool were to be adjusted over the cycle. An adjustable core funding ratio would work in much the same way as the countercyclical capital buffer proposed by the Basel Committee. It would build buffers (in this case funding-liquidity buffers) during a boom by increasing the core funding ratio above its 75 percent minimum, and release such buffers during an economic downturn to prevent a possible credit crunch when funding conditions tighten.

In addition to the channels outlined above, important signaling or moral suasion effects may be available that could work to enhance the macroprudential properties of the core funding ratio. The announcement of any adjustment would send a powerful signal to banks, their investors, rating agencies, and the public at large about the regulatory authority’s unease or concern with the rapid pace of credit growth, or financial imbalances. Market behavior may therefore be influenced by the announcement itself in a way that positively reinforces the actual increase in the core funding ratio.

As with a fixed core funding ratio, the impact on credit growth during a boom will depend on what happens to credit spreads. Overall, an adjustable core funding ratio could play a useful supplementary role in stabilizing the credit cycle, while building further resilience of the banking system to funding-liquidity shocks.

Future Steps

The RBNZ is still in the early stages of developing its macroprudential policy framework. For example, the “Macro-prudential Indicator Report,” which is used internally, will continue to be refined. This report attempts to identify emerging vulnerabilities in the financial system that might justify macroprudential interventions. This report will include ongoing examination of the sorts of trigger variables that might be helpful for indicating when to ease macroprudential settings (e.g., release the countercyclical capital buffer or reduce the core funding ratio). The analysis so far confirms that the available indicators are imperfect and cannot be used in a mechanical fashion. Thus, a checklist of indicators is being developed, and judgment must continue to be exercised.

As mentioned earlier, the RBNZ is continuing to work through the various governance issues associated with the macroprudential policy framework. Part of this work includes a consideration of the bank’s legal powers in relation to extending the framework beyond banks to nonbank lenders.

Macroprudential Measures: The Bangladesh Experience

Shitangshu Kumar Sur Chowdhury

Bangladesh has consistently pursued a cautious, prudent stance in its monetary and fiscal policies, with fiscal deficits around or below 4 percent of GDP since the beginning of the 2000s10. The government’s modest revenue base (as a percentage of GDP) is widening steadily with ongoing reforms in revenue administration, rising to 12.5 percent in fiscal year 2012 (FY2012) from 10.9 percent in FY2010. The country’s medium-term macroeconomic framework targets the revenue base to reach 14.5 percent of GDP by FY2015.

The Bangladesh economy was not severely affected by the 2008–09 global financial crisis and economic downturn, owing to its limited and regulated external exposure, and pro-active government policies. Crisis-related downturns in mature advanced economies caused some lagged effects, however, prompting Bangladesh to reposition itself through a framework of macroprudential measures aimed at addressing the negative impacts of the global economic slowdown. A brief description of the measures and their after effects follows.

Capital Flows

Although a member of the World Trade Organization since its inception in 1995, with an open trade regime and full current account convertibility of the Bangladesh taka (Tk.), Bangladesh maintains some capital account controls to protect its relatively small economy from destabilizing surges of footloose international capital flows. Bangladesh permits unrestricted inflows and outflows of nonresident-owned direct or portfolio investments and earnings thereon, but restricts investment abroad by residents, as well as short-term fund inflows and outflows other than normal trade credit. This policy regime kept banks and financial institutions in Bangladesh free of toxic assets and contagion from external markets in the global crisis, safeguarding their solvency and liquidity.

The crisis-related downturn in mature advanced economies brought about some lagged effects, however, in a brief spell of export and import slowdown and an attendant mild decline in GDP growth. During this spell, the government extended support to the affected export sectors and enhanced social safety net expenditure to bolster domestic demand. Regulations for undertaking forward transactions of foreign exchange have been liberalized to reduce the foreign exchange risk in international trade. Export subsidies and cash incentives have been enhanced for a wider range of industries, specifically frozen food and jute and leather products. Loan rescheduling conditions were relaxed, waiving down payment requirements (until June 2010) for recession-hit export-oriented industries, especially frozen food, leather and leather products, jute and jute goods, textiles (including spinning) and ready-made garments (RMG). Fiscal stimulus of Tk. 4.5 billion was provided to support recession-hit export sectors of jute, leather, and frozen food. Steps have been taken to obtain a sovereign credit rating for Bangladesh to facilitate borrowing abroad by private sector industrial enterprises, and confirmation of credit lines on more favorable terms. A sovereign rating is expected to reduce the costs of trade finance through low-cost funds and loans (because lower country-risk premiums would be charged) and letter-of-credit confirmation lines.

A recovery in growth followed shortly; external trade accelerated sharply in FY2011 with both exports and imports growing by more than 40 percent year over year. Total external trade in FY2011 exceeded US$50 billion. Apparels exports have bounced back strongly, with low labor costs retaining their competitive edge even after the recent wage hike. In the post crisis surge, exports to new markets in fast-growing Asian economies and exports of newer items like marine vessels and information technology–enabled services are gaining momentum.

Trade deficit improved to US$3.5 billion in the first five months of FY2013 compared to the deficit of US$4.5 billion in the same period of the preceding fiscal year. Workers’ remittance received over US$1.0 billion for each 13 consecutive months up to December, 2012 contributed to a surplus in current account balance of US$43 million in the first five months of FY2013 as opposed to the deficit in the same period of the previous fiscal. Likewise, financial account recorded a surplus of US$1.5 million during the same period. These developments contributed to a surplus of US$1.8 billion in overall balances during July-November, 2012 against a deficit of US$0.9 billion million recorded during the corresponding period of the previous year. Foreign exchange reserves reached at US$12.7 billion at end-2012 from the level of US$9.5 billion at end FY2009; the current level is equivalent to 4.23 months’ import payments.

Monetary Policy Measures

Bangladesh Bank (BB) reduced the repo rate in 2009 as a short term measure to deal with the global financial crisis. BB remains proactive in using the monetary policy tools at hand to adjust demand pressures in domestic markets from excessive monetary growth. Cash reserve requirements (CRR) for banks was enhanced in both FY2010 and FY2011, and Bangladesh Bank’s policy interest rates (repo, reverse repo) were enhanced three times in FY2011 and reduced once in the second half of FY 2013.

Bangladesh Bank’s guidance for local financial markets in their management of the surging financing needs of real sector entrepreneurs includes advice for helping and encouraging entrepreneurs in accessing equity and term borrowing from abroad for part of their investment needs (for which the prevailing policy regime is very congenial). The bank also requires established well-run businesses to go public and issue equity and debt in the local capital market to raise funds instead of depending solely on bank loans.

Domestic growth was projected to be 7.2 percent in the FY2013 budget under the assumption of stable domestic and global economic conditions. However, primarily due to sluggish global economy, various forecasts highlight significant dampening influences on that growth target. BB forecasts that, in FY 2013, the real GDP growth is unlikely to be less than the previous year’s average and it may exceed if the global condition improves (Output growth may range between 6.1 percent to 6.4 percent for FY 201311).

Credit Policy

Against the backdrop of the global economic downturn, Bangladesh Bank continues to keep credit conditions easy, placing emphasis on channeling liquidity into productive and supply-augmenting investments, including mandatory agricultural and small and medium enterprise activities that are expected to lead to more broad-based and inclusive growth processes while discouraging excessive consumer credit and similar demand-side lending to avoid a buildup of inflationary pressures. As the central bank of a developing country, Bangladesh Bank uses its monetary and credit policy tools in an integrated way, seeking to maintain an optimal trade-off between growth and inflation. A positive outcome of this approach has appeared in GDP growth gains, with core (nonfood) inflation remaining in the lower single digits. Domestic prices of food and fuel commodities (which are large components of headline CPI inflation) follow the trends of their import prices (the Bangladesh government subsidizes user prices of fuels and some agricultural inputs to cushion shocks from upward trends in global prices; this is a large fiscal burden).

Recently, banks were advised to limit their interest rate spread12 within the lower single digits in different sectors other than high-risk consumer credit (including credit cards) and loans to small and medium enterprises.

Although Bangladesh Bank usually pursues a sector-neutral credit policy, however, due to excessive credit growth in nonproductive consumer goods and real estate sectors, financing policy was tightened in 2011 through an increase in the necessary minimum equity participation of the borrower, to 70 percent from 50 percent for consumer goods, and to 30 percent from 20 percent for real estate.

