Chapter 1: Institutional Needs for Optimal Macroprudential Arrangements
- Steven Barnett, and Rodolfo Maino
- Published Date:
- April 2013
Institutional Arrangements for Macroprudential Policy
This introductory section addresses three issues:
What are the defining elements of macroprudential policy and what is its role?
Which institutions and bodies now hold the macroprudential mandate and relevant responsibilities?
What are the key desirables of macroprudential policy arrangements and how do different models meet them?
Elements Defining Macroprudential Policy
Views still differ on what macroprudential policy is. For instance, clearly delineating micro- and macroprudential policies, which is important for assigning the responsibilities to particular institutions, is difficult. The prevailing view is that macroprudential policy should be seen as a complement to microprudential policy.
Yet, views vary as to whether macroprudential policy should be regarded as a particular perspective of prudential policy or as a new policy area in its own right (filling a gap between microprudential and monetary policies). At one end of the spectrum, some argue that prudential policy, as carried out in the past, already had some macroprudential aspects, and that the 2008–09 global economic and financial crisis has reinforced this orientation. In this case, “micro” and “macro” can be seen as tensions between perspectives regarding the use of prudential instruments that will need to be managed.
At the other end of the spectrum, many emphasize that the philosophies behind micro- and macroprudential policies are fundamentally different, with the latter focusing more on interactions with the rest of the economy and macroeconomic policies, possibly also involving the use of nonprudential tools, and requiring a different type of expertise. This would indicate that macroprudential policy should be regarded as a different kind of public policy, rather than as an add-on to microprudential policy.
Notwithstanding these differences, the emerging consensus seems to suggest that the objective of macroprudential policy is to identify, monitor, and limit systemic or system-wide financial risk in both time and cross-sectional dimensions. Its analysis should cover all potential sources of systemic risk regardless of from where they emerge. Macroprudential policy should focus on risks arising primarily within the financial system, or risks amplified by the financial system, leaving other identified sources of systemic risk to be dealt with by other public policies. Its toolkit consists mainly of prudential-type instruments that form the core, constructed or calibrated to deal specifically with systemic risk. However, other instruments can be added, if they explicitly and specifically target systemic risk and if they are placed at the disposal of an authority with a clear macroprudential mandate, accountability, and operational independence. They can be both the tools under direct control of the institution or body assigned the macroprudential function and the tools influenced indirectly through recommendations to activate or change their calibration. The latter can be other policies’ tools needed to address identified systemic risks residing in other policies’ domains. In activating them, a balance must be struck between the effectiveness of the policy for macroprudential purposes and the need to preserve the autonomy of other established policies.
Who Holds the Macroprudential Mandate in Practice?
The survey of 63 countries carried out by the IMF at the end of 2010 showed that in 88 percent of those countries, some institution has a financial stability mandate; 43 percent of countries also signaled they had institutions with a macroprudential policy mandate. The mandates were both explicit and implicit; few countries have explicit mandates embedded in the law. Central banks seem to play an important role in this policy area, having been appointed as holders of macroprudential mandates most frequently. The responses indicated that central banks play a dominant role in all aspects of macroprudential policymaking: risk identification, systemic impact assessments, decisions to take action, implementation, and enforcement. They were most frequently cited as the lead institutions or coordinators (financial stability committees were the second-most frequently mentioned). Central banks were also cited as the lead institutions or coordinators for reporting to the executive or to parliament.
Who Should Hold the Macroprudential Mandate?
Establishing a well-functioning institutional framework for macroprudential policy is a precondition to effective policymaking. “Real-life” institutional models for macroprudential policies are new and emerging. Hence, it is difficult to assess the effectiveness of these models empirically. To overcome this problem, an analysis was made of to whom to assign the mandate and the powers, given the characteristics of the policy itself (as already defined). “Stylized” institutional models were identified for macroprudential policies, drawing on existing financial stability frameworks, and in light of key dimensions that differentiate them. The strengths and weaknesses of these models were assessed conceptually, based upon criteria that seem to be important for successful mitigation of systemic risks.
Contrary to previous attempts (BIS, 2011) in which the model is defined by who holds the mandate, a broader approach was taken (Nier and others, 2011), and five criteria were applied to differentiate them: the degree of institutional integration between the central bank and supervisory agencies; ownership of the macroprudential policy mandate; the role of the government; the degree of separation between policy decisions and control over instruments; and the existence of a separate body coordinating policy decisions.
Three basic criteria were defined to assess the models. Because a desirable institutional model should be conducive to the mitigation of systemic risk, it should provide for (1) the effective identification, analysis, and monitoring of systemic risk, which requires access to relevant information and the appropriate resources and expertise to use the information; (2) the timely and effective use of macroprudential policy tools, which requires a strong mandate and powers combined with the ability and willingness to act preemptively as well as strong accountability; and (3) effective coordination across policies that aim to address systemic risk, to reduce gaps and overlaps.
