Understanding Financial Stability & Macro-prudential Policy

Dr. Ayman F. AlfiFinancial Stability Division, SAMADeputyship of Research and International Affairs

Dec. 21, 2014

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Outline

• What is Financial Stability (FS)?

• Why Financial Stability

• What is Macro-prudential Policy – Definition & Objectives

• Systemic Risk: Sources & Dimensions

• Macro-prudential Toolkit

• Macro-prudential Policy Interaction with Other Economic Policies

• Example for Systemic Risk Assessment – Saudi Arabia

• Macro-prudential Issues and Challenges

The Economic Circular Flow – Role of financial Systems

3

4

What is Financial Stability (FS)?

• Ability to withstand shocks (resilience) – e.g., macro and micro shocks

• Ability of the financial system to process transactions without interruption or intervention

• Market participants have confidence in the financial system

• Stable capital market in the sense that prices are based on fundamentals

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FS Definitions by Other Central Banks

Central Bank Definition

AustraliaA stable financial system is one in which financial intermediaries, markets and market infrastructure facilitate the smooth flow of funds between savers and investors and by doing so, helps promote growth in economic activity

South AfricaThe absence of the macroeconomic costs of disturbances in the system of

financial exchange between households, businesses and financial‐service firms

ECB

A condition in which the financial system—comprising of financial intermediaries, markets and market infrastructures—is capable of withstanding shocks and the unraveling of financial imbalances, thereby mitigating the likelihood of disruptions in the financial intermediation process which are severe enough to significantly impair the allocation of savings to profitable investment opportunities

Japan“Financial system stability” refers to a state in which the financial system functions properly, and participants, such as

firms and individuals, have confidence in the system”

Why Financial Stability?

• Significant developments in the financial world (deregulation, innovation, globalization)

• Frequent Financial Disruptions

Currency crisis in Mexico (1994)

Asian financial crisis (1997)

LTCM collapse (1998)

Argentina crisis (2000)

The GFC (2007 --)

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Common symptoms of Crises

1. Exchange rate miss-valuation

2. Current account deficits (BoP crises)

3. Rising Debt (consumer, corporate, Government)

4. Low/Falling reserves

5. Mismatch on balance sheets (currency, maturity)

6. Erosion of policy credibility/Poor regulation (Confidence issues)

7. Sensitivity to external shocks

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Why Financial Stability?

Crises revealed/re-emphasized that:

• Financial Crisis cause too much damage and output losses, contagious, and too costly to resolve

• Price stability is not enough

• Real and financial sectors inter-dependence

• Government-financial sector relationship

• Healthy financial system ensures smooth policy transmission mechanism• Financial markets host fiscal and monetary transmission channels

Should consider Financial Stability as an explicit economic policy objective and develop a policy to achieve it

Macro-prudential Policy

What is MP Policy

Policy aimed at maintaining financial stability

The use of primarily prudential (regulatory) tools to limit systemic risk (IMF, 2011)

Systemic risk is “the risk of disruptions to the provision of financial services that is caused by an impairment of all or parts of the financial system, and

can cause serious negative consequences for the real economy” (IMF , 2009)

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Origins & Evolution

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June,

1979

• BIS meeting on International lending

• “… microeconomic problems began to merge into macroeconomic problems at the point where micro-prudential problems became what could be called macro-prudential ones”

Oct, 1979

• BoE background note: “This macro-prudential approach considers problems that bear upon the market as a whole as distinct from an individual bank, and which may not be obvious at the micro-prudential level”

1986

• First public appearance when published in a BIS report on Recent innovations in international banking which defined it as a policy that promotes “the safety and soundness of the broad financial system and payments mechanism

1992

• BIS report on Recent developments in international bank relations

1998-2000

• Triggered by the Asian crisis, IMF report Toward a framework for a sound financial system stated that “… macro-prudential analysis […] focuses on developments in important asset markets, other financial intermediaries, and macroeconomic developments and potential imbalances.

• BIS GM (Andrew Crockett) speech in the international conference of banking supervisors comparing Micro Vs. Macro – prudential policies.

Macro-prudential Policy Objectives

• Three main objectives:

1. Increase resilience of the financial system to aggregate systemic shocks

2. Contain the build-up of systemic vulnerabilities over time – time dimension

3. Control the build-up of vulnerabilities within the financial system that arises through inter-linkages - structural (cross-sectional) dimension

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Sources of Systemic Risk

Systemic Risk

Global -Domestic

Inter-linkages

Government-Bank

Feedback Loop

With-in system

(sectoral) Inter-linkages

Macro -Financial

Inter-linkages

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Systemic Risk Dimensions

Time Dimension

Pro-cyclicality: excessive risk taking during booms

Two Key elements:Credit (leveraging)

Liquidity (maturity mismatch)

Cross-Sectional (Structural) Dimension

Distribution of risk in the financial system at a given point of time

Key elements:

Size

Interconnectedness

Substitutability

Concentration 13

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MP Toolkit

Time Dimension Tools

Capital Requirements

(CAR, CCB, Counter-

cyclical buffers)

Dynamic Provisioning

Time-varying risk weights

Reserve Requirement

Liquidity Requirements

(LCR, NSFR)

