Deficiencies in VAR based estimates of risk
Basel 2: Internal rating-based approached Guiding principle
2.6 Macro-prudential analysis and intellectual challenge
A common theme of this chapter is the vital importance of a system-wide macro-prudential perspective. The lack of such a perspective, and the failure to specify and to use macro-prudential levers to offset systemic risks, were far more important to the origins of the crisis than any specific failure in supervisory process relating to individual firms. Getting macro-prudential analysis and tools right for the future is vital. This section covers:
(i) What we mean by macro-prudential analysis and policy.
(ii) How to ensure that it is effectively performed in the UK.
(iii) How to ensure intellectual challenge at the international level.
2.6 (i) Macro-prudential analysis and tools
Macro-prudential analysis needs to identify the trends in the economy and in the financial system which have implications for financial stability and as a result for macroeconomic stability, and to identify the measures which could be taken to address the resulting risks. The factors considered could include trends in:
• The extension of credit to the economy, the pricing of credit, and levels of borrower leverage, and the implications for the risks which both borrowers (households, individuals and companies) and lenders are running.
• The pattern of maturity transformation and resulting liquidity risks e.g. the extent to which banks are increasing or decreasing maturity mismatches, and are relying on wholesale funding or on ‘liquidity through marketability’.
• Asset prices in property, equity and securitised credit markets and their possible relationship to long run equilibrium levels.
• Leverage within the financial system, whether at the institutional level (bank capital to asset ratios) or embedded in collateral margins and ‘haircuts’.
• The roles being played in the financial system by different institutions and in particular
whether the institutions not currently subject to prudential requirements (e.g. hedge funds) are increasingly operating in a way which could create systemic risk.
This analysis could inform the conduct of monetary policy. But it could also lead to decisions to use macro-prudential levers e.g. varying capital requirements in a discretionary and countercyclical fashion (see Section 2.2 (iv) above) or to vary liquidity policies and guidance (see Section 2.2(vii)).
Fiscal policy choices might also be informed by the analysis.
2.6 (ii) Macro-prudential analysis and policy in the UK
The failure to do this analysis and to take action on it was one of the crucial failures of the years running up to the financial crisis. It is not unfair to characterise what occurred as follows.
• The Bank of England tended to focus on monetary policy analysis as required by the inflation target, and while it did some excellent analytical work in preparation for the Financial Stability Review, that analysis did not result in policy responses (using either monetary or regulatory levers) designed to offset the risks identified.
• The FSA focused too much on the supervision of individual institutions, and insufficiently on wider sectoral and system-wide risks.
• The vital activity of macro-prudential analysis, and the definition and use of macro-prudential tools, fell between two stools. In the words of Paul Tucker, now Deputy Governor of the Bank of England for financial stability, the problem was not overlap but ‘underlap’.
Looking forward the analysis needs to be done by both the Bank of England and the FSA, bringing together insights from macro, sector-wide and firm-specific analysis, and with the analysis intensely debated between the two authorities, resulting if needed in agreed actions to translate analysis of risks into macro-prudential policy changes.
There are a number of different ways in which the formal character of the relationship between the Bank of England and the FSA could be defined. These could include:
• The Bank of England being the ultimate arbiter of judgements relating to the position in the economic cycle and the definition of macro-prudential risks, but with the FSA making decisions about which regulatory levers to adjust and by how much. The Bank of England could, for instance, write formally to the FSA setting out its analysis of macro-prudential risks;
and the FSA could be required to respond setting out what actions it had taken in response.
• The Bank of England being not only the ultimate arbiter of judgements about the macro- prudential position but also able, at the limit and in the absence of agreement, to require the FSA to take specific macro-prudential measures.
• The Financial Stability Committee, currently defined as a purely Bank of England
committee, being designed as a joint committee of the Bank of England and the FSA, with this committee making the final judgement as to macro-prudential conditions and final decisions as to appropriate policy responses.
In principle there are attractions to the third approach.
But it is vital to realize that whichever way the formal institutional relationship is defined, it will only work effectively if there is intense joint working to bring together macroeconomic
analysis and insight from specific institutions, and from sectoral and business model analysis, and if this analysis results in agreed points of view on how risks are evolving and what
offsetting actions need to be taken. To achieve such an agreement, it is likely that devices such as joint evidence review and analysis sessions, combining both the top management of the Bank and the FSA and specialist staff, will be essential.
It will, moreover, be vital to achieve external challenge to conventional wisdom assumptions. One of the crucial failures of the years running up to 2007 was that the conventional wisdom relating to the global financial system – that risks had been diversified and reduced – was widely accepted and was wrong. Devices such as inviting external academics to review the conclusions of analysis, and to present deliberately counter conventional wisdom views, should be considered.
2.6 (iii) Macro-prudential analysis and intellectual challenge at the international level
This need for intellectual challenge is also vitally important at the international level. The failure to identify growing system wide risks was a global one. Indeed, it is important to note that not only was there a failure to identify hugely increased risks, but a widely held and authoritatively asserted conventional wisdom that the financial system had become more stable, and the amplitude of economic cycles less pronounced, precisely because of the financial market developments which we now believe led to crisis. The excerpt from the IMF Global Financial Stability Review (GFSR) of April 2006, shown on Exhibit 2.9 below, is an example of such an assertion.
y b k s i r t i d e r c f o n o i s r e p s i d e h t t a h t n o i t i n g o c e r g n i w o r g s i e r e h T
“
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. t n e i l i s e r e r o m m e t s y s l a i c n a n i f l l a r e v o d n a g n i k n a b
d n a s e r u l i a f k n a b r e w e f n i n e e s e b y a m e c n e i l i s e r d e v o r p m i e h T
s k n a b l a i c r e m m o c e h t y l t n e u q e s n o C . n o i s i v o r p t i d e r c t n e t s i s n o c e r o m
” s k c o h s c i m o n o c e r o t i d e r c o t y a d o t e l b a r e n l u v s s e l e b y a m
6 0 0 2 l i r p A , t r o p e R y t i l i b a t S l a i c n a n i F l a b o l G F M I
Exhibit 2.9: The conventional wisdom – 2006
Intellectual challenge to conventional wisdoms is therefore essential. But so too is freedom from political pressure. For while the excerpt in Exhibit 2.9 illustrates that the IMF, like other
institutions, failed to challenge what in hindsight looks like a clearly mistaken set of propositions, it is also true that the IMF in other sections of its GFSRs and in other reports and documents did often warn that specific developments in financial markets and in economies, and in particular the rapid growth of credit extension in several countries, were unsustainable and were creating risks.
But these warnings were often ignored, in particular by the major rich developed nations. And IMF reports, which are agreed in a somewhat politicised process of review by national directors and the board, can be subject to influence to fit in better with dominant intellectual assumptions and to avoid overt criticism of major powers.
One of the vital challenges at the global level, which needs to be taken forward in the forthcoming G20 meetings, is to turn high level commitments to improved ‘early warning systems’,
‘surveillance,’ and ‘peer review’ into robust institutional arrangements which will empower the IMF or other international institutions to produce wholly independent analysis of system-wide risks, and which will require major international powers to take such report seriously as inputs to domestic macro-economic and macro-prudential policy decisions.