Suitability of Different Models
By applying the above criteria to the stylized models, the following conclusions are reached:
All models have strengths and weaknesses, but not all models appear equally supportive of effective macroprudential policymaking. Additional mechanisms can be used to address the potential weaknesses, which can ease or sometimes even eliminate them.
All relevant institutions should be involved in macroprudential policymaking. The identification and reduction of systemic risk is a challenging public policy area. Systemic risk is fluid; it evolves over time and has multifaceted manifestations, requiring the monitoring and comprehensive analysis of large amounts of quantitative and qualitative information, and various instruments assigned to different authorities. The involvement of supervisors, central banks, and government, at a minimum, is indispensable.
The central bank should play a prominent role in every model. Central banks have good knowledge of the economy as a whole, which is important for any macroprudential decision maker because the interactions of the financial system with the real sector play an important role in macroprudential analysis. Central banks usually have developed systemic analyses of financial systems to perform their financial stability functions. They are active in the nonregulated markets on a day-to-day basis. They generally have the advanced research capabilities that are needed for modeling the policy or for the analysis of financial innovations in the context of systemic risk. They are independent of the political cycle and have a high propensity for preemptive action because it is costly for them to clean up once the systemic risk evolves into a crisis. Central banks have experience in communicating risk, setting them apart from, for example, supervisory agencies.
Participation by the treasury in the policy process is useful, but a leading role for the treasury may pose risks. Even though the government of each country is ultimately responsible for its economic outcome, the government should not lead macroprudential policy. The key arguments are twofold: governments usually have no expertise in such complex issues, and at times political economy considerations make it difficult for government to set the necessary macroprudential parameters (an argument that is also relevant for monetary policy). However, the government should be involved in policymaking; it should understand the process well so it can request new powers from parliament for the macroprudential decision maker if there were to be regulatory or cross-border arbitrage.
Systemic risk prevention and crisis management are different policy functions and should be supported by separate organizational arrangements. However, there is no doubt that the government has to lead the crisis-management process, especially if it involves spending public money. Thus, assigning different roles to different authorities in different processes requires that they be organizationally separate.
Fragmentation of responsibility between institutions should be avoided, but if it is necessary, should be compensated for with appropriate coordination mechanisms. The result of fragmentation of responsibility may be that some important systemic risks will fall between the cracks and stay unaddressed. The greater the number of institutions involved, the stronger the need for effective cooperation and coordination arrangements.
At least one institution involved in assessing systemic risk should have access to all relevant data and information. The assessment of systemic risk is a complex task involving many sources of data and information. Shared analysis may not be an optimal solution.
Institutional mechanisms should support the willingness to act against the buildup of systemic risk and reduce the risk of delay in policy actions. The 2008–09 financial crisis revealed a strong bias toward inaction due to difficulties in the identification and assessment of systemic risk. Even if risks are identified, authorities may not take timely action if they have other conflicting objectives. Thus, it is important to set up mechanisms in advance that support action (the choice of leading institutions, governance arrangements, communication policy, and so forth).
A lead macroprudential authority should be identified, vested with the necessary mandate and powers, and subject to formal accountability. If fragmentation of institutions involved in macroprudential policy cannot be avoided, the appointment of a lead institution, which will formally be accountable for the effectiveness of the process, is sensible. Common responsibility, under which addressing systemic risk is no one’s prime responsibility, can be less effective.
Macroprudential policy frameworks should not compromise the autonomy of other established policies. They should not be used as a “Trojan horse” to compromise the goals of other policies (monetary, microprudential). However, to ensure the effectiveness of the overall policy process, it is important to recognize what “autonomy” means and from whom it is important to be preserved.
These general conclusions for the setup of macroprudential policy are not the only elements that should be taken into account when devising the framework. Countries’ specific circumstances are also important, such as institutional factors (the quality of existing institutional arrangements, legal traditions), political economy considerations (attitude toward concentration of political power), and cultural issues, as well as the availability of resources (which, for example, have allowed the United States to establish an Office of Financial Research, whereas such resources may not be available in other countries). Finally, it should still be remembered that one size does not fit all.
Challenges of Executing a Financial Stability Policy Objective at the Central Bank of the Philippines
Johnny Noe E. Ravalo
Financial crises have always brought with them both hard socioeconomic dislocations and a set of identified policy lessons. During the 1997 Asian financial crisis, the most highlighted issue was the mismatch of maturity and tenor in the loans made by banks and how this mismatch created havoc in the real economy. In the global financial difficulties following the 2008–09 crisis, financial stability has clearly been the primary concern.
The term financial stability is not a product of the recent crisis. Substantive literature dating back to at least 1997 addresses the issue.1 However, there is clearly something new about the current emphasis on financial stability. The absence of an accepted universal definition for what constitutes financial stability has not hindered its overall pursuit. Most reform initiatives today—from the Basel Accords to governance to regional integration—are, in fact, explicitly premised on achieving financial stability.
