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Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Future of Banking Regulations and
macro-prudential policies
Jon DanıelssonSystemic Risk Centre
London School of Economics
www.systemicrisk.ac.uk
May 8, 2017
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Post crisis regulated developments
• Banks hold much more capital
• Financial institutions are more restricted
• Much more compliance
• Insurance companies and asset managers seen assystemically important (SIFI) and regulated accordingly
• We regulate (or aspire to regulate) much more holistically
• Applying an increasingly similar methodology toeverybody
• Convergence in risk models and business practices
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Why?
• We had a big financial crisis in 2008
• The political leadership (G20) told the financialauthorities
“Do something about finance”
• The authorities have to comply and show action
• Fear of the “unknown unknowns”
• Which is used to justify the regulatory agenda
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The financial authorities might say:
• “Before 2008 the financial sector misbehaved”
• “We admit we were asleep”
• “But now are fully on top of the problem”
• “And are creating rules that promise:”
a. Reducing the frequency and severity of crises
b. Making the economy more resilient and grow more
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Which is the most likely?GDP over a century
0 20 40 60 80 100
0
10
20
30
40
50
year
GD
P
3% growth
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Which is the most likely?GDP over a century
0 20 40 60 80 100
0
10
20
30
40
50
year
GD
P
4% growth
3% growth
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Which is the most likely?GDP over a century
0 20 40 60 80 100
0
10
20
30
40
50
year
GD
P
4% growth
3% growth
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Which is the most likely?GDP over a century
0 20 40 60 80 100
0
10
20
30
40
50
year
GD
P
4% growth
3% growth
2% growth
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Helicopter view of what is happening with
financial regulations
• Much more emphasis on measuring risk, all the way fromthe most detailed activities up to the entire system
• Use those measurements to control the financial system
• Regulations (what could be called the regulatoryphilosophy) is converging to a Basel style worldview
• All are treated the same: bank, insurance, assetmanagement, pension funds
• The key question is: Is this a positive development?
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Macro and micro prudential regulations
• Macro prudential (MacroPru) — Protect the system
• minimize systemic risk and contain systemic crises
• Micro prudential (MicroPru) — Protect the clients
• Basel II/III is mostly micro
• Current bank stress testing is only micro
• We are now developing macroprudential stress testing(see discussion below)
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
What is systemic risk?FSB-IMF-BIS report to G20 (2009)
• Risk of disruption to financial services that is:
• Caused by an impairment of all or parts of the financialsystem and
• Has the potential to have serious negative consequencesfor the real economy
• Criteria
• Size• Substitutability (the extent to which other components
of the system can provide the same services in the eventof a failure)
• Interconnectedness
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Top down and bottom up
Micro
Retail clients
SMEs
Corporates
Government
Asymmetric abilitiesAbuse
ConductCulture
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Top down and bottom up
Micro
Retail clients
SMEs
Corporates
Government
Asymmetric abilitiesAbuse
ConductCulture
MacroThe economy
Financial system
Government
SIFI
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Top down and bottom up
Institution
Micro
Retail clients
SMEs
Corporates
Government
Asymmetric abilitiesAbuse
ConductCulture
MacroThe economy
Financial system
Government
SIFI
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Top down and bottom up
Institution
Micro
Retail clients
SMEs
Corporates
Government
Asymmetric abilitiesAbuse
ConductCulture
MacroThe economy
Financial system
Government
SIFI
Basel
Processes
Stress test
TLACLTV, DTI, *
Capital
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The five key questions
1. Can we measure risk sufficiently well to control thefinancial system?
2. Does controlling by risk stabilize or destabilize?
3. Should we de-risk?
4. What about the unknown unknowns?
5. Is it desirable to follow a regulatory philosophy thatmakes the financial system more homogeneous?
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
What drives risk?
