Published on 2 July 2018, Evaluating Macroprudential Policies is an ESRB staff working paper which looks at this relatively new policy field, the goal of which is to preserve financial stability and to prevent the build-up of systemic risk that may have adverse effects for the functioning of the financial system and for the real economy. New institutions have been tasked with the implementation of macroprudential policies, and new policy instruments have been introduced, yet uncertainty about the state of the financial system and the effects and effectiveness of these policy instruments is high. This uncertainty entails two risks: the risk of acting too late (inaction bias) and the risk of choosing an inappropriate instrument or inadequate calibration.

In this paper, the authors argue that both these risks can be mitigated if macroprudential policy is embedded in a structured policy process, which should involve four steps: defining policy objectives for macroprudential policies; choosing intermediate objectives and appropriate indicators; linking instruments to these indicators through ex-ante evaluation studies; and analysing the effects of these policies through ex-post evaluation studies. They argue that the infrastructure for this policy process can be further improved by providing data for policy evaluation, establishing or strengthening legal mandates for policy evaluation, establishing mechanisms for international cooperation, and building up repositories of evaluation studies.

Also published on 2 July, Cyclical Investment Behavior Across Financial Institutions is an ESRB staff working paper in which the author contrasts the investment behaviour of different financial institutions in debt securities as a response to past returns. For identification, he uses unique security level data from the German Microdatabase Securities Holdings Statistics. He finds that banks and investment funds respond in a pro-cyclical manner to past security-specific holding period returns, while, in contrast, insurance companies and pension funds act counter cyclically – they buy when returns have been negative and sell after high returns. These heterogeneous responses can be explained by differences in their balance sheet structure.

Published by the CGFS, on 5 July, Financial Stability Implications of a Prolonged Period of Low Interest Rates identifies channels through which a “low-for-long” interest rate scenario might affect the health of banks, insurance companies and private pension funds, and finds that this scenario would be harder on insurers and pension funds than on banks. Even though the analysis did not show that measures of firms’ financial soundness dropped significantly, prolonged low rates could still involve material risks to financial stability. In particular, a “snapback”, involving an unexpected sudden increase in market rates from currently low levels, could affect banks’ solvency and create liquidity issues for insurers and pension funds.

On 5 July, the ESRB reported on the 30th regular meeting of its General Board, which was held on 28 June. The General Board noted that more broad-based economic growth is supporting the outlook for the stability of the EU financial system. However, tail risks remain elevated amid significant political, geopolitical and policy uncertainties. Furthermore, the General Board discussed the vulnerabilities in the EU commercial real estate (CRE) sector; endorsed the publication of the third EU Shadow Banking Monitor; and exchanged views on macroprudential approaches to NPLs.

Alongside this, the ESRB released the 24th issue of its Risk Dashboard. In overview, this reports that geopolitical and political uncertainties pushed up market-based indicators of systemic stress in the EU over the past quarter. Considering macro risk, economic growth in the EU moderated from the high levels seen in 2017; and although most countries deleveraged in the years following the global financial crisis, debt levels remain elevated across countries and sectors in the EU. Looking at finance industry sectors, bank profitability in the EU continued to improve in the first quarter of 2018 and banking sector resilience continued to strengthen. Meanwhile, total assets of EU investment funds and other financial institutions changed little in 2017, although the euro area saw slightly stronger growth. And, in recent quarters, CCPs’ resources have remained broadly stable, while the contributions of larger clearing members are relatively high.

Subsequently, on 9 July, the ESRB Chair, Mario Draghi, addressed an ECON hearing, in Brussels, alongside which the ESRB published its seventh Annual Report, which presents the ESRB’s risk outlook together with the underlying analysis and discusses ESRB contributions to the EU macroprudential policy framework; and also documents the follow-up to ESRB recommendations. In his remarks the Chair focused firstly on the most recent developments in macroprudential policy at the national level; and then secondly, moving on to macroprudential policy at the European level, on the main features of the recent ESRB recommendation aimed at addressing liquidity and leverage risks in investment funds.