The Context of Financial Stability
Definitions aside, effective macroprudential policies are widely understood to be a prerequisite to achieving financial stability. As noted in FSB, IMF, and BIS (2011), macroprudential policies are broadly meant to dampen the buildup of financial imbalances, contain the impact of downswings, and address common sources of contagion.
Straightforward as the idea may be, a number of technical details are often overlooked in the discussions. Toward this end, a report issued by a BIS working group highlighted the need for nuanced analytical capabilities in executing the macroprudential task (BIS, 2011). In particular, the report argues that
Macroprudential policy is not simply the summation of microprudential concerns;
The covariances between risk positions are just as important as the respective positions themselves; and
Contagion and spillover effects cannot be properly evaluated by simply looking at the individual components alone.
These concepts restate a point that is cited by risk technicians but sometimes forgotten in policy discussions: the financial system is a network of nonlinear relationships because financial risks are nonadditive and nonseparable. The implication is that financial stability is a different policy issue even if macroeconomic theory, monetary policy, the regulation of financial institutions, fiscal policy, and financial market infrastructure are understood separately. Thus, the BIS report puts forward the conclusion that a “complete range of instruments uniquely oriented to macroprudential policy has not yet been developed, let alone deployed” (BIS, 2011, p. 47).
The Central Bank of the Philippines’ View of Financial Stability and Macroprudential Policy
The Central Bank of the Philippines (Bangko Sentral ng Pilipinas, or BSP) subscribes to the nuanced view of financial stability and macroprudential policy described above. Despite the well-developed framework for macroeconomic theory, monetary policy, the regulation of financial institutions, fiscal policy, and financial market infrastructure were not enough to provide a full appreciation of the underlying pressures that evolved into the crisis. Discounting for the surprises that arise from information asymmetries, it can be argued that the policy objective of financial stability in its present form is entirely new. With it, a new understanding of financial risks is needed if we are to mitigate systemic instability.
In putting in place a financial stability framework at BSP, it is recognized that a holistic view is warranted. This is not merely convenient rhetoric. Rather, it is an acknowledgment that although financial linkages may start from retail transactions, the linkages will coalesce into a system-wide effect that will always have a feedback loop back into micro agents.2
BSP accepts that financial markets are inherently risky. The objective, though, is not the elimination of all financial risks because managing those risks deemed acceptable is central to the value proposition of financial markets. Furthermore, financial risks are not independent of each other even though prudential oversight treats risks separately in practice.
From a comprehensive standpoint, the macroprudential task is not limited to identifying the different risks or institutionalizing the appropriate risk mitigants. Instead, it requires that an understanding be developed of how different risks comingle. This gives the macroprudential policymaker an appreciation for the linkages that develop once transactions are triggered. This is the necessary condition that must be met for macroprudential analysis. However, it is not sufficient because the path that comingled risks take in evolving from transaction-level risks to system-wide risks must also be understood.
The above discussion summarizes the key principles that BSP espouses on financial stability. They are not conjectures because they are, in fact, demonstrable by basic portfolio theory. In a two-asset portfolio, portfolio risk as measured by the variance of the portfolio’s returns,
The above equation highlights the point that systemic risk is a nonlinear, nonadditive, nonseparable function of the risks of the component assets. However, this point was as much true in the 1950s when Markowitz proposed the portfolio theory framework as it is today. Thus, although the case can be made that markets are now more volatile, it also should not be forgotten that the decomposition of system (portfolio) risks has not really changed despite the added complexities in the market.
The same basic equation is useful in highlighting another key point. Representing “monetary policy” as asset A and “financial institution supervision” as asset B provides a convenient expression for identifying the components that delimit financial stability concerns. In particular, systemic risk may arise for microprudential reasons. If the microprudential reasons are to remain within the domain of the microprudential regulator, then these sources of systemic risk do not automatically constitute a case for macroprudential policy intervention. Under this framework of policy separation, the covariances that go into the pairwise relationships ρij and ∀i and j play a critical role. Any shock that goes through ρij is definitely a macroprudential issue because it is through these pairwise channels that transaction-level risks comingle and get transmitted through channels that subsequently evolve into systemic risk.
The Working Arrangements for Financial Stability in the BSP
The point of the above discussion is to serve as a reminder that specific policy objectives still have distinct roles to play, even in a financial stability–centric world. Macroprudential policy on its own does not substitute for monetary policy, prudential oversight, or the management of financial infrastructure. Yet it also points to the challenge of organizing for a financial stability policy objective.