• 2008 happened because of decisions made years earlier
• In 2003 all the signs pointed to risk being low
• The authorities and the private sector thought we weresafe
• And so it was perfectly OK to take extra risk
• But
• “Stability is destabilizing” (Minsky)
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The unknown unknowns
• The US stock market goes down by $200 billion in oneday and nobody cares
• Potential subprime losses of less than $200 billion, andOMG, it’s the end of civilization
• The risk we know we prepare for — known unknowns
• The risk we don’t know is the dangerous type
• The unknown unknowns are most damaging
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Risk is endogenousDanielsson–Shin (2002)
• Risk is exogenous or endogenous
exogenous Shocks to the financial system arrive fromoutside the system, like with an asteroid
endogenous Financial risk is created by the interactionof market participants
“The received wisdom is that risk increases in recessions andfalls in booms. In contrast, it may be more helpful to think ofrisk as increasing during upswings, as financial imbalances
build up, and materialising in recessions.”Andrew Crockett, then head of the BIS, 2000
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
• Market participants are guided by a myriad of models andrules, many dictate myopia
• Prices don’t follow random walks in adverse states ofnature
• Because that is when the constraints bind
• Endogenous risk is created by the interaction of humanbeings
• All with their own objectives, abilities, resources, biases
• All large market outcomes are endogenous
Risk models underestimate risk during calm times andoverestimate risk during crisis — they get it wrong in all states
of the world
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Two faces of risk
• When individuals observe and react — affecting theiroperating environment
• Financial system is not invariant under observation
• We cycle between virtuous and vicious feedbacks
• perceived risk — as reported by risk models• actual risk — hidden but ever present
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Endogenous bubble
1 3 5 7 9 11 13 15 17 19
1
3
5
7
9 PricesPrices
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Endogenous bubble
1 3 5 7 9 11 13 15 17 19
1
3
5
7
9 PricesPrices
Perceived risk
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Endogenous bubble
1 3 5 7 9 11 13 15 17 19
1
3
5
7
9 PricesPrices
Perceived risk
Actual risk
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
How often do systemic crises happen?
• Ask the IMF–WB systemic crises database (only OECD)
• Every 43 years (17 for UK)
• Best indication of the target probability for policymakers
• However, most indicators focus on much more frequentevents
• Typically every month to every five months
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The 43 year cycle of systemic risk
2000 2010 2020 2030 2040
actual riskbuilds up
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The 43 year cycle of systemic risk
2000 2010 2020 2030 2040
actual riskbuilds up
hidden
trigger
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The 43 year cycle of systemic risk
2000 2010 2020 2030 2040
actual riskbuilds up
hidden
trigger
perceived riskindicators flash
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The 43 year cycle of systemic risk
2000 2010 2020 2030 2040
actual riskbuilds up
hidden
trigger
perceived riskindicators flash
improvisedresponses
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The 43 year cycle of systemic risk
2000 2010 2020 2030 2040
actual riskbuilds up
hidden
trigger
perceived riskindicators flash
improvisedresponses
MacroPruimplemented
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The 43 year cycle of systemic risk
2000 2010 2020 2030 2040
actual riskbuilds up
hidden
trigger
perceived riskindicators flash
improvisedresponses
MacroPruimplemented
actual riskbuilds up
rulesossifying
regulatoryarbitrage
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The 43 year cycle of systemic risk
2000 2010 2020 2030 2040
actual riskbuilds up
hidden
trigger
perceived riskindicators flash
improvisedresponses
MacroPruimplemented
actual riskbuilds up
rulesossifying
regulatoryarbitrage
The 43 year cycle
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The 43 year cycle of systemic risk
2000 2010 2020 2030 2040
hidden
trigger
perceived riskindicators flash
improvisedresponses
MacroPruimplemented
actual riskbuilds up
rulesossifying
regulatoryarbitrage
The 43 year cycle
Perceived risk
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The 43 year cycle of systemic risk
2000 2010 2020 2030 2040
hidden
trigger
perceived riskindicators flash
improvisedresponses
MacroPruimplemented
actual riskbuilds up
rulesossifying
regulatoryarbitrage
The 43 year cycle
Perceived risk
Actualrisk
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
“Learning from History:Volatility and Financial Crises”
(2017)with Marcela Valenzuela (University of Chile)
Ilknur Zer (Federal Reserve)
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Crises volatilities
“Volatility in markets is at low levels, both actual andexpected, ... to the extent that low levels of volatility mayinduce risk-taking behavior ... is a concern to me and to the
Committee.”Federal Reserve Chair Janet Yellen, 2014.