Strengthening the Financial System

After the global crisis, Bangladesh Bank’s supervisory oversight on risk management practices in banks has been strengthened, and the cornerstone has been laid for increased activity in macroprudential supervision.

  • Risk-based capital adequacy. To comply with international best practices and to make bank capital more risk sensitive as well as more shock resilient, Bangladesh entered into the Basel II regime on January 1, 2010, after a one-year parallel run with Basel I. Scheduled banks are required to comply with the revised regulatory framework on capital adequacy (Risk Based Capital Adequacy for Banks, which is part of the revised regulatory capital framework in line with Basel II). Basel II’s Standardized Approach for Credit Risk, Standardized (Rule Based) Approach for Market Risk, and Basic Indicator Approach for Operational Risk are being followed. The capital adequacy ratio has been fixed for banks at 8 percent or more for January 2010 to June 2010, 9 percent or more for July 2010 to June 2011, and 10 percent or more for July 2011 onward.

  • Stress testing and resilience of the system. Steps have been initiated to build up an adequate pool of stress-testing capabilities in an effort to introduce stress-testing routines to identify institutional and systemic vulnerabilities to probable stress events. Banks have been provided with core risk management guidelines for credit risks, asset and liability or balance sheet risks, foreign exchange risks, internal control and compliance risks, money laundering risks, and information and communications technology security for banks and financial institutions. Guidelines for assessing environmental risk along with credit risk for an overall credit rating before disbursement of a loan or credit facility and policy guidelines for green banking have been issued with a view to developing a strong and environmentally friendly banking system. In addition to the core risk guidelines, focusing on specific areas, overarching risk management guidelines for banks have been issued. These guidelines focus on how risk management should be governed, and give particular emphasis to capital management.

  • Bank performance analysis. Regulatory and supervisory capacity at Bangladesh Bank is continually being upgraded. Current supervision routines include supervisory CAMELS13 ratings of banks based on a newly-revised set of performance indicators and qualitative assessment factors, early warning to banks with deteriorating trends in performance indicators, and intensive oversight on problem banks with CAMELS ratings below a specified minimum. The further development of the Enterprise Data Warehouse has greatly increased the speed at which data are available for analysis, and further improvements to the collection and editing of data and the automated generation of computerized reports for financial analysis are envisioned.

  • Loan classification and provisioning. To strengthen credit discipline and bring classification and provisioning regulation in line with international standards, Bangladesh Bank, in late 2012, revised policies on classification and provisioning (to recognize expected loan losses at an earlier stage and to introduce more qualitative factors into the evaluation) and on rescheduling (to discourage “evergreening” of the loan portfolio). The main effect of the revised policies has been to increase the confidence in bank financial statements, which is an important component in financial stability.

  • Credit information bureau. To ensure prompt collection of credit data from sources and instantaneous delivery of credit reports to users, online credit information bureau services opened on July 19, 2011. The service has brought huge advantages to the banking sector of Bangladesh. Physical presence is no longer needed for the collection of credit reports or the submission of credit information to the credit information bureau database.

  • Corporate governance. Liquidity and solvency problems caused by poor governance in banks can have harmful systemic consequences in the broader economy that relies on banks for credit and payment services. Therefore, high priority is given to corporate governance in banks, including putting in place checks and balance comprising a mix of legal, regulatory, and institutional provisions that specify the roles and accountability of the board, the executive management, external and internal audit, and disclosure and transparency prescriptions. Good corporate governance can contribute substantially to a cooperative working environment between banks and their supervisors. It supports not only a well-managed banking system but also contributes to protecting depositors’ interests. Bangladesh Bank has recently taken several measures to put in place good corporate governance in banks. These include fit and proper tests for chief executive officers of private commercial banks, constitution of the board audit committee, enhanced disclosure requirements, and others. In continuing these reforms, the roles and functions of the board and management were redefined and clarified with a view to specifying the powers of management and restricting the intervention of directors in day-to-day management of the bank.

  • Financial Stability Department. To develop and implement macroprudential policies and monitor the stability of the entire financial sector (with special emphasis on the banking sector), Bangladesh Bank in 2012 created the Financial Stability Department (FSD). The FSD, and before it, the Department of Off-site Supervision (DOS), have issued Bangladesh Bank’s first and second Financial Stability Reports. As its functions develop, it will monitor the possible accumulation of stress in the financial system, using indicators such as real estate and other asset prices, household and corporate debt, credit growth, and so forth. The FSD will monitor bank liquidity from a system-wide perspective, focusing on the interconnectedness among institutions. It will also consider the introduction of macroprudential measures such as countercyclical provisioning and capital buffers and adjusting maximum loan-to-value ratios.

A cautious supervisory stance on banking sector risk management, in broad conformity with Basel Committee on Banking Supervision standards, has served Bangladesh well in preventing large risk buildups that could threaten systemic stability. There have been rare episodes of risk-management weaknesses leading to problems in a few individual banks needing to be sorted out with Bangladesh Bank intervention, but none of these threatened instability by contagion to other banks and financial institutions.


The 2008–09 global financial crisis and sovereign debt crises in a number of countries have prompted policymakers to periodically review financial stability. Financial stability through macroprudential measures is gaining increasing importance in macroeconomic management toward sustainable economic growth. But the fact should also be acknowledged that macroprudential measures have limitations and need to be used in conjunction with other policies, such as monetary policy, to be effective.

Although risk-management practices in the banking sector in Bangladesh have served their purposes fairly well in averting systemic crises, there is no room for complacency; these practices must be improved and developed continuously in step with increasing the depth, diversity, and sophistication of Bangladesh’s financial market and its services.

Macroprudential Practice in China

Liao Min

Supervisory Measures from the Macroprudential Perspective

In 2003, when the China Banking Regulatory Commission (CBRC) was first established, it worked together with the People’ Bank of China (PBC) and other related authorities to prioritize China’s banking reform, focusing on the systemically important institutions, that is, the state-owned commercial banks and rural credit cooperatives. Both reforms have achieved significant progress.

China has strengthened the firewall between the banking sector and capital markets, prohibiting bank credit from financing stock trading, which helped prevent further price surges during the stock market boom in 2007.

The CBRC has conducted peer-group comparisons to identify similar risk exposures and trends in the banking sector.

Since 2006, the CBRC has held quarterly meetings with the board and senior management of major banks, sharing its analyses of changing economic and financial conditions as well as views on inherent financial risks. This initiative has been widely welcomed by the Chinese banks.

Countercyclical Measures during the Economic Upswing

During the past economic upswing, the CBRC adopted a number of countercyclical measures:

  • In 2007, when the housing market was overheating in many Chinese cities, the CBRC tightened the risk-management criteria for property lending. For the purchase of second homes, the loan-to-value ratio cap was lowered from 70 percent to 60 percent, and the benchmark lending rate was raised by 10 percent.

  • Banks were required to increase loan loss provisions. At the end of 2008, the average provisioning coverage ratio in Chinese banks reached 116 percent.

  • Banks were required to conduct securitization transactions in a prudent manner. Since 2008, the securitization of nonperforming assets has been prohibited.

Countercyclical Measures during the Economic Downturn

In early 2009, with the deepening of the global financial crisis, the CBRC adjusted a number of supervisory requirements in credit policies, including encouraging the financing of mergers and acquisitions; allowing the restructuring of certain loans; promoting the development of small business, rural, and consumer finance; and increasing the loan-to-value ratio limit for first home mortgages to 80 percent from 70 percent.

Countercyclical Measures since the Rapid Credit Growth in 2009

In view of the rapid loan growth that started in late 2008, a capital conservation and countercyclical buffer of 2.5 percent and a capital surcharge of 1 percent for large banks was implemented in 2009. At the same time, the CBRC required banks to increase their provisioning coverage ratio to 150 percent by the end of 2009. The loan-to-value ratio ceiling has been adjusted several times in response to rapidly rising housing prices. As of mid-2012, the loan-to-value ratio limit for first home mortgages is 70 percent and that for second home mortgages is only 40 percent. The CBRC issued its Rules on Leverage Ratio in June 2011. The minimum standard for the leverage ratio is 4 percent for all banks, but with different transition periods. Systemically important financial institutions (SIFIs) must comply by end-2013; others by end-2016.

Strengthening Supervision of SIFIs

The CBRC is formulating a policy framework for SIFIs.