Creating a High-Level Financial Stability Committee within the BSP
The organizational challenge was evident from the outset when the pursuit of financial stability began to be conceptualized as an objective for the BSP. The importance of financial stability as a proactive initiative was recognized despite the knowledge that financial stability is presently not explicit in the BSP charter. Toward this end, the Financial Stability Committee (FSComm) was created as a high-level internal body that would take steps to address the potential buildup of systemic pressures in conjunction with the explicit mandates that the BSP—as a monetary authority, bank regulator, and financial infrastructure provider—already pursues.3
The creation of the FSComm needs to be viewed in the context of the regular operations of the BSP. As an institution, the BSP operates in pursuit of three pillars: price stability, banking system stability, and a safe and reliable payment system. Each of these pillars is managed by a sector composed of line units that are staffed by full-time personnel. At the operational level, although there is a fair amount of interaction across sectors, there is mutual recognition of which sector takes the lead on any issue because the issues typically fall uniquely into their respective pillars.
The BSP established a working definition of financial stability:
Financial stability is achieved when the governance framework of the market and its financial infrastructure enable and ensure the smooth functioning of the financial system conducive to sustainable and equitable economic growth.
This definition explicitly targets financial governance (of both infrastructure and conduct), a functioning financial market, and high-quality economic growth. Clearly, then, cross-pollination of expertise and information across the BSP’s three pillars is necessary. This cross-pollination will foster the formation of a holistic view within the BSP. It is also the basis for the appropriate crafting and implementation of the corresponding macroprudential policy actions.
Although the intent is clear, the challenge lies not in the pursuit of a new policy objective of financial stability but rather in merging existing mandates to achieve the goal of stability. Existing mandates are still to be pursued by existing responsible units and the new objective is to be executed by the same existing responsible units. At the most basic level, this is an issue of time constraints because existing personnel already have full-time jobs.
However, situations will arise in which a desired action for one mandate may not be positive for all of the other mandates. These situations are the more binding constraints. They occur more frequently than otherwise thought, and the appropriate course of action needs to be determined against an objective that surpasses the original mandates.4 A case can be made that financial stability represents that higher objective, but at the same time it also points to the operating difficulties that personnel face when organizing for this new policy objective while operating under existing mandates.
And these coordination issues must be dealt with even though financial instability is more well defined than is financial stability. Thus, even as the BSP is defining the context within which it approaches financial stability, these coordination issues present parallel challenges that are no less daunting than defining the operating targets for stability.
Creation of the Financial Stability Coordination Council (FSCC)
In 2010, the creation of a voluntary interagency body specifically for financial stability was proposed and formally approved. This event elevates the issues to the national level because the policy objective is now a collective task of the Securities and Exchange Commission (SEC), the Insurance Commission (IC), the Philippine Deposit Insurance Corporation (PDIC), the BSP, and the Department of Finance in its capacity as the fiscal authority.
The creation of the FSCC neither supersedes nor negates the FSComm of the BSP. A symbiotic relationship premised on complementary action between microprudential actions and macroprudential policy is envisioned, as is evident from the process that led to the creation of the FSCC itself.
Establishing the FSCC was an act of the Financial Sector Forum (FSF). Executing financial market regulation along traditional market classifications and functions, the FSF is a voluntary interagency body with membership from the SEC, IC, PDIC, and the BSP. Prudential issues commonly faced by the four agencies are discussed and acted upon through the FSF. Among the issues to surface since 2010 are the prudential oversight of entities that act in several markets and the system-wide risks that may no longer be confined to any single supervisory authority. It was in this context that the coordinating body for financial stability was crafted, pulling together the four existing microprudential authorities and the fiscal authority.
At the time of this writing, the steering committee of the FSCC had already convened and identified its initial policy agenda. The agenda needs to be confirmed and approved by the Executive Committee of the FSCC, which was to have been convened shortly. Operationally, content and coordination issues similar to those presently faced by the BSP’s FSComm are expected to be encountered.
An Aside on Stress Testing
Before leaving organizational issues, this section reverts to the issue of the still-missing macroprudential indicators specific to financial stability.
As pointed out in FSB, IMF, and BIS (2011, p. 2), “many policies could and should influence financial stability and systemic risk, but not all such policies should be considered macroprudential.” The operational challenge of this distinction is highlighted in BIS (2011), which states that “to date no instruments uniquely suited to macroprudential policy have been deployed” (p. 37). The recourse then is to deploy existing microprudential instruments for the purpose of financial stability.5
In pursuing a macroprudential objective, the BSP is focusing on five metrics. Four of these are works in progress: a financial computable general equilibrium model, contingent claims analysis, network modeling, and other valuation models. The one macroprudential metric that is already in place is the stress-testing exercise. Stress tests are also being used in other countries, however, the BSP has moved beyond the standard shocks, reflecting its recognition that risks always comingle even if procedurally they are analyzed individually.
In this view, stress tests are most viable as indicators of pressure points if the framework allows for different stress points to be conceptually linked to each other. The BSP has devised a holistic stress-testing framework that highlights the linkages between variables and the sequence of potential effects.