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
What drives risk?
• 2008 happened because of decisions made years earlier
• In 2003 all the signs pointed to risk being low
• The authorities and the private sector thought we weresafe
• And so it was perfectly OK to take extra risk
• But
• “Stability is destabilizing” (Minsky)
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The volatility — crisis cycle
t = 1 t = 2 t = 3 t = 4
Volatility
low
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The volatility — crisis cycle
t = 1 t = 2 t = 3 t = 4
Volatility
low
Appetiteforrisk
↑
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The volatility — crisis cycle
t = 1 t = 2 t = 3 t = 4
Volatility
low
Appetiteforrisk
↑
Credit↑
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The volatility — crisis cycle
t = 1 t = 2 t = 3 t = 4
Volatility
low
Appetiteforrisk
↑
Credit↑
Defaults↑
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The volatility — crisis cycle
t = 1 t = 2 t = 3 t = 4
Volatility
low
Appetiteforrisk
↑
Credit↑
Defaults↑
Bankingcrisis
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The volatility — crisis cycle
t = 1 t = 2 t = 3 t = 4
Volatility
low
Appetiteforrisk
↑
Credit↑
Defaults↑
Bankingcrisis
Volatility
↑
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Empirical approach
• We construct a comprehensive database on historicalvolatilities from primary sources (1800 to 2010, 60countries
• Realized volatility
• Decomposed with HP filter into low and high volatilities(deviations from trend)
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
• Strong and significant support for volatility cycle
• Low volatility increases the probability of banking crisesyears in future
• Low volatility significantly increases risk-taking(credit-to-GDP)
• High volatility correlated with crisis but not causal
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Overview
• Recognition that we did not regulate well before 2007
• Initial reaction was to take before 2007 regulations andmake them more strict
• Increased understanding that this is not sufficient orcorrect
• Searching for better solutions
• But considerable regulatory fatigue — resistance tochanges
• Basel IV unlikely to happen for many years
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Non–bank drivers
• G20 called for policies to prevent “Too Big To Fail” in2010
• G20 in 2011 asked the FSB and IOSCO to preparemethodologies to identify systemically important NBNIs
• FSB list of global systemically important insurers in 2015
• Grappling with asset managers (next slide)
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Asset managers
• Maybe largest managers, like BlackRock, Vanguard,Allianz, Asmundi
• Limits on fund leverage?
• Limits on liquidity mismatches?
• Minimum capital?
• More disclosure?
• More scrutiny?
• Stress tests?
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Harmonization I — Regulatory philosophy
• All parts of the financial system to be brought under theregulatory umbrella
• asset managers, insurance companies, non-bank banks
• Best understood is banking
• So apply banking vulnerability analysis to the rest
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Internal management of risk
• Some banks use the same methodology for managing riskacross the board
• annual report, regulatory capital, trading floor, riskcapital allocations
• Others use different models and methodologies acrossoperations
• multiple models and stress tests for risk-taking
• Dependent on institution sophistication and size, andsupervisor preference
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Harmonization II — Models
• If we regulate by models, the regulators must believethere is one true model
• Therefore, banks should not report different risk readingsfor the same portfolio
• However, forcing model harmonization across banks ispro–cyclical
• So is forcing the same models to be used for everythinginternally
• Forcing the same models on non-banks is even worse
• And pro–cyclicality negatively affects economic growthand increases financial instability
• The rationale is to reduce cyclicality but it can easilyachieve the opposite
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The SIFI paradox
• Most would argue that SIFIs are not good for clients norsystem (micro and macro undesirable)
• Still they are growing and new are being formed
a. Useful in resolving failed institutions (Lloyds, MS, etc. )b. Governments like national champions (DB, HSBC, Citi,
etc.)