  • A methodology is being developed for identifying SIFIs. The methodology considers four categories of systemic importance—size, interconnectedness, substitutability, and complexity.

  • Stricter supervisory requirements will be introduced for SIFIs. A 1 percent capital surcharge for SIFIs has been implemented. Other supervisory policies under discussion include a liquidity surcharge and stricter limits on large exposures.

  • Activity restrictions and firewalls will reduce complexity and interconnectedness. In China, banks are prohibited by law from conducting nonbanking activities. However, in the past few years, some banks have been allowed to establish nonbank subsidiaries on a trial basis and with approval by the State Council.

The most important element in the SIFI policy framework is enhanced and intensified supervision. The CBRC has also worked with other relevant agencies to improve its resolution regime and tools. To increase the resolvability of the SIFIs, the CBRC will require N-SIFIs to formulate recovery and resolution plans. Bail-in mechanisms are also being considered for the future. The CBRC will continue its efforts to enhance supervisory cooperation and coordination, especially for SIFIs, both in the cross-sectoral and the cross-border dimensions.

Mitigation of Risks Related to Economic Restructuring

The CBRC continues the practice of closely tracking economic and financial developments and communicating them to the industry, improving its risk monitoring and early warning systems, conducting regular analysis of exposures by industrial sectors, and guiding banking institutions to optimize their credit allocation and fend off risks arising from economic restructuring. Along with the efforts to implement macroeconomic adjustment policies, the CBRC further strengthened the supervision of credit exposures to industries and projects identified as high polluting, energy intensive, and with redundant capacity. In addition, the CBRC guided banking institutions to recover and resolve loans to enterprises whose production capacity was considered obsolete, and to adjust their portfolios in favor of green credit.

Mitigation of Risks Related to Real Estate Loans

In accordance with the Notice of the State Council on Firmly Containing the Surging Housing Price in Certain Cities and the latest real estate loan policies, the CBRC introduced stringent regulatory requirements in a bid to strengthen the supervision of banks’ lending to real estate markets. A list of property companies was compiled for reference by banks in making property-development loans.

With respect to risk management for property development loans, banks were required to take precautionary measures such as appropriately assessing their risk exposures to property developers, conducting stringent reviews of property developers’ capital adequacy and own-funding status, requiring high quality collateral, and applying dynamic management of loan-to-value ratios.

With respect to risk management for land reserve loans, banks were required to strictly assess the adequacy of collateralization to avoid reckless credit supply. For risk management of residential mortgages, banks were instructed to implement dynamic and differentiated credit policies, and to strictly adhere to the supervisory guidance on the adjustment of down payments and mortgage rates. The requirements that banks interview and sign the contract with the mortgage borrowers in person, and visit the resident property to stem speculative investment, were reiterated. In general, the CBRC closely monitored the credit risks arising from the property market and advised banks to conduct stringent stress tests on their real estate loans and make diligent assessments of the impact of price declines and macroeconomic changes on the quality of their real estate loan portfolios.

The CBRC will review and resolve rule-breaking behaviors in real estate lending, specifically requiring banks to properly manage the loans made to real estate developers, and strengthen the verification, evaluation, and management of the corresponding collateral. Furthermore, dynamic and differentiated residential mortgage policies continue to be implemented to prevent speculation in the housing market.

Challenges ahead

The divergence in the path to recovery following the 2008–09 global financial crisis between advanced and emerging economies was pronounced. In 2011, China still faced a challenging task in boosting domestic consumption as an important driving force behind economic growth.

The increasingly severe structural overcapacity, and a growth model featuring intensive energy consumption and pollution, underscored the urgency of economic transformation and industrial restructuring. With imported inflationary pressure edging up, the work to curb inflation and maintain stable growth faced a harsh test.

Economic Growth and Industrial Structure Transformation

In 2011, China’s GDP grew by 9.2 percent year-on-year, a decrease compared with 10.3 percent in 2010; the consumer price index increased cumulatively by 5.4 percent; and the producer price index increased by 6.0 percent. With the double pressure of slow economic growth and increasing inflation, industrial restructuring was more urgent and efforts were further intensified. During the Eleventh Five-Year Plan period, the obsolete capacity in some industries, including iron and steel, coke, cement, and paper making, was decreased by 50 percent; the emissions reduction target for sulfur dioxide was achieved one year ahead of schedule, the target for chemical oxygen demand half a year ahead, and that for energy consumption per unit of GDP was completed on schedule.

Real Estate Loans

Although an array of adjustment measures have been taken to ensure stable and sound development of the housing market, certain deep-rooted factors that may lead to housing bubbles still exist. Because the housing market has long-term and significant implications for the well-being of the banking sector, it is vital that banks participate in the management of housing market risks, particularly with regard to land reserve loans and lending to real estate developers.

Prevention and Mitigation of Systemic Risk

Although a wide range of instruments and tools under the macroprudential framework have been proposed and implemented, finding the trigger point and sending warning signals to the market in an accurate and timely way is still the most difficult job. The techniques for monitoring, measuring, preventing, and mitigating systemic risk are still limited and inadequate, and need further development.

Internationally, the uncertainty of the U.S. economic recovery, the risks to euro area financial stability, and an environment of weakening macroeconomic growth prospects cast doubt on the effectiveness of the current initiatives. Nationally, the banking sector is becoming larger and more globally connected, thus increasing the difficulty of systemic risk management. Furthermore, in the context of interest rate and exchange rate liberalization, the increasing business complexity, sophistication, and interconnectedness of the banking sector make the task even more difficult.

A broader vision is needed when managing systemic risk. The 2008–09 global financial crisis shows that during a debt cycle, the leverage ratios of four sectors—government, household, financial, and nonfinancial—are correlated and may interact with each other. Since the crisis, the financial sector leverage ratio has been closely monitored and controlled, but the other three sectors need the same level of attention. Therefore, management of systemic risk from the banking sector cannot and should not rely only on regulatory and central bank efforts. All relevant government authorities should also give serious thought to the issue of systemic risk when formulating their policies, and a smooth, prompt, cooperative, and coordinated mechanism should be in place to deal with all possibilities. However, in China, given the government’s influence over economic activity, monitoring and controlling the government sector’s leverage ratio is particularly important for improving the management of systemic risk.

Macroprudential Infrastructure in Cambodia

Buy Bonnang Pal

Macro-Financial Linkage

The link between the real sector and the financial sector in Cambodia is relatively strong as witnessed during the economic slowdown in late 2008 and 2009. The collapse of four major sectors of the economy—garments, tourism, construction, and agriculture—significantly affected the banking sector as the nonperforming loan ratio almost doubled. Conversely, the lack of credit to the real sector, coupled with depressed consumption and investment, has prolonged recovery of the real sector, which increases concerns in the banking sector because of profitability and liquidity tightening.

Macroeconomic Policies

Before the 2008–09 global economic and financial crisis, Cambodia experienced a period of rapid growth fueled by easy monetary policy and large capital inflows, especially via cross-border banking. Credit expanded rapidly, averaging growth of more than 50 percent per year. Easy monetary policy coupled with fiscal expansion led to an asset-price bubble, especially in the real estate sector given the absence of a capital market.

At the same time, inflation pressures resulting from high oil prices and the food price crisis necessitated intervention by the authorities. Reserve requirements were doubled and fiscal expenditure was tightened to fight inflation and to mitigate the asset bubble. These policy actions, although effective at lowering inflation and asset prices, produced negative externalities as liquidity in the banking system was squeezed and a credit crunch emerged. Consumption and investment were also scaled back, causing a recession in the overall economy.

Easing monetary policy and providing fiscal stimulus were required for the authorities to put the economy back on track. Reserve requirements and liquidity facilities support were adopted and tax exemptions and reductions in tax rates were implemented for key sectors. In short, policies for macroeconomic management in Cambodia were in place that allowed imbalances to build up over time and also contributed to procyclicality both before and during the global crisis.

Microprudential Measures

Cambodia still complies with Basel I and is in transition to Basel II. Given the less complicated banking system in Cambodia, adopting Basel II or Basel III is less of a priority. However, key ideas introduced by Basel II and Basel III are important to updating the regulatory and supervisory regime in the country. The capital standard in Cambodia (the capital adequacy ratio) has always been high, almost double the international standard. In this sense, the 15 percent minimum capital adequacy ratio already encompasses the capital buffer and the procyclicality buffer. This capital adequacy level also limits the leverage ratio of banking institutions to 1:6 (borrowing up to six times capital is allowed). The definition of capital has been updated as recommended by Basel III, and the requirements for an additional capital surcharge have been put in place. Despite this progress, the liquidity rule remains lacking and is being updated to align it with international standards.