Published on 11 July, A Risk-Centric Model of Demand Recessions and Macroprudential Policy is a BIS staff working paper, in which the authors demonstrate how the zero lower bound on interest rates can constrain the capacity of monetary policy to stabilise asset markets and the economy in the case of an adverse financial shock. Macroprudential policy that curbs speculation by optimistic investors in the boom can mitigate downward spirals in the bust as it safeguards optimistic investors from suffering heavy losses during downturns, thus preserving their stabilising role.

On July 16, the Executive Board of the IMF concluded its annual Article IV consultation on euro area policies with member countries. This year, the consultation also included a discussion of the findings of the Financial Sector Assessment Program (FSAP) exercise for the euro area. The Executive Board Assessment includes paragraphs stating that:

“Directors welcomed the improvement in overall banking health, as documented in the FSAP review. They urged further efforts to strengthen the resilience of the system, in particular in terms of profitability, and encouraged vigilance against financial stability risks. They appreciated the strengthening of banking supervision under the Single Supervisory Mechanism, while noting remaining challenges. Directors encouraged ongoing supervisory and other actions to clean up legacy assets. They recognized that bank crisis preparedness and management have been upgraded, yet saw the need to address certain transitional and structural issues. They agreed on the importance of building up “bail-in-able” debt in banks, and gradually reducing financial intermediaries’ exposures to home sovereign debt, both of which will help attenuate sovereign bank feedback loops. Further progress on building the Capital Markets Union and enhancing the supervision of nonbanks were viewed as valuable in themselves, and all the more so in the context of Brexit.

Directors considered architectural reforms a necessary complement to national action. They urged swift progress on reducing the legal fragmentation across national lines, creating a credit line from the European Stability Mechanism to backstop the Single Resolution Fund, and establishing a common deposit insurance scheme. Most Directors saw merit in developing over time a central fiscal capacity to support macro stabilization, embedding strong safeguards against permanent transfers and moral hazard.”

For ease of comparative reference, the most recent annual Article IV consultation on UK policies was concluded by the IMF’s Executive Board on 12 February. The Executive Board Assessment on that occasion includes a paragraph stating that:

“Directors welcomed the resilience of the UK financial sector, owing in part to post-crisis regulatory reform. They encouraged the authorities to maintain robust prudential and supervisory standards, and to continue monitoring consumer credit and bank risk weights. Directors commended the authorities for proactively helping financial institutions prepare for the [Br]exit, given the uncertainties regarding the future of financial service arrangements with the EU. They called on all parties involved to work together to mitigate transition risks related to changes in regulatory regimes and responsibilities. More generally, they underscored the importance of close cross-border cooperation in a potentially more fragmented European financial system.”

On 19 July, the EBA published the latest periodical update to its Risk Dashboard, which summarises the main risks and vulnerabilities in the EU banking sector using quantitative risk indicators, along with the opinions of banks and market analysts from its Risk Assessment Questionnaire. In the first quarter of 2018, the updated dashboard identified ongoing improvements in the repair of the EU banking sector but also residual risks in banks’ profitability. The results of the Risk Assessment Questionnaire also show that cyber risk and data security are considered as the main drivers for the increase in operational risk. They are also assumed to be the main factors that might negatively influence market sentiment, along with geopolitical uncertainties including the UK’s decision to leave the EU.

Measuring Risks to UK Financial Stability is a Bank of England staff working paper, published on 20 July, in which the authors present a framework for measuring the evolution of risks to financial stability over the financial cycle, which they apply to the UK. They identify 29 indicators of financial stability risk, drawing from the literature on early warning indicators of banking crises, which they normalise and aggregate to produce three composite measures, capturing: leverage in the private non-financial sector, including the level and growth of household and corporate debt, as well as the UK’s external debt; asset valuations in residential and commercial property markets, and in government and corporate bond and equity markets; and credit terms facing household and corporate borrowers. They assess these composite measures relative to their historical distributions and present preliminary evidence for how they influence downside risks to economic growth and different horizons. They consider that the measures provide an intuitive description of the evolution of the financial cycle of the past three decades and that they could lend themselves to simple communication, both with macroprudential policymakers and the wider public.