Although the framework has been defined, another challenge has arisen that may not have been given due consideration. To execute stress tests, the full cooperation of covered institutions, banks in this particular case, is absolutely required. Different banks, however, will have different levels of efficiency in their backroom operations. This matters because the quality of the aggregated stress tests depends on whether the regulator is comfortable with the quality of the individual tests from each bank.
Equivalent quality is not a given even for the standard tests segregated by risk types, that is, credit risk, market risk, and liquidity risk, among others. Work needs to be done to coordinate properly between the banks and the banking regulator, not only in the disposition of the stress tests but more so in the information that should actually go into the tests themselves. Before the BSP migrates to the more holistic stress tests, this coordination is required, even for the most basic of stress tests. In the absence of such coordination, the results of the aggregated stress tests suffer from questions of suitability and data integrity.
Working toward the Establishment of a Macroprudential Infrastructure
Markets have become increasingly interconnected and complex, making it necessary for economies to be more aware of and more focused on addressing financial stability matters. Financial stability requires the identification and implementation of macroprudential policies to manage systemic risks. Banking is about the management of risks and thus, addressing risks has always been its business. On a system-wide basis, however, no local regulator in the Philippines is yet focused on this.
The Bangko Sentral ng Pilipinas (BSP; the central bank of the Philippines) formally pursued the policy objective of financial stability in 2010. In September of that year, a high-level Financial Stability Committee (FSComm) was created to put in place a financial stability framework within the BSP. To address the need for collaborative efforts across policies, a Financial Stability Coordination Council (FSCC) was established in January 2011.
Organizational matters have been a challenge for the FSComm and the FSCC. Adopting a uniform understanding and establishing a work plan across departments and agencies were the first orders of business. The identification of macroprudential tools and models are also being undertaken.
It is recognized that establishing the appropriate infrastructure to support financial stability objectives is a complex, and perhaps even an overwhelming, task. The Philippines, however, has already began the process.
The 2008–09 global economic and financial crisis demonstrated a crucial characteristic of the financial industry—the growing complexity and interconnectedness of its members. Since then, policy has focused more on strengthening regulation and supervision of the financial system as a whole while linking it to the macroeconomy. Economies began establishing their respective macroprudential infrastructures to manage financial stability.
Adopting Financial Stability as an Objective at BSP
In September 2010, the FSComm was created to establish a work plan for effecting a financial stability prudential policy framework and vision within the BSP, focusing on financial risks arising from the macroeconomy, payments and settlements, and the financial institutions under its supervision.
The FSComm is chaired by the governor of the BSP, and includes the deputy governors for the supervision and examination sector (SES), the monetary stability sector (MSS), and the resource management sector. BSP’s assistant governors for the MSS and treasury departments and the managing director for the central supervisory support subsector of the SES are the other members of the FSComm, the latter of whom is also the head of the technical subcommittee.
The FSComm’s work is spread throughout BSP’s various departments given that members from all units are represented in the FSComm’s three subcommittees—market monitoring, reports and communications, and quantitative and policy. The market monitoring subcommittee is the FSComm’s daily monitoring arm for emerging local and global risks for stakeholders within the BSP. The reports and communications subcommittee is responsible for providing the appropriate financial stability documents and communicating them to other regulatory institutions throughout the archipelago. The quantitative and policy subcommittee is currently identifying appropriate financial stability models to be adopted by the FSComm and provides the policies to effect the FSComm’s objectives.
Financial Stability as a Collaborative Effort
At the beginning of 2011, the pursuit of financial stability as a collaborative effort across regulatory agencies was furthered through the consideration of a discussion paper (Ravalo, 2011), expanding on an earlier paper prepared in 2010. This proposal was formally presented in a meeting held by the Financial Sector Forum (FSF) in January 2011.6 This was the opportune venue because the FSF involves the appropriate regulatory and policy agencies—the BSP, the Insurance Commission, the Securities and Exchange Commission, and the Philippine Deposit Insurance Corporation. Financial stability issues, however, extend beyond coordination and information sharing; thus, the formal body tasked to handle financial stability needed to be a distinct and separate platform from the FSF. In addition, the Department of Finance (DOF) needed to become involved to embrace the influence of fiscal policies on financial stability. Thus, an “FSF Plus” was proposed. A year later, the proposed FSF Plus was established as the Financial Stability Coordination Council (FSCC). The mission of the FSCC was to design a technical work program to identify and mitigate the buildup of systemic risks as well as to institutionalize arrangements and processes during both normal times and periods of financial crisis. As may be warranted, the FSCC may also recommend to the legislature measures to improve the handling of financial stability.
The Next Challenge: Macroprudential Modeling
Developing an appreciation for a new and emerging framework for financial stability has been a challenge to Philippine financial regulators. Settling on the definition of financial stability in March 2010 amid varying interpretations was an endeavor.