Macroprudential Measures

Macroprudential Tools

The macroprudential policy instruments adopted consist of reserve requirements, loan-to-value ratios, caps on credit expansion or credit growth to high risk sectors, monitoring of currency mismatches and maturity mismatches, and additional capital and provisioning. Reserve requirements have served as both monetary policy and prudential tools. Reserve requirements have proved to be effective at mitigating credit expansion and providing reserves for liquidity shortages within banking institutions. Loan-to-value ratios also serve as important instruments to curb credit expansion and risk-taking behavior of the banking institutions. Caps on credit to high-risk sectors were adopted in early 2008 during the credit and real estate bubble, but it was abolished in early 2009 to ease credit flows as well as to stimulate growth. Monitoring of currency mismatches and maturity mismatches has been conducted as part of the assessment of currency and liquidity risks, but these instruments also serve as macroprudential tools. Any signs of distress resulting from currency and maturity mismatches would require immediate remedial actions. Additional capital buffers and provisioning have also been adopted to improve loss-absorbing capacity and to strengthen banking institutions’ positions against possible shocks, especially against the impact of the global crisis.

Some of the tools were adopted specifically to prick the bubble in the real estate sector. However, in general, the tools are used to achieve the ultimate target of ensuring stability in the banking sector and the financial sector as a whole. The main criteria for choosing the instruments are their simplicity and their effectiveness. In practice, the instruments have proved to mitigate risk effectively and achieve the ultimate objective of ensuring stability. In particular, the reserve requirement plays a significant role, influencing credit growth, liquidity, and the risk-taking behavior of institutions. The cap on credit to high-risk sectors also directly affects banks’ credit expansion and promotes diversification rather than concentration of credit portfolios. Additional capital and provisioning works best to enhance banking institutions’ solvency positions and ability to absorb losses. It helps to counteract adverse shocks to the system, especially during economic downturns. However, monitoring currency mismatches and maturity mismatches is constrained in achieving its objectives because of the high degree of dollarization and the level of development of the local market, in which long-term sources of funds are scare.

Correctly assessing the costs and impacts is the major challenge in adopting effective macroprudential instruments. Because the Cambodian financial market is at an early stage of development, the evidence of the outcomes of these instruments is somewhat uncertain.

Instruments need to be regularly tested and assessed to ensure their effectiveness. But, instruments also need to be aligned with the circumstances and conditions of the specific market in which they are to be used. For instance, increasing the reserve requirement ratio and placing restrictions on credit portfolios were considered to be appropriate measures in response to the asset-price bubble; however, these actions led to a liquidity shortage in the system requiring that the policy stance be eased so that the reserve requirement was reduced and the cap on credit portfolios was abolished.

Monitoring Systemic Risk

There are no available indicators for identifying systemic risk in the Cambodian financial sector as yet. An initiative is under way to identify systemic risk within the banking sector, focusing on systemically important banks (SIBs).

Relevant indicators applied to the SIBs include asset quality, liquidity, management, capital, profitability, and sensitivity to market risk. Employing common indicators to assess systemic risk is being reviewed. In the Cambodian market, the major sources of vulnerability originate from liquidity and solvency issues. Indicators relevant to liquidity and solvency risk, such as liquidity coverage, sources of funds, solvency ratios, and nonperforming assets, are the major tools for macroprudential monitoring as well as for monitoring systemic risk. In addition, macroeconomic indicators are also used for monitoring purposes. Leading indicators such as financial deepening, inflation, and money supply have been adopted. However, additional indicators need to be developed to effectively monitor the development of the market.

The systemic risk assessment methodology at present is very basic. There is no formal procedure and no specific quantitative or qualitative model employed to review systemic risk. Indeed, no macroprudential stress test is carried out by the central bank. The macro-financial linkage stress test is a new concept in Cambodia and little progress has been made on this issue. A sample stress test was conducted with assistance from the IMF, but there were questions about its effectiveness and its usefulness.

Basel III Proposal

Macroprudential tools proposed by Basel III, consisting mainly of capital buffers, procyclicality buffers, and leverage ratios, are less relevant to the Cambodian context given the fact that the capital standard in the country is relatively high compared with the international standard for capital adequacy. The business environment in which the banks operate and the lack of risk-management tools give rise to the need for a higher capital standard. In addition, banking is a fast-growing industry in the country and capital needs to be built up for future expansion as well as to absorb losses.

Managing Capital Flows

Capital flows into the country have been in the form of direct investment, remittances, and cross-border banking resulting from the lack of a money market and a capital market. Remittances and direct investment have been regarded as the most stable capital flow events during the global crisis. Cross-border banking, however, is the most volatile capital flow. Before 2008, cross-border capital inflows were high—and fueled both the growth of credits and the real estate bubble in the country. Once the capital retreated, the banking system as a whole experienced a liquidity shortage, rising nonperforming loans, and compressed liquidity. Liquidity and solvency of the system became the major concerns. Prudential measures were then placed on short-term cross-border banking capital flows and it proved effective in mitigating the risk.

Challenges for Adoption of Macroprudential Regulations

Institutional Setup

The law does not specifically provide a mandate for financial stability to the National Bank of Cambodia (NBC) or to other agencies in the country. However, because the banking sector is the dominant player in the financial sector, the NBC has taken the initiative to perform a major role in financial stability, but in collaboration with other regulators, for example, the Securities and Exchange Commission of Cambodia and the ministry of the economy and finance. Similarly, no formal legal mandate exists for macroprudential policy. Currently, the NBC is proposing that the Central Bank Law and the Law on Banking and Financial Institutions be amended so that it can carry out the function of financial stability, including macroprudential policy. The proposed amendment is being discussed at the council of ministers and once completed, the proposal will be sent to the National Assembly for endorsement. The draft amendment does not define macroprudential policy. However, it is the intention of the policy to reduce systemic risk and to include a crisis-management function.

Given the current structure of the financial system in Cambodia, the responsibility for macroprudential policy is shared between the NBC and the ministry of economy and finance, but the NBC plays the leading role. At the institutional level, the NBC has already established a financial stability committee and a financial stability unit to carry out this new mandate; at the national level, the financial stability commission has not yet been set up. Discussions are under way between the NBC and the ministry of economy and finance to institutionalize the function of financial stability at the national level and to initiate the role of crisis management.

Ensuring Effectiveness of Macroprudential Policies

Using the right tools for the right jobs and ensuring coordination among related institutions have been considered to be the keys factors for maintaining stability. Given the tools available, deciding on which tools to use is the most challenging part of the process. The cost and impact of each policy instrument needs to be carefully assessed. Communicating with related institutions to ensure the right tools are employed is also important. Enormous energy and effort are sometimes required to convey an understanding of the policy instrument.

Domestic and International Coordination

Coordination with related institutions is essential for the success of the macroprudential policy. Effective communication among the authorities needs to be in place. International coordination is also important to understand the risk at a regional level as well as to participate in regional efforts to enforce common instruments.

Macroprudential Policy Framework: The Republic of Korea

Tae Soo Kang

Potential Systemic Risks Unique to Korea

Increased capital flow volatility and household debt are potential sources of systemic risk that Korea is currently confronting. These two risk factors contribute to procyclicality, implying that the Korean economy is exposed more to systemic risk in the time-series dimension than in the cross-sectional dimension.

Capital flow volatility’s amplification of business cycle fluctuations is a systemic risk factor common to emerging Asian economies. It may be conjectured that this phenomenon has been caused by emerging Asian economies’ heavy reliance on capital inflows for credit, rather than on funding by domestic bank deposits (Figure 3.12).

Figure 3.12.Korea: Ratio of Capital Flows to GDP and GDP Growth

Source: Bank of Korea.

Sudden reversals of capital flows have repeatedly occurred at periods of deterioration in the external financial environment and have consequently led to higher volatility in important market indicators such as exchange rates, interest rates, stock prices, and others (Figure 3.13).

Figure 3.13.Korea: Effect Capital Flows on Volatility

Source: Bank of Korea.

Note: EU = European Union; KOSPI = Korea Composite Stock Price Index.

1Three-month moving average of standard deviation.