On 24 July, EIOPA published its updated Risk Dashboard based on the first quarter 2018 data, which shows that the risk exposure of the EU insurance sector remains stable overall with a decline in macro and insurance risks and an increasing trend in market risks. Points highlighted by EIOPA include that:

• persisting low yields and recent adverse developments such as increased protectionism should not be neglected, despite the improvement in recent economic data and the ongoing normalisation of monetary policy;

• higher volatility in bond markets since March led to an increase in market risks, but these continue at a medium level; and

• credit risks also remain at a medium level, although spreads increased across all bond segments.

On 31 July, EIOPA published the third in a series of papers with the aim of contributing to the debate on systemic risk and macroprudential policy, which until now has mainly focused on the banking sector. This third paper builds on and supplements the previous ones by carrying out an initial assessment of other potential tools or measures to be included in a macroprudential framework designed for insurers. EIOPA carried out an analysis focusing on four categories of tools: (i) capital and reserving-based tools; (ii) liquidity-based tools; (iii) exposure-based tools; and (iv) pre-emptive planning – focusing on whether a specific instrument should or should not be further considered. This initial assessment represents a first step in a process and is not yet a formal proposal.

Published on 1 August, Shadow Banking and Market-Based Finance is an IMF staff departmental paper. Noting that variants of non-bank credit intermediation differ greatly, the authors provide a conceptual framework to help distinguish various characteristics – structural features, economic motivations, and risk implications – associated with different forms of nonbank credit intermediation. Anchored by this framework, they take stock of the evolution of shadow banking and the extent of its transformation into market-based finance since the global financial crisis. In light of the substantial regulatory and supervisory responses of recent years, they highlight key areas of progress while drawing attention to elements where work still needs to be done.

Would Macroprudential Regulation Have Prevented the Last Crisis? is a Bank of England staff working paper, published on 3 August, in which the authors consider how well equipped are today’s macroprudential regimes to deal with a re-run of the factors that led to the global financial crisis? They argue that a large proportion of the fall in US GDP associated with the crisis can be explained by two factors: the fragility of financial sector – represented by the increase in leverage and reliance on short-term funding at non-bank financial intermediaries – and the build-up in indebtedness in the household sector. They describe and calibrate the policy interventions a macroprudential regulator would wish to make to address these vulnerabilities; and compare and contrast how well placed two prominent macroprudential regulators – the US Financial Stability Oversight Council and the UK’s Financial Policy Committee – are to implement these policy actions.

On 9 August, the EBA published 12 indicators and updated the underlying data from the 35 largest institutions in the EU, whose leverage ratio exposure measure exceeds €200 billion. This end-2017 data contributes to the internationally agreed basis on which a smaller subset of banks will be identified as G-SIIs, following the BCBS and FSB final assessments. The EBA, acting as a central data hub in the disclosure process, will update this data on a yearly basis and aggregate it across the EU. A stable sample of 33 institutions shows that their aggregate total exposures, as measured for the leverage ratio, decreased by 1.1% and stood at €24.3 trillion at the end of 2017.

On 6 September, ESMA published its latest Trends, Risks, and Vulnerabilities (TRV) Report (No 2, 2018). This TRV, which covers the first half of 2018, finds that overall risk levels for the EU’s securities markets remained stable but at high levels for most risk categories, with equity and bond volatility spikes in February and May reflective of growing sensitivities. The TRV identifies the following key risks in EU securities markets:

• market risk remains at a very high level accompanied by very high risk in securities markets and elevated risk for investors, infrastructures and services – the outcome of the Brexit negotiations remains at this stage the most important political risk for the EU;

• credit risk and liquidity risk remain high with a deterioration in outstanding corporate debt ratings, and deteriorating measures of corporate and sovereign bond liquidity; and

• operational risk continues to be elevated with negative outlook, as cyber threats and Brexit-related risks to business operations remain major concerns.

Going forward, EU financial markets can be expected to become increasingly sensitive to mounting economic and political uncertainty from diverse sources, such as weakening economic fundamentals, transatlantic trade relations, emerging market capital flows, Brexit negotiations, and others. Assessing business exposures and ensuring adequate hedging against these risks will be a key concern for market participants in the coming months.