Succeeding months were spent on organizational matters, establishing the subcommittees, outlining a work plan for the technical modeling, and defining the necessary output.
The FSComm is focusing now (mid-2012) on identifying the appropriate macroprudential tools for the Philippine setting. It is well known, however, that financial stability has long been an issue; thus, tools are already in place, albeit for the risk-management purposes of a more microprudential (banking oversight) objective. These tools mainly involve policy measures that handle interconnectedness, particularly credit exposures. The BSP has explicit guidelines for the management of large credit exposures to single individuals and entities. It also has supervisory rules on transactions and loans to connected parties and related interests. Under the purview of the FSF, a project on conglomerate mapping was established while other standard measures, such as loan-to-value ratios, provisioning, and real estate caps, have been in place for some time. In line with its implementation of the Basel III framework, the BSP is also introducing tools such as the capital conservation buffer to be in place by 2014.
Stress testing has also been a major tool for risk measurement. In January 2011, a technical working group on stress testing was established by the SES to conduct stress exercises on the balance sheet of banks. These tests are designed to evaluate the banks’ collective and individual capability for handling shocks to their respective banking operations. Market events considered in the stress tests include unusual changes in local and foreign interest rates; market illiquidity; or defaults caused by credit exposures to economic activities, large counterparties (i.e., conglomerates), and in the consumer portfolios of these banks.
Similar models could be developed for macroprudential purposes. Other new models are also being evaluated for the purposes of the FSComm and the FSCC.
Complementing Microprudential with Macroprudential Policy: A Major Reform?
Financial stability is becoming a central supervisory concern across the financial industry. Taking a proactive stance, the BSP has endeavored to make this macroprudential framework available in the Philippine banking industry. Much effort, however, is still required to formalize the implementation of macroprudential policies. The concept of financial stability is multifaceted and is proving to be difficult to grasp. This then necessarily leads to the clear challenge of complementing microprudential regulations with macroprudential policies, which is a key concern that still needs to be emphasized and appreciated. Organizational matters also need to be ironed out. Microprudential tools may already be familiar, but molding them to financial stability purposes and creating additional measures are still challenges.
The beginning has not been easy. Despite the challenges ahead, however, the Philippines is on its way to creating the necessary and appropriate infrastructure to effect macroprudential regulation in the local banking industry.
No one will dispute that pursuing a financial stability mandate is essential, particularly within the current paradigm for financial markets that relies on cross-border, cross-currency, complex-instrument transactions. Risks can arise from different sources and successfully managing these risks is the value proposition of financial markets in general.
However, the financial stability task is not a marginal exercise, and institutionalizing the capacity to undertake macroprudential policy is rife with challenges. The BSP approaches financial stability with the clear understanding that it is not a unique state defined by absolute values of indicators. Instead, multiple possible combinations allow a system to thrive and address the evolving needs of its constituents. What may be consistent with stability in the past may be a recipe for instability in a different market situation.
It is also believed that financial stability is neither the micro-foundation of macro policy nor the macroeconomic translation of micro behavior. Instead, financial stability should bind macro, monetary, financial, infrastructure, and fiscal policies together so that the systemic implications of transaction-level risks can be understood. To move forward, sharper tools, a harmonized view on managing and mitigating financial risks, and a commitment to cooperation and coordination are needed.
None of these prerequisites are trivial. But apart from the coordination challenges discussed above, the personnel of regulatory institutions need to develop new core competencies. BSP Governor Amando M. Tetangco Jr. points out
it would be very useful to develop staff who have the expertise of a macro-financial economist, the preciseness of a financial engineer, the orderliness of an accountant, the eloquence of a commentator, the imagination of a physicist and the perspective of a market practitioner.7
Such a multifaceted skill set is not innate to any financial regulator. However, it appears to be the minimum required if, indeed, an effective foray into financial stability is to be made.
Macroprudential Policy in Mongolia
Macroprudential policy is new to many countries and became an overarching public policy item amid the global financial crisis. The main objective of the Bank of Mongolia is to ensure the stability of Mongolia’s currency, the togrog (tog). Within this main objective, the Bank of Mongolia also promotes the balanced and sustained development of the national economy. The Bank of Mongolia’s functions include supervision of banking activities, financial supervision of commercial banks, and the review of applications for the establishment of new commercial banking entities and branches of existing financial institutions.
Since the establishment of the two-tiered banking system in 1991 by the new banking law, Mongolia has faced two waves of banking failures, in the 1990s and in 2008–09. Currently, the Bank of Mongolia plays a crucial role in the banking sector as regulator, but the supervision and regulatory policies governing the nonbank financial sector are conducted by the Financial Regulatory Committee of Mongolia.