The rapid buildup of household debt is another systemic risk factor in Korea. The ratio of household credit to disposable income reached its highest-ever level (155 percent as of 2010; Figure 3.14, panel a). The principal concern about household debt is the vulnerability in its structure. Most household loans are installment loans without regular amortization of principal, and interest is at floating rates (Figure 3.14, panel b). Under the current debt structure, household solvency could be rapidly undermined by rising interest rates or banks’ pressure for loan redemption caused by worsening economic conditions at home and abroad.

Figure 3.14.Korea: Household Debt and Mortgage Loans

Source: Bank of Korea.

1Nine major domestic banks, as of end of 2011.

Macroprudential Measures Deployed

Responses to Capital Flow Volatility

The Korean authorities have strived to mitigate capital flow volatility by employing a macroprudential policy aimed at stabilizing short-term capital inflows and establishing safeguards against sudden capital outflows (Figure 3.15). Macroprudential policy tools, such as ceilings on foreign exchange derivative positions, the macroprudential stability levy, and the taxation of foreigners’ bond investments, were implemented with a focus on the stabilization of short-term capital inflows, thereby minimizing negative side effects on the financial system and the economy. In open emerging markets, noncore liabilities usually take the form of short-term external debt, which, when accumulated in excess, increases vulnerability to the outbreak of a crisis (Shin and Shin, 2010). Moreover, high capital flow volatility can cause interest and foreign exchange rates to deviate from economic fundamentals and distort term structures, thereby weakening the monetary policy transmission channel (Figure 3.16).

Figure 3.15.Korea: Macroprudential Response to Capital Flow Volatility

Source: Bank of Korea.

Figure 3.16.Korea: Effect of Macroprudential Policies on Foreigners’ Investment

Source: Bank of Korea.

So far, the macroprudential policies have proved to be effective, reducing short-term external debt, reducing arbitrage incentives, and increasing the share of foreigner’s investment in long-term bonds (Figure 3.17).

Figure 3.17.Korea: Effect of Macroprudential Tools on Debt

Source: Bank of Korea.

Responses to Rapid Increase in Household Debt

In response to household debt, the debt-to-income (DTI) and loan-to-value (LTV) ratio regulations have been tightened, which has been effective in the short term. However, more work is needed to establish how much of the change in housing prices and loan growth is attributable to macroprudential policy tightening (Figure 3.18).

Figure 3.18.Korea: Housing Indicators (Seoul Area) before and after Loan Regulation Tightening

Sources: Bank of Korea; Kookmin Bank; and Korean Ministry of Land, Transport, and Maritime Affairs.

Note: Comparison between six-month periods before and after strengthening of loan regulation.

Possible Obstacles to Implementation

Asymmetry in their impacts when addressing procyclicality is pointed out as a weakness of macroprudential measures such as countercyclical buffers and dynamic provisioning, ceilings on loan-to-income and DTI, and adjustments of risk weights on specific exposures. There are claims that these macroprudential measures are less effective in alleviating credit supply contractions during economic downturns than in holding down credit expansion.

Countercyclical Buffers and Dynamic Provisioning

Countercyclical buffers, dynamic provisioning, and adjustments of risk weights on specific exposures are measures taken to reduce procyclicality within the capital regulation framework. These measures either adjust the capital ratio K or the risk weight w in the general formula for capital regulation:

in which K is the capital ratio, E is equity, w is the risk weight, and A is asset value.

For countercyclical buffers, it has been assumed that if the authorities were to increase the capital ratio in times of credit expansion, banks would downsize their assets and credit supply, and if the authorities were to decrease the capital ratio during times of credit contraction, banks would be more lenient in scaling back their credit supply. However, in times of credit expansion, banks’ improved profitability would increase their net worth (E ↑) and would lower risk weights (w ↓), both bringing about higher capital ratios for the banks (K ↑). Under such circumstances, the banks may choose to continue increasing their exposures to high-risk, high-return assets regardless of the increased burden of countercyclical buffers. Also, the effects of the current countercyclical buffers may be offset by time lags or they may be less effective during periods of rapid credit expansion, given that banks are given a grace period of up to 12 months to meet the targets.14 Dynamic provisioning is subject to the issue of time lags as well, given that the additional charges are determined by past data and that the banks could postpone meeting their reserve requirements until the end of the fiscal year. In times of credit contraction and uncertainty about the duration of a crisis, however, banks are likely to opt to maintain capital buffer targets set during the past boom, out of concern that declines in their capital ratios might be interpreted as a worsening of their financial soundness. See Figure 3.19.

Figure 3.19.Operating Mechanism and Effectiveness of Countercyclical Buffers

Source: Author’s calculations.

DTI and LTV Regulations

Ceilings on DTI and LTV ratios are means of directly limiting excessive credit supply, and are therefore effective in limiting excessive credit provision by banks during economic upturns. But they may be less effective in improving liquidity conditions or the supply of credit because, despite the easing of LTV and DTI limits, banks are likely to focus on cash hoarding rather than lending. Empirical analysis shows that stricter LTV and DTI regulations have had significant effects on loan size in Korea but there has been less effect when they are loosened (Figure 3.20 and Table 3.5).

Figure 3.20.Korea: Mortgage Loan Fluctuations

Source: Bank of Korea.

Note: DTI = debt-to-income ratio; LTV = loan-to-value ratio.

Table 3.5.Determinants of Loan Size
Dependent variable: Household loans (with income information)
2006 (Tighter DTI)2007 (Tighter DTI)2008 (Eased DTI)2009 (Tighter DTI)2010 (Eased DTI)2011 (Tighter DTI)
Financial variablesLog (collateral value)0.705***0.622***0.653***0.782***0.687***0.621***
Income of borrower0.009***0.022***−0.003***0.010***0.014***0.011***
Interest rate (CD yield)1−0.072***−0.029***−0.095***−0.136***−0.043***0.072***
High credit2 dummy0.082***0.038***−0.059***0.089***0.046***0.048***
Gangnam3 dummy0.045***0.075***0.171***0.003***0.088***0.111***
Nonfinancial variableInterest only payment4 dummy−0.164***−0.043***0.059***0.118***0.101***0.006***
Group loan dummy−0.019***0.017***0.035***0.089***0.083***−0.007***
Business owner5 dummy0.023***0.024***0.026***0.042***0.034***0.029***
Regulatory variablesLTV dummy−0.093***−0.046***0.004***−0.102***−0.031***−0.116***
DTI dummy−0.051***−0.096***−0.066***−0.046***−0.008***−0.019***
Adjusted R20.3640.3080.2950.3320.2920.282

Rates at the time of loan.

Borrowers with high credit ratings (1–4) = 1, others = 0.

Loans at the Gangnam District = 1, others = 0.

Loans with only the interest repaid = 1, others = 0.

Borrowers that own individual businesses = 1, others = 0. * = significant at 90 percent, ** = 95 percent, *** = 99 percent, respectively. (Test statistics are adjusted for heteroskedasticity.)

Rates at the time of loan.

Borrowers with high credit ratings (1–4) = 1, others = 0.

Loans at the Gangnam District = 1, others = 0.

Loans with only the interest repaid = 1, others = 0.

Borrowers that own individual businesses = 1, others = 0. * = significant at 90 percent, ** = 95 percent, *** = 99 percent, respectively. (Test statistics are adjusted for heteroskedasticity.)

Adjustment of Risk Weights on Specific Exposures

Adjusting the risk weights on specific exposures provides incentives to reduce exposures to an asset class by requiring more capital and adjusting the risk weight upward when the credit risk related to the specific asset class increases. However, banks may respond to an upward adjustment of risk weights in an unintended manner, by recapitalizing (E ↑) or reducing other low-return exposures (Aj ↓) rather than reducing their exposure to the profitable asset class (Ai ↓), in which case the policy would be less effective. According to Francis and Osborne (2009), only 25 percent of banks reduced their exposures to the targeted risky assets, whereas 50 percent recapitalized and 25 percent reduced exposures to other asset classes. The banks’ responses to risk weight adjustment is given by equation (3.2):

Macroprudential Framework and Measures: The Indonesian Experience

Sukarela Batunanggar

Overview of Financial System Stability Framework

As a result of the Asian crisis of 1997–98, awareness of the importance of maintaining financial system stability grew. The roles of maintaining monetary stability and promoting financial system stability are closely related. Both roles aim to achieve macroeconomic stability (Batunanggar, 2002, 2005).