• Regulations have fixed and variable cost, both are growing
• The fixed cost gives competitive advantage to the largest
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Healthy financial systems are heterogenous
• Encourage different models to be used internally andacross industry
• Have different regulations for different parts of theindustry
• Regulate banks differently from insurance companies andthose differently from asset managers
• When some sell we want others to buy
• Encourage new forms of intermediation
• Encourage new entrants• Shadow banking Parallel banking and fintec is good• Just make sure to not regulate them with banking
regulators
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Do we like where we are going?
• Policy makers know that homogeneity is pro—cyclical
• But “We have to do our job, what else can we do?”
• And march towards uniformity
• The same government agency could regulates banks,asset managers, insurance and parallel banks
• Using very similar regulatory methodology
• Because that is easier
• But we will not say that instead say
• “more consistent, simpler, fairer, cheaper, more reliable,less subjective,...”
• Pity it won’t work
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Regulations and risk controls
• Any control process, internal and regulatory, can onlytarget known risk
• We are really good in managing the risk that doesn’tmatter
• It is much easier to control the known knowns
• Because we can easily measure it
• We ignore the risk we should care about
• Because it is much harder to model and plug into acontrol process
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Risk is multifaceted
• Some aspects of risk are good, others bad
• Some risk can be measured, other not
• Different people and financial institutions care about verydifferent aspects of risk
• The trader, the CEO, the stockholder, the pension saver,the house buyer, the regulator, the risk manager all seerisk very differently
• Trying to distill risk into a single set of numbers (likeVaR) is not helpful
• And can easily be destabilizing
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
De-risking
Fact A lot of risk was being taken before 2008, oftenin obscure and hidden ways
Fact The crisis of 2008 revealed the scale of thisrisk-taking and the severity of the consequences
The usual conclusion We therefore need to reduce theamount of risk in the financial system
Question Is that true?
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Does de-risking make us better off?
• No
• The only way the economy will grow is if we take riskydecisions
• With risk comes failure
• If we de-risk, we de-grow
• Losses and failures and some crises
• Are a sign of healthy well-functioning economy
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Risk models and stress tests
• Widespread recognition of limitations of risk models
• The common solution is stress tests (both internal andexternal)
• Run a portfolio or a financial institution on a historical ormade-up scenario
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Regulators bank tests
• US — CCAR (Comprehensive Capital Analysis & Review)
• macroeconomic scenarios from Fed• market
• EU — EBA,
• macroeconomic• market shocks (e.g. included credit risk market risk and
counterparty credit risk, op risk• static balance sheet
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Pros and cons
• Pros
a. recognition of some risks not picked up by modelsb. evaluation of risk engines and processes
• Cons
a. often impossible to identify likelihood of scenariosb. an infinite number of potential scenariosc. paralysis by analysis
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Issues
• Test the resiliency of each individual institution to anexogenous shock
• A useful complement to risk models
• Misses out on systemwide interactions
• For that, macroprudential stress tests (next slide)
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Macroprudential stress tests
• Interaction of all sectors of the financial system
• banks, asset managers, insurance companies, sovereignwealth funds, parallel banks
• each with their own cyclicality
• Jointly model how they interact
• Capturing feedback loops (like bubbles and fire sales)
• Ultimately may inform capital determination and othermacroprudential rules
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
MacroPru objectives
a. Prevent excessive risk accumulating
b. Contain financial crises when they happen
c. Ensure the financial system contributes to growth
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Effective MacroPru authorities needVoxEU.org (2016) Jon Danielsson and Robert Macrae
a. Estimates of systemic risk (and its impact on the realeconomy)
• from the early signs of a build-up of stress to• the post-crisis economic and financial resolution
b. Tools to implement effective policy remedies
c. Legitimacy, a reputation for impartiality, and politicalsupport
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Central banks and monetary policy
• The powers given to central banks are extraordinary for ademocratic society
• Justified by the importance of politicians notmanipulating monetary policy for short-term gains
• But it is relatively straightforward
a. One measurement (inflation)b. Two tools (price and quantity of money)
• Clear objective, target and tools
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
By contrast
• Micropru is complex and ill-defined
• Indicators are imprecise and conflicting
• Surgical tools are ineffective
• Powerful tools too blunt
• Identifies clear winners and losers (lobbying and politics)
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Major financial stress events
• Very few stress events arise purely from excessive risk
• Most are strongly influenced by politics
a. Warsb. Venezuelac. Transition between political systemsd. Populism and anti-globalism
• The macropru event is only a consequence of somethingbigger
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The dilemma of political risk
• Can a nonpolitical entity legitimately implementmacroprudential policies that affect democraticoutcomes?