Then, on 10 September, the ESRB published the EU Shadow Banking Monitor 2018, which covers data up to end-2017 and is the third issue in an annual series that contributes to the monitoring of a part of the financial system that has grown in recent years and, while little changed in 2017, now accounts for around 40% of the EU financial system. While the size of the shadow banking system is important for monitoring purposes, it is not, in itself, a measure of risks and vulnerabilities. Nevertheless, the report does identify several key risks and vulnerabilities in the EU shadow banking system, namely:

• liquidity risk and risks associated with leverage among some types of investment funds;

• interconnectedness and the risk of contagion across sectors and within the shadow banking system, including domestic and cross-border linkages;

• procyclicality, leverage and liquidity risk created through the use of derivatives and SFTs; and

• vulnerabilities in some parts of the other financial institution sector, where significant data gaps prevent a comprehensive risk assessment.

Subsequently, on 11 September, the Joint Committee of the ESAs published its latest report on risks and vulnerabilities in the EU financial system, which shows that the EU’s securities, banking and insurance sectors continue to face a range of risks. The report highlights the following risks as potential sources of instability:

• abrupt yield increases could generate substantive asset price volatility and lead to losses across asset classes;

• repricing of risk premia and potentially increasing interest rates could affect financial institutions and may bring with them a risk of contagion between different sectors; and

• uncertainties around the terms of the UK’s withdrawal from the EU and the need to prepare for a no-deal scenario, as well as trade policy uncertainties and wider geo-political risks.

In light of the ongoing risks and uncertainties, especially those around Brexit, supervisory vigilance and cooperation across all sectors remains key. Therefore, the ESAs advise the following policy actions by European and national competent authorities as well as financial institutions:

• stress tests – should be conducted and developed further across all sectors;

• risk appetite – supervisory authorities need to pay continued attention to the risk appetite of all market participants;

• contagion risks – macro- and microprudential authorities should contribute to addressing possible contagion risks, including continuing their efforts in monitoring lending standards; and

• Brexit – it is crucial that EU financial institutions and their counterparties, as well as investors and retail consumers, plan appropriate mitigating actions to prepare for the UK’s withdrawal from the EU in a timely manner, including the risks associated with a no-deal scenario.

Macroprudential Stress Tests and Policies: Searching for Robust and Implementable Frameworks is an IMF staff working paper, published on 11 September. Macroprudential stress testing (MaPST) is becoming firmly embedded in the post-crisis policy-frameworks of financial-sectors around the world. They can offer quantitative, forward-looking assessments of the resilience of financial systems as a whole to particularly adverse shocks; and are thus well suited to support the surveillance of macrofinancial vulnerabilities and to inform the use of macroprudential policy-instruments. This report summarizes the findings of a joint-research effort by the IMF’s Monetary and Capital Markets Department and the LSE based Systemic Risk Centre, which aimed at (i) presenting state-of-the-art approaches on MaPST, including modelling and implementation-challenges; (ii) providing a roadmap for future-research, and; (iii) discussing the potential uses of MaPST to support policy.

The Real Effects of Disrupted Credit - Evidence from the Global Financial Crisis is a, 13 September, paper written by the former Chairman of the US Federal Reserve, Ben S. Bernanke, and released by the Brookings Papers on Economic Activity. This paper firstly reviews research since the crisis on the role of credit factors in the decisions of households, firms, and financial intermediaries and in macroeconomic modelling. This research provides broad support for the view that credit market developments deserve greater attention from macroeconomists, not only for analysing the economic effects of financial crises but in the study of ordinary business cycles as well.

Secondly, new evidence is provided on the channels by which the recent financial crisis depressed economic activity in the US. Although the deterioration of household balance sheets and the associated deleveraging likely contributed to the initial economic downturn and the slowness of the recovery, the paper finds that the unusual severity of the Great Recession was due primarily to the panic in funding and securitization markets, which disrupted the supply of credit. This finding helps to justify the government’s extraordinary efforts to stem the panic in order to avoid greater damage to the real economy.