Bank Indonesia (BI) formulated a financial system stability framework and established a unit responsible for overseeing financial system stability in mid-2003. In line with the enactment of Law No. 23 of 1999, BI incorporates financial system stability in its mission “to achieve and maintain stability of the Indonesian rupiah through maintaining financial stability and promoting financial system stability for sustainable national development.” In accordance with its mission, BI formulated a framework that contains the objective, strategy, and instruments required for maintaining financial system stability. BI’s goal is to play an active role in maintaining Indonesia’s financial system stability.

Since the late 1990s, there has been an increasing trend in the establishment of dedicated units in central banks to perform financial stability functions and publish financial stability reports. In mid-2003, BI established a new unit, the Bureau of Financial System Stability, responsible for performing macroprudential surveillance to identify major risks to Indonesia’s financial system and for proposing macroprudential policies to complement monetary policy. Since then, BI has also published the biannual Financial Stability Review, which discusses development of the financial system and analyzes systemic risks, as well as proposes policy recommendations to mitigate such risks (Santoso and Batunanggar, 2007).

To achieve a stable financial system, BI has adopted four strategies: microprudential supervision, macroprudential supervision, coordination and cooperation, and crisis management (Figure 3.21).

Figure 3.21.Bank Indonesia’s Financial System Stablility Framework

Source: Bank Indonesia.

Note: BCP = Basel Core Principles; CPSIPS = Core Principles for Systemically Important Payment Systems.

Microprudential supervision. Microprudential supervision is aimed at identifying and mitigating the idiosyncratic risks in individual financial institutions, especially banks, to create and maintain a safe and sound banking system. Consistent implementation of international prudential regulations and standards are required as a sound basis for both regulator and the market players in conducting their business. In addition, consistent discipline of the market players needs to be fostered. Microprudential supervision will be performed by the newly established Financial Services Authority (FSA), with the transfer of banking supervision from BI in January 2014.

Macroprudential supervision. Macroprudential supervision is focused on identifying and mitigating systemic risks in the financial system to create and maintain financial system stability. Macroprudential supervision covers two areas: macroprudential surveillance and macroprudential regulation. Risks that may endanger financial system stability are measured and monitored by the use of several tools and indicators, including an early warning system that is composed of microprudential and macroprudential indicators, as well as stress testing. Analysis of the threats to financial stability can be accomplished by focusing on risk factors originating within and from outside the financial system. Research and surveillance are aimed at producing recommendations for macroprudential policy and regulations for maintaining financial system stability.

Crisis management. A safety net and crisis management framework and protocol are required for resolving a financial crisis, once it occurs. These tools include policy and procedures for serving as the lender of last resort, and deposit insurance, which has replaced the blanket guarantee. Before 2004, there was no clear legal framework for crisis resolution in Indonesia. According to Law No. 23/1999, BI is only allowed to provide lending to address liquidity problems faced by banks during normal times, but not in a systemic crisis situation. The 2004 amendment of the Bank Indonesia Law stipulates BI’s role as lender of last resort in the event of crisis. BI can provide emergency liquidity assistance for a bank with systemic risk, complemented with a government guarantee.

Coordination and cooperation. Coordination and cooperation with related agencies is crucial, especially in times of crisis. The Financial System Stability Forum (FSSF) was formed based on a memorandum of understanding signed December 30, 2005, between the Minister of Finance and the Governor of Bank Indonesia. The FSSF serves as a venue for coordination and information sharing among the authorities. Under the Financial Services Authority Law of 2011, a Financial System Stability Coordination Forum was established, composed of the Minister of Finance, Governor of Bank Indonesia, the head of the Board of Commissioners of the FSA, and the head of the Board of Commissioners of the Indonesian Deposit Insurance Corporation (IDIC).

Institutional Arrangement for Maintaining Financial System Stability

There are four financial safety net players in Indonesia: BI is the monetary authority responsible for monetary stability and financial system stability; the FSA is responsible for microprudential supervision and regulation of financial institutions and capital markets; the IDIC is responsible for administering the deposit insurance scheme and resolution of failed banks; and the ministry of finance is responsible for fiscal stability.

Banking supervision will be transferred from BI to the FSA in January 2014. The FSA law states that the FSA is responsible for microprudential supervision of financial institutions and capital markets, while BI is responsible for macroprudential policy. In addition, BI still can perform special on-site examinations of systemically important banks and certain other banks in line with its task of macroprudential policy. However, the complete division of authority between macroprudential and microprudential needs to be clearly defined by BI and the FSA and spelled out in a memorandum of understanding.

The division of responsibilities among BI, FSA, and IDIC, based on their respective enabling legislation, is summarized in Figure 3.22 and Table 3.6.

Figure 3.22.Financial Safety Net Player in Indonesia

Source: Bank Indonesia.

Table 3.6.Division of Roles and Responsibilities among Financial Safety Net Players in Indonesia
Bank Indonesia (BI)Financial Services Authority (FSA)Indonesia Deposit Insurance Corporation (IDIC)
Legal basisBI Law No. 23 of 1999 and amendment No. 3 of 2004FSA Law No. 21 of 2011IDIC Law No. 24 of 2004
ObjectivesTo achieve and maintain the stability of the rupiah value (through maintaining monetary stability and financial system stability; proposed revision).To ensure that the overall activities in the financial services sector are
  • managed in an orderly way, fairly, transparently, and with accountability;

  • able to realize sustainable growth and stable financial system; and

  • able to protect the interests of consumers and society as a whole.

  • Insure customers’ deposits

  • Actively participate in maintaining the stability of the banking system in accordance with its authority

Key tasks
  • To formulate and implement monetary policy

  • To regulate and safeguard the payment system

  • To regulate and supervise banks (until January 2014)

  • (To promote financial system stability; proposed revision)

To perform integrated regulatory and supervisory oversight of all activities of the financial services sector, including banking, insurance, pension funds, investment companies, and other financial institutions, as well as the capital markets
  • Formulate and determine implementation policies of deposit insurance

  • Implement the deposit insurance program

  • Formulate and implement the resolution policy for failing banks that do not have a systemic impact

Crisis Management and ProtocolTo provide liquidity support to the banking system or to individual banks with systemic impact under a government guaranteeTo provide information about and analysis of problem financial institutions that have a systemic risk impactHandle failing banks subject to systemic risk
Ministry of finance, BI, FSA, IDIC, and Financial System Stability Forum have developed a crisis management protocol, at both the institutional and the national level, to prevent and resolve crises.
Source: Bank Indonesia.
Source: Bank Indonesia.

The Indonesian financial safety net framework was developed in 2003 and includes roles and responsibilities, policy measures, and coordination mechanisms among financial safety net players in Indonesia for preventing and resolving crises (Batunanggar, 2003 and 2007). The coordination mechanism was initially stated in a memorandum of understanding, then in the draft of the Indonesian Financial Safety Net (IFSN) Law (summarized in Table 3.7), and currently in the FSA Act of 2011. The coordination mechanism among financial safety net players in Indonesia, based on the FSA Law and the draft of IFSN Law, is summarized in Table 3.8.