Having been introduced only recently, the macroprudential mandate has yet to be defined and thus its compatibility with microprudential supervision can only be inferred. Within the Bank of Mongolia, the two perspectives are to be implemented by separate departments: Macroprudential policy would likely be determined and defined by the Monetary Policy department and microprudential supervision will be carried out by the Supervision department. Any potential conflicts or clashes in policy implementation could be resolved through regular and active dialogue between the two units and with other relevant authorities.
In accordance with its legal strengths and functions, the Bank of Mongolia has used several prudential tools as macroprudential policy instruments. The economy involves time-varying risks, and consistent coordination between fiscal and monetary policies is questionable. As a consequence, the liquidity coverage ratio was increased from 18 percent to 25 percent in November 2011; the capital adequacy ratio was raised from 12 percent to 14 percent in December 2011 and the countercyclical buffer for systemically important banks was added in accordance with the Basel Capital Accord; the minimum capital requirement was increased from tog 8 billion to tog 16 billion in 2011; the reserve requirement was increased from 9 percent to 11 percent in August 2011; and the policy interest rate was increased to 12.75 percent in March 2012. See Figure 1.1.
Figure 1.1.Mongolia: Capital Adequacy of the Banking Industry
Source: Bank of Mongolia supervisory database.
Mongolia’s economy is highly dependent on a few commodities and thus is vulnerable to procyclicality (overheating). The Bank of Mongolia, the ministry of finance, and other regulatory authorities should implement countercyclical policies to sustain macroeconomic and financial stability and avoid a repeat of the boom-and-bust cycle, thereby dampening systemic risk and limiting spillovers from stress.
As a step to keep pace with recent changes in international financial standards, in particular Basel III, and to contain the threat of high levels of inflation, excessive lending, and the like—which were a recurring theme for the recent period in Mongolia—sets of policy initiatives that aim to strengthen the resilience of both the financial system as a whole and the individual sectors or institutions have been proposed and are under robust discussion among policymakers. Among the policies proposed are to raise the policy rate to curb high-speed inflation and lending, and to require banks to increase their current minimum paid-in capital requirement to twice its size by the middle of 2013 to improve the creditworthiness of banks.
The Bank of Mongolia is surveying new policy instruments to adopt in the near future, including dynamic provisioning, provisioning on normal loans, caps on foreign currency lending, credit limits by economic sector, and time-varying capital requirements.
There are several practical methods for dynamic provisioning; the Spanish model is the most well-known. In 1999, Spain had the lowest ratio of loan loss provisions to gross loans in a decade. Competition among banks was on the increase, with banks lowering interest rates and spreads, which resulted in inadequate loan pricing. The Spanish banks’ loans were concentrated in the construction sector during the asset bubble period, up to 2009, which led to a significant increase in bad loans. The Bank of Spain first introduced dynamic or statistical provisioning in 2000 to limit credit growth and to create a buffer for the bad times (Saurina, 2009).
Dynamic provisioning in Spain was based on a comparison between a bank’s current specific provisioning and the average latent loss in its loan portfolio. Dynamic provisioning initially included three types of provisioning: specific, generic, and statistical. Latent risk differs depending on the type of loan, and fixed parameters were used and a cap was placed on the size of the provision fund to avoid excessive expense pressure on banks. Spanish banks criticized dynamic provisioning, arguing that it put them at a disadvantage in the international market. These issues, coupled with the theoretical and practical arguments about accounting for statistical provisioning, led regulators to reform statistical provisioning. In 2004, statistical provisioning was subsumed under generic provisioning and a new cap was introduced. The formula for the general provisions is shown in equation 1.2:
in which gent is general provisions required to be set aside at period t, spet is specific provisions at period t, α is the coefficient representing the latent loss, β is the average specific provisioning for full lending during the business cycle, Ct is the stock of loans at period t, and ΔCt is credit variation (positive in a lending expansion, negative in a credit crunch). The estimation of general provisioning differs across six risk buckets of loans based on the economic outlook and different risk profiles. Thus, equation (1.2) can be transformed into the following:
However, data limitations make it impossible to estimate the parameters of the Spanish model for Mongolia. The Spanish system is based on detailed information about credit losses from the credit register managed by the Bank of Spain. Without equivalent information for Mongolia, the more accurate system of dynamic provisioning cannot be put in place. For example, the dynamic provisioning models are estimated by the Bank of Spain based on analysis of 40 years of historical data. In contrast, the credit registry operated and managed by the Bank of Mongolia has collected data only since 2010 and the database lacks accurate data on loan losses.
A criticism of the Spanish model is that the estimation is historical rather than forward looking and there is no guarantee that history will repeat. In addition, unlike in Spain, Mongolia’s banks have come to no consensus about the risk buckets or types of loans.