• Recall Bank of England and Brexit
• Does the mandate given by the political leadership to theregulator extend to the behavior of the politicalleadership?
• If the macropru authorities are not able to incorporatepolitical risk in their analytic frameworks, how effectivecan they be?
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
MacroPru directions
• Most are passive, focusing on crisis resolution and fixedrules that hold through the financial cycle
• Ambitious macroprudential policies aim to lean againstthe wind in a discretionary manner
• Discretion to deviate from rules• Tighten capital and liquidity requirements during
upswings and relax the same rules during and after acrisis
• Cut through the amplifying feedback loops
• Discretionary macropru policies aim to be countercyclical
• If successful, of considerable benefit to the wider economy
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
SP−500 annual volatility
ECB Systemic Stress
Composite Indicator
0%
10%
20%
30%
40%
50%
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08
20
10
20
12
20
14
20
16
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
The potential for procyclical macropruVoxEU.org (2016) Jon Danielsson, Robert Macrae, Dimitri Tsomocos, Jean-Pierre Zigrand
• Minsky argument;
• Homogenization of the financial system;
• Most current indicators of systemic risk, only identifyperceived risk;
• Danger of reacting with some time lag to the postulatedindicators that are themselves measured with a time lag;
• When macropru policy is known to the market, banks willschedule risk-taking around indicators, stress tests andexpected policy reaction;
• The authorities should be willing to reduce aggregaterisk-taking and leverage during booms and increase it intimes of stress.
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
All of these objections call for a procyclical
policy response
• “Banks are failing because they already extended toomuch credit”
• “Surely bank capital needs injections rather than allowingthe banks capital to absorb losses”
• “Helping the City to increase lending now leads to evenbigger moral hazard”
• “Macropru is discredited because it was supposed to haveprevented this credit event in the first place, why shouldit do better this time?”
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Can models beat the FT?
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Can models beat the FT?
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Towards useful risk models
• Understanding model risk is a precondition for risk modelsbeing useful
• Good scientific practice suggests that risk modeloutcomes should come with confidence bounds
• Focus on the unknown unknowns
• Risk of unknown unknowns usually not to be found inmarket data
• But they can be bound
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Risk models are
most useful for controlling traders
less useful in internal risk capital allocation
• e.g. invest in European equities or JPG
often useless for micro–prudential regulations
• Traders read things like Basel III as manualfor where to take risk
dangerous when used for macro–prudential policy
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Policies intended to protect us from the
financial system could easily increase
instability
• MacroPru can be pro–cyclical
• Basel can be pro–cyclical
• Shrinking the known risks encourages the unknown onesto grow
• Monoculture destabilizes the financial system
• Excessive regulation suppresses growth
• Excessive regulation increases the rewards for regulatoryarbitrage and sows the seeds of the next crisis
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Next crisis
• There will be another crisis
• And that is not necessarily a bad thing
• Crises are also a healthy consequence of good risk taking
• Unlikely to be found in 2008 or where the authorities arelooking now
• To speculate
Future of Banking Regulations and macro-prudential policies © 2017 Jon Danielsson
Introduction Nature of risk Volatility Regulations Stress tests and risk Macro Pru Conclusion
Next crisis
• Fixed income
• Suppose inflation hits target levels
• With interest to follow
• And considering duration of some sovereign and corporatedebt
• And rapidly growing EM corporate USD bond issues
• The trigger may be
• Italy