Table 3.7.Key Content of Indonesian Financial Safety Net Law Final Draft
ElementKey Content
Main objective
  • To create and maintain financial system stability

  • To prevent systemic risk and to contain financial crisis

  • Banks and insurance companies with systemic risk implications

  • Crisis in government securities market

Governance bodyFinancial System Stability Forum, the main functions of which will be to determine systemic impacts and enact crisis statutes as well as to devise prevention and resolution strategies
MeasuresLiquidity problems
  • Emergency liquidity assistance for banks from BI or the government

  • Liquidity assistance for insurance companies from the Indonesian Deposit Insurance Corporation (IDIC)

Solvency problems
  • Temporary investment in banks and insurance companies by IDIC

Government securities problems
  • Government or BI to buy government securities in the secondary market as crisis-prevention measure

  • Government to buy back government securities or BI to buy government securities in the primary market as crisis-resolution measures

Sources of funds
  • BI (guaranteed by the government) for systemic liquidity assistance for banks

  • State budget for systemic liquidity assistance for banks in a crisis

  • IDIC for systemic liquidity and solvency assistance for insurance companies

Private sector solution
  • Private sector may be involved in the resolution of bank and insurance companies

  • Securities issued by banks may be converted into capital (contractual bail-in)

  • Obligations to policyholders for insurance companies may be restructured (contractual basis)

Crisis management protocolBI, IDIC, ministry of finance, and Financial Services Authority (FSA) must have a crisis management plan in place
Information sharingBI, IDIC, ministry of finance, and FSA share information related to crisis prevention and resolution with the Financial System Stability Forum (FSSF)
Accountability and reporting
  • FSA to announce its report to FSSF concerning systemic impact of banks and insurance companies within three months after FSSF releases decisions on crisis prevention and resolution

  • FSSF to periodically report about the handling of bank or insurance company problems to the president

  • The president to submit a formal report on crisis prevention and resolution to the parliament based on the FSSF report

Source: Bank Indonesia.
Source: Bank Indonesia.
Table 3.8.Coordination Mechanisms among Financial Safety Net Players in Indonesia
AspectCoordination Mechanism
Prudential regulationFinancial Services Authority (FSA) coordinates with Bank Indonesia (BI) in formulating banking regulations, such as capital adequacy, banking information systems, offshore borrowing, banking products, determination of systemically important banks, and data that are excluded from secrecy.
On-site examination and bank rating
  • BI can perform special on-site examinations of certain banks by sending a prior written notice to the FSA. BI does not derive a bank assessment rating. BI provides the report of examination to the FSA within one month of the examination’s completion.

  • The Indonesian Deposit Insurance Corporation (IDIC) can perform onsite examinations of banks in line with its function, tasks, and authority by coordinating first with the FSA.

Problem bankThe FSA informs IDIC about problem banks. If the FSA identifies that a bank faces liquidity problems or its condition worsens, the FSA will immediately inform BI to take the necessary steps according to BI’s authority.
Information sharingThe FSA, BI, and IDIC must develop and maintain an integrated information-sharing mechanism.
Crisis management protocolsThe ministry of finance, BI, the FSA, IDIC, and Financial System Stability Forum (FSSF) develop crisis management protocol, at both the institutional and national levels, to prevent and resolve crises.
Financial System Stability Forum
  • The FSSF was established to maintain financial system stability.

  • The forum consists of the finance minister as coordinator, the governor of BI, the head commissioner of the FSA, the head commissioner of IDIC; and is facilitated by a secretariat.

  • Decision making in the FSSF is based on consensus. If a consensus is not obtained, the decision is made based on majority vote.

  • During normal conditions, FSSF will monitor and evaluate financial system stability, meet at least once every three months, make policy recommendations for maintaining financial system stability, and exchange information.

  • To prevent and resolve crises during abnormal conditions, if any of the FSSF members identifies a potential for crisis or an actual crisis in the financial system, that member can call for a meeting of the FSSF to determine steps for crisis prevention and resolution.

  • Each of the FSSF members is authorized to make decisions on behalf of and for the institution he or she represents in the FSSF during abnormal conditions.

  • The FSSF determines and executes policy required to prevent and resolve a financial crisis in line with its authority.

  • The decision of the FSSF related to the settlement and resolution of a failed bank identified as posing systemic risk binds the IDIC.

  • FSSF policy related to state finances must be proposed to parliament for approval. A parliamentary decision must be made within 24 hours from when the proposed policy is accepted by parliament.

Source: Bank Indonesia.
Source: Bank Indonesia.

Post–Global Crisis Macroprudential Policy Measures

As a response to the 2008–09 global financial crisis, BI adopted macroprudential policy measures integrated with banking supervision (microprudential policy) and monetary policy. The policy measures are aimed at two key objectives: first, to mitigate the risk from short-term and speculative capital inflows, as well as the risk of sudden reversals in capital flows; and second, to enhance the effectiveness of liquidity management and to mitigate risk from capital inflows by attempting to lock them up longer and thereby also help to develop the financial markets. Macroprudential policy measures in Indonesia subsequent to the global crisis are summarized in Table 3.9.

Table 3.9.Post–Global Crisis Macroprudential Policy Measures
Issue or TriggerMeasureObjectives
The high and increasing demand for BI certificates (SBI) and volatility in demand is vulnerable to external shock. This condition could pressure exchange rate stability and output in the long run.Minimum holding period on SBI of one month beginning in July 2010, and increased to six months in 2011.To put “sand in the wheels” of short-term and speculative capital inflows, as well as to mitigate the risk of sudden reversals.
The increasing volume and trend of short-term portfolio holdings (largely offshore), including for SBI, which could pressure exchange rate stability.Lengthen the time between auctions (from weekly to monthly) and offer longer maturities (3, 6, and 9 months) for SBI, as of June 2010.

Shifting SBI to term deposits as of July 2010, because these bills are a nonmarketable securities instruments.
To enhance the effectiveness of liquidity management and to mitigate risk from capital inflows, by locking up funds to longer terms and encouraging the development of financial markets.
  • To lock up domestic liquidity to longer terms and limit the supply of SBI in the market.

  • To facilitate longer-term investment of offshore portfolios through the banking system.

The increasing volume and trend of offshore borrowing, especially in the short term. This condition triggers volatility of capital inflows, especially through the banking system.Reinstate limits on short-term offshore bank borrowing from 20 percent to 30 percent of a bank’s capital.
  • To limit short-term and volatile capital inflows.

  • To limit foreign exchange exposure of the banking system stemming from capital inflows.

Relatively low foreign exchange reserve requirements of banks is not sufficient to mitigate shocks in capital inflows. In addition, idle foreign exchange liquid assets could trigger volatility of the exchange rate.Increase foreign exchange reserve requirements of banks from 1 percent to 5 percent on March 2011 and to 8 percent on June 2011.
  • To strengthen foreign exchange liquidity management and thereby the resilience of the banking system in confronting increasing foreign exchange exposure emanating from capital inflows.

  • To help absorb excess domestic liquidity.

Excess liquidity in the banking system and relatively slow lending growth reflected by a low LDR. Banks tend to invest a large part of their portfolios in liquid and low-risk assets (SBI and government bonds).Increase rupiah primary RR from 5 percent to 8 percent in November 2010. This measure was complemented with a minimum LDR for banks. Banks with LDR of 78 to 100 percent are not obliged to increase their RR ratio, as of March 2011.To absorb domestic liquidity and enhance liquidity management by banks without exerting a negative impact on lending required to stimulate growth.
Source: Modified from Alamsyah, 2011.Note: LDR = loan-to-deposit ratio; RR = reserve requirement; SBI = Sertifikat Bank Indonesia, or Bank Indonesia certificate.
Source: Modified from Alamsyah, 2011.Note: LDR = loan-to-deposit ratio; RR = reserve requirement; SBI = Sertifikat Bank Indonesia, or Bank Indonesia certificate.

Indonesia’s exchange rate policy is directed to ensuring that the rupiah’s value is stable and consistent with macroeconomic development. Amid rapid foreign capital inflows and appreciation pressures in 2010, BI undertook exchange rate stability policy to minimize exchange rate volatility. Because of the complexity of the problems, intervention policy alone was insufficient, and required complementary adoption of macroprudential policy. In this regard, BI introduced a one-month holding period for Bank Indonesia Certificate purchases in June 2010. In addition, BI implemented other policy measures to address the rapid pace of foreign capital inflows.

The Indonesian economy faces a number of challenges, including rising inflation, rapid inflows of foreign capital, sizable excess liquidity, and problems in the real sector. In line with the imbalances in the recovery of the global economy, foreign capital continued to flow into the country during 2010. Regardless, inflation was well under control.

Financial factors play a crucial role in the transmission of monetary policy through the corporate balance sheet channel, through bank balance sheets, and through the risk-taking behavior of banks and firms (Satria and Juhro, 2011; Agung 2010). However, amid the sizable excess liquidity, the role of banks in promoting economic growth was still limited. In addition, Indonesian banks are less competitive as measured by efficiency, capital, and assets compared with their regional peers.

These challenges complicated monetary policy and BI faced a trilemma between exchange rate stability, price stability, and financial system stability. BI cannot rely on one policy, but should use a policy mix to maintain a balanced economy, both internally and externally. Monetary and macroprudential policy should be integrated to ensure macroeconomic stability. To achieve an internal balance, interest rate policy should be used in conjunction with macroprudential policy. Meanwhile, to achieve external balance, exchange rate policy and macroprudential policy covering foreign capital flows should be integrated. Macroprudential policy has been adopted to overcome short-term capital flows, manage liquidity in the domestic economy, and mitigate the risk of instability in the financial system.