On 19 September, the EBA published reports on EU banks’ funding plans and asset encumbrance respectively, which aim to provide important information for EU supervisors to assess the sustainability of banks’ main sources of funding. The results of the assessment show that banks plan to match the asset side increase in the forecast years by a growth in client deposits as well as market-based funding. 159 banks submitted their plans for funding over a forecast period of three years (2018 to 2020). According to the plans, total assets are projected to grow, on average, by 6.2% by 2020. The main drivers for asset growth are loans to households and to non-financial corporates. The asset encumbrance report shows that in December 2017 the overall weighted average asset encumbrance ratio stood at 27.9%, compared to 26.6% in 2016, with the modest increase mostly driven by a reduced volume of total assets as opposed to an increase in encumbered assets.

On 24 September, ESMA published an article setting out the details of its analysis of volatility in financial markets. The potential of market volatility to undermine financial stability as well as to impose unexpected losses on investors, is a subject of concern for securities market regulators, and is a key element of ESMA’s market monitoring. Relatively high levels of volatility increase the likelihood of stressed financial markets. Also, however, a prolonged period of relatively low volatility may lead to a more fragile financial system, promoting increased risk-taking by market participants. ESMA will continue to monitor the development of market volatility and include regular updates in the TRV and Risk Dashboards, on a quarterly basis.

Also published on 24 September, Managing the Sovereign-Bank Nexus is an ECB staff working paper on the various channels that give rise to the interconnectedness between the financial health of banks and sovereigns – the “sovereign-bank nexus”. The authors find that the link is caused by three interacting channels: banks hold large amounts of sovereign debt; banks are protected by government guarantees; and the health of banks and governments affects/is affected by economic activity. The paper underlines the need for a holistic policy response to decrease this interconnectedness, arguing for stronger balance sheets and bank governance, disincentives to holding of large amounts of sovereign bonds and limits on public guarantees.

The ESRB held its third annual conference, on 27 and 28 September, in Frankfurt. Mario Draghi, ESRB Chair, opened the conference and gave a keynote address to conference participants. Subsequent keynote speeches were given by Philip Lane, Governor, Central Bank of Ireland and Chair of the ESRB ATC; and John Schindler, Associate Director, Board of Governors of the Federal Reserve System. Panel discussions were conducted on sustainable finance; international perspectives on macroprudential policy; identifying and assessing risks in the shadow banking system; and macroprudential policy in recovering economies.

Also on 28 September, the Bank of England hosted a Conference on Non-Bank Financial Institutions and Financial Stability. The opening keynote speech was given by Alex Brazier, Executive Director, Financial Stability Strategy and Risk, Bank of England; and a keynote lecture, Asset Managers and Financial Fragility, was delivered by Itay Goldstein, Wharton School of Business, University of Pennsylvania. Discussions sessions considered the indirect impact of leverage ratio on banks and non-banks; systemic risk in asset managers and insurance companies; financial networks and peer-to-peer lending; and trading behaviour and financial stability.

Cross-border Banking and the Circumvention of Macroprudential and Capital Control Measures is an IMF staff working paper, published on 28 September, in which the authors analyse the joint impact of macroprudential and capital control measures on cross-border banking flows, while controlling for multidimensional aspects in lender-and-borrower-relationships (eg distance, cultural proximity, microprudential regulations). They uncover interesting spillover effects from both types of measures when applied either by lender or borrowing countries, with many of them most likely associated with circumvention or arbitrage incentives.

Published on 2 October, the sixth edition of the semi-annual ECB Macroprudential Bulletin contains three articles on key macroprudential topics. The first article analyses the leverage ratio and its links with the repo markets; the second focuses on the regulatory framework for G-SIBs, which was developed by the BCBS to address the negative externalities that a failure of these large banks could exert on the financial sector and the economy as a whole; and the third aims to facilitate the discussion on potential macroprudential liquidity instruments for investment funds by providing a preliminary assessment of the effectiveness and efficiency of several instruments. As in previous issues, this Macroprudential Bulletin also provides an overview of macroprudential policy measures which currently apply in euro area countries.

Contact: David Hiscock david.hiscock@icmagroup.org