The current proposal is that a 1 percent provision be set aside for all new lending. This loan provisioning will be included in Tier 2 capital as a potential buffer against loan losses. According to an initial assessment conducted by the Bank of Mongolia, this approach can build up a provision fund of tog 13.6 billion. Large banks will need to hold reserves of tog 9.3 billion, equivalent to 0.3 percent of all new lending on average. See Figure 1.2.
Figure 1.2.Mongolia: Proposed Dynamic Provisions and Loan Quality
Source: Bank of Mongolia supervisory database.
This proposed approach to dynamic provisioning has a somewhat significant effect on banking capital adequacy. It may lead to a decrease in the Tier 1 capital ratio of 0.2–0.4 percent. In other words, the approach will affect banks with higher Tier 2 capital. However, this proposed approach has less effect on the profitability of banks. Dynamic provisioning is expected to help reduce risky lending and to help banks accumulate capital buffers during noncrisis times.
There are several advantages and disadvantages to introducing dynamic provisioning to Mongolian financial markets.
Among the advantages are
the ability to accumulate provisions so as to reduce provisioning and reserves during bust times,
reduced vulnerability of banks during crises,
limits placed on credit growth through the Tier 1 capital ratio, and
an increase in Tier 1 capital.
The disadvantages of dynamic provisioning include the following:
does not comply with international accounting standards,
results in inconsistency between audit reports and accounting principles,
reduces profitability of the banking industry,
puts pressure on commercial banks, and
constrains banking development.
To introduce this approach, the Mongolian regulators and policymakers need to reconsider laws, codes, and regulations related to accounting and reporting.
Bank for International Settlements (BIS), 2010, “Macroprudential Instruments and Frameworks: A Stocktaking of Issues and Experiences,” Committee on the Global Financial System Paper No. 38 (Basel).
Bank for International Settlements (BIS), 2011, “Central Bank Governance and Financial Stability,” Central Bank Governance Group (Basel).
Crockett, Andrew,1997, “Why Is Financial Stability a Goal of Public Policy?” in Maintaining Financial Stability in a Global Economy, Symposium Proceedings (Kansas City: Federal Reserve Bank of Kansas City), pp. 55–96.
Davis, E.,2001, “A Typology of Financial Instability,” Financial Stability Report No. 2, (Vienna: National Bank of Austria), pp. 92–110.
Financial Stability Board, International Monetary Fund, and Bank for International Settlements (FSB, IMF, and BIS), 2011, “Macroprudential Policy Tools and Frameworks: Update to G20 Finance Ministers and Central Bank Governors” (Basel and Washington).
Nier, E., J.Osiński, L.Jacome, and P.Madrid,2011, “Institutional Models for Macroprudential Policy,” IMF Staff Discussion Note 11/18 (Washington: International Monetary Fund).
Ravalo, Johnny Noe E.,2010, “Making Financial Stability Work: From Buzz Word to Functional Mandate,” Discussion paper prepared for the 2010 BSP Mid-Year Planning Exercise (Manila: Central Bank of the Philippines).
Ravalo, Johnny Noe E.,2011, “Coordinating Financial Stability in the Philippine Context: Making the Case for FSF Plus,” Discussion paper (unpublished; Manila: Bangko Sentral ng Pilipinas).
Saurina, Jesus,2009, “Loan Loss Provisions in Spain: A Working Macroprudential Tool,” Estabilidad Financiera N. 17, Banco de España.
This can be demonstrated, for example, with bank reserve policy. By containing the creation of liquidity among banks, we likewise create the same high-powered money that feeds into the real economy. As profits are made from economic activity, some of the cash flows return to micro agents as savings, which then get retransmitted into bank deposits subject to reserves, creating the next round of micro-to-macro-to-micro loop.
The FSComm was created on September 14, 2010, under Office Order 0867. The committee is chaired by the BSP governor and includes six other members: the deputy governor for the Supervision and Examination Sector, the deputy governor for the Monetary Stability Sector, the deputy governor for the Resource Management Sector, the assistant governor for the Monetary Policy Sub-Sector, the assistant governor in charge of the Treasury Department, and the managing director of Supervision and Examination Sector, who also heads the technical committee.
Monetary policy concerns may require that the policy rate be increased as an appropriate policy response. This increase, however, will have a negative impact on banks that may not find suitable borrowers in risk-adjusted terms at the higher hurdle rates. Similarly, the operator of the payment system may introduce measures that will streamline operations, but the same improvements may require costly adjustments that may just be passed on to the retail consumers of banks.
The same point is made in BIS (2010).
The FSF was created in 2004 to strengthen supervisory coordination and the exchange of information among the BSP, the Insurance Commission, the Securities and Exchange Commission, and the Philippine Deposit Insurance Corporation.
From the session remarks delivered by Amando Tetangco Jr at the Bank of Japan and Bank for International Settlements High-Level Seminar “Financial Regulatory Reform,” November 2010, Hong Kong Special Administrative Region.