Policy coordination is also essential. Policy coordination with the fiscal authority as well as with other sectors is crucial, considering that inflation stemming from the supply side creates the majority of inflation volatility. Coordination between monetary policy and macroprudential policy, as well as microprudential policy, will become more important and more challenging following the transfer of banking supervision from BI to the new FSA in January 2014. In addition, an effective communication strategy is also important for the implementation of both monetary and macroprudential policies.

Sri Lanka’s Experience

Kumudhini Saravanamuttu

Sri Lanka’s financial system is relatively small, with financial institution assets roughly equivalent to 120 percent of GDP in 2011. The financial system is dominated by the banking sector, which accounts for about 60 percent of financial system assets. The credit-to-GDP ratio in Sri Lanka is low at about 40 percent. The capital market is underdeveloped, with the stock market equivalent to 35 percent of GDP.

The mandate for maintaining financial system stability has been given to the Central Bank of Sri Lanka (CBSL) by law, and it is one of the core objectives of the CBSL, along with economic and price stability. The Financial System Stability Committee (FSSC), an internal committee of the CBSL, is chaired by the deputy governor in charge of financial system stability. The FSSC monitors the buildup of vulnerabilities emanating from different sources, monitors systemic risk, and makes policy recommendations. There is also a Monetary Policy Committee chaired by the deputy governor in charge of price stability. The membership of the FSSC is wide and includes members of the Monetary Policy Committee to ensure that macroprudential policy and monetary policy complement each other.

Regulatory responsibilities are divided among multiple institutions. The CBSL regulates banks, finance companies, and the payment system. The Securities and Exchange Commission (SEC) regulates the listed equity and securities market and the Insurance Board (IB) regulates the insurance sector. The deputy governor of the CBSL in charge of financial system stability is on the board of the SEC and the IB. Coordination among regulators is facilitated by the Inter-Regulatory Institutions Council, chaired by the governor of the CBSL, and comprises all financial regulators and quasiregulators.

With regard to the regulation of banks, Sri Lanka migrated to Basle II in 2009 under the simpler approaches for Pillar I. At present, work is under way to implement Pillar II, Supervisory Review.

Macroprudential Regulation in Sri Lanka

Macroprudential policy is defined as the use of primarily prudential tools to limit system-wide financial risk and to prevent disruption of key financial services and the economy. The role of macroprudential policy is to curb excessive risk taking by the domestic financial system. However, macroprudential policy is not sufficient to maintain financial stability; both monetary policy and fiscal policy need to play an active role.

The analytical framework for identifying and reducing systemic risk seeks to cover both the time and cross-sectional dimensions. The former deals with risks caused by credit cycles and the procyclicality of the financial system, whereas the latter deals with that result from interlinkages and common exposures between financial institutions. Macroprudential policy has been primarily applied to banks, and in some cases to finance companies, in Sri Lanka.

Time Dimension of Systemic Risk

A number of countercyclical policies have been implemented to dampen excessive credit expansion:

  • General provisioning requirement. During a period of high credit growth, a general provisioning requirement applies to all advances extended by banks. The general provision of 1 percent was imposed in 2006, and was subsequently lowered to 0.5 percent in 2009 as credit growth waned.

  • Time-varying capital requirements (enhanced risk weights). The risk weight for capital adequacy for retail loans provided by banks was increased from 100 percent to 120 percent in 2006.

  • Time-varying limits on margin trading requirements. During the stock market boom, a credit limit on margin trading facilities granted for stock market transactions of 5 percent of total loans of banks was introduced in 2010. This was removed in 2012.

  • Ceiling on credit growth. In response to bank credit growth of greater than 30 percent in 2010 and 2011, a limit of 18 percent credit growth was imposed on banks for 2012. This measure was mainly aimed at reducing the trade deficit.

  • Limits on net open position. Limits on net open positions in foreign exchange of banks were reduced in 2011 to limit speculative trading in forward transactions.

  • Statutory cash reserve ratio. All banks are required to maintain a cash ratio of 5 percent on rupee deposits.

  • Statutory liquid asset ratio. Since 1989, all banks have been required to maintain liquid assets of not less than 20 percent of total deposit liabilities.

Cross-Sectional Dimension of Systemic Risk

Policies to contain large exposures have been implemented.

  • Single and group exposure limits. A limit of 30 percent of capital funds has been imposed on single and group borrowers, including financial firms.

Systemic Risk Assessment Tools and Indicators

  • Monitoring of cyclical trends in credit growth. Cyclical trends in private sector credit growth are monitored (Figure 3.23) to ascertain if a credit boom is being experienced, based on the methodology used by Mendoza and Terrones (2008).

  • Financial stress indicator. A composite indicator of the stress levels in domestic financial markets and the banking sector. The variables include volatility of interbank call money rates; volatility of 91-day treasury bill yield rates; term spreads between 91-day treasury bill and five-year treasury bond yield rates; volatility of the exchange rate; three-month forward exchange rate premium; Exchange Market Pressure Index; volatility of the All Share Price Index; beta index of the banks, finance, and insurance sub-index and the overall stock market index; gross nonperforming loan ratio of the banking sector; and private sector credit growth (Figure 3.24).

  • Banking soundness indicator. An aggregate indicator of the soundness and stability of the banking sector, based on the CAELS (capital, asset quality, earnings, liquidity, and sensitivity to market risk) methodology. The variables included capital adequacy ratios, nonperforming loan ratios, profitability ratios, liquidity ratios, and interest rate and foreign exchange risk ratios (Figure 3.25, panels b and c).

  • Corporate creditworthiness indicator. Monitors the debt-paying capacity of listed companies. The variables include leverage, profitability, and liquidity ratios (Figure 3.25 panel d).

  • Financial stability indicator. This indicator is under development. It will be an aggregate of a macroeconomic stability indicator, financial markets stability indicator, and a banking soundness indicator.

  • Stress testing. Stress testing of banks is done periodically, using the FSAP methodology (sensitivity analysis). This covers credit risk, market risk, and liquidity risk. In addition, a simple credit risk model is used to assess the impact of macroeconomic variables on the asset quality of banks (Figure 3.25, panels e and f).

  • Network analysis. To assess interbank bank and financial institution exposures. This is under development.

Figure 3.23.Sri Lanka: Cyclical Trends in Private Sector Credit Growth

Source: Central Bank of Sri Lanka.

Figure 3.24.Sri Lanka: Financial Stress Indicator

Source: Central Bank of Sri Lanka.

Figure 3.25.Sri Lanka: Macroprudential Indicators

Source: Central Bank of Sri Lanka.

Note: ASPI = all shore price index; AWLR = average weighted lending rate (percent); BFI = finance and insurance sector (beta index); UER = unemployment rate.


An earlier survey of monitoring tools is presented in IMF (2011a); IMF (2011b) evaluates a small set of measures.

Reserve Bank of India’s mid-term review of its Annual Policy of 2005–06.

However, New Zealand households remain highly indebted by international standards despite reducing the rate of debt accumulation and improving debt-to-income ratios. Moreover, the New Zealand economy also has a very high level of external indebtedness, which creates vulnerability and a dependency on developments in global financial markets.

Nonbank deposit-taking institutions comprise credit unions, building societies, and deposit-taking finance companies. The wider nonbank lending sector also includes non-deposit-taking finance companies, which are not regulated by the RBNZ. At its peak, the nonbank lending sector accounted for about 8 percent of total lending and $25 billion in assets. As of December 2011, the sector is half this size—a result of a number of finance company failures and the ongoing restructuring and consolidation in the sector (including two institutions that left the sector and registered as banks).

For a fuller discussion, see various RBNZ Financial Stability Reports;Bollard, 2011; Ha and Hodgetts, 2011; and Spencer, 2010.

In FY2012 the deficit was 5.1 percent of GDP and in FY2013, it is projected to be 5.0 percent of GDP.

Refer to Monetary Policy Statement January 2013 of Bangladesh Bank.

The difference between the lending rates and the weighted average rate of interest on deposits or the intermediation spread

CAMELS stands for capital adequacy, asset quality, management capability, earnings, liquidity, and sensitivity to market risk.

To give banks time to adjust to a buffer level, a jurisdiction will pre-announce its decision to raise the level of the countercyclical buffer by up to 12 months (Basel III rule text paragraph 141).

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