Loan-To-Deposit (LTD)

ratio

Leverage ratios

Ceilings on credit/credit

growth

Cross-Sectional Tools

Systemic Capital

Surcharges

Debt-To-Income (DTI)

ratio

Systemic Liquidity

Surcharges

Limits on margin lending

Limits on foreign

exposure/ lending

Loan-To-Value (LTV) ratios

Macro-prudential Policy Interactions

Macro Vs. Micro Prudential Policies

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• Despite the differences, they should work together

– Micro-prudential is a necessary, but not sufficient condition for financial stability

• But where to draw the line between “micro” and “macro” prudential policies

– Some instruments are used for both policies

Top-Down Macro-prudential Policy

Financial Stability

Bottom-Up Micro-prudential Policy

Macro Vs. Micro Prudential PoliciesThe Macro- & Micro-prudential Perspectives

ComparedMacro-prudential Micro-prudential

Objective Stability/limit distress of the financial system as a whole (system-wide)

Stability/limit distress of individual institutions (Idiosyncratic)

Concern Financial instability (avoid crises)

Consumer Protection (investors/depositors)

Characterization of Risk Endogenous (system-wide Correlations)

Exogenous (independent of individual agents’ behavior)

Fallacy of composition: the state of the whole is NOT the sum of the state of seemingly independent parts

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Macro-prudential Vs. Monetary

• Is there a trade off between the two policies’ objective (Monetary Vs. Financial Stability)

– Complements or Substitutes?

• Monetary policy as a blunt tool; Can MP policy help?

• Could MP policy prevent the GFC? A case on MP & Monetary policies coordination

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A Conflict May Arise …

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OR

Or May NOT !!!

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AND

Macro-prudential Vs. Fiscal Policy

• Prudent fiscal Policy low systemic risk less burden on MP policy

• Tax structure

– Current structure encourages leveraging

– Can assist MP by targeting risky sectors21

Prudent Fiscal Policy

• Debt sustainability

• Budget Surpluses

Lower systemic risk

• No sovereign-bank feedback loop

• Low volatility in bond markets

Stable Financial systems

• Less need for frequent MP interventions

• Sustainable growth rates

Macro-prudential Vs. Other Policies

• Competition Landscape:

• Cross-border MP policies– Regulatory Arbitrage

– Need for International Cooperation

• Crisis Management Policies– Deposit Insurance Schemes (DIS)

– Resolution frameworks

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competition Risk TakingSystemic

RiskFinancial Instability

The complete interaction landscape

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Source: The Basel III Accord

Macro-prudential policy and Systemic Risk Assessment – Saudi Arabia

SAMA’s Macro-prudential Toolkit

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Instrument Regulatory Requirement

Capital Adequacy Ratio Basel requirement of a Minimum of 10.5%

Provisioning General: 1% of total loansSpecific: Minimum of 100% of NPLs

Leverage Ratio Deposits/(capital + Reserves) ≤ 15 times

Reserve Requirement 7% for Demand Deposits4% for Time Deposits

Loan-To-Value (LTV) Mortgage loans ≤ 70% of home value

Debt Service – To – Income (DTI) Monthly repayments ≤ 33% of Income

Loan-to-deposit (LTD) ratio 85%

Liquidity:• SLR• LCR (Basel III)• NSFR (Basel III)

Liquid Assets/deposits ≥ 20%100 % by 2019 (already fulfilled)100 % by 2019 (already fulfilled)

Counterparty Exposure Individual Exposure/total capital ≤ 25%

Foreign Exposure Approval Needed

Systemic Risk Assessment: Fiscal Sustainability

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1.537 1.6692.040

2.4622.721 2.793

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2009 2010 2011 2012 2013 2014(Sep)

(Tri

llio

n R

ls)

SAMA's Reserve Assets

-86.629

87.731

291.092

374.093

180.347

-5.4

4.4

11.613.6

6.4

-10

-5

0

5

10

15

-200

-100

0

100

200

300

400

2009 2010 2011 2012 2013

Budget Surpluses

Fiscal Balance Fiscal Balance-to-GDP Ratio

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8.5

5.43.6

2.7

0

5

10

15

0

50

100

150

200

250

2009 2010 2011 2012 2013

(BIL

LIO

N R

LS)

Public Debt

Public Debt Debt-to-GDP Ratio

• Source: SAMA

Source: SAMA

Source: SAMA

Source: SAMA

Systemic Risk Assessment: Global Interconnectedness

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-150-140-130-120-110-100

-90-80-70

2012,Q1

2012,Q2

2012,Q3

2012,Q4

2013,Q1

2013,Q2

2013,Q3

2013,Q4

2014,Q1

(Bill

ion

Rls

)

Net Capital Flow mean

4.9

12.7

23.7 22.4

18.0

0

5

10

15

20

25

0

100

200

300

400

500

600

700

2009 2010 2011 2012 2013

(%)

(BIL

LIO

N R

LS)

Current Account Surplus Current Account Surplus Relative to GDP

4.2

3.83.7

2.9

3.5

2009 2010 2011 2012 2013

Inflation

Source: SAMA

Source: SAMA

Source: SAMA

Source: SAMA

-1.000

0.000

1.000

2.000

3.000

4.000

5.0002

00

9 Q

12

00

9 Q

22

00

9 Q

32

00

9 Q

42

01

0 Q

12

01

0 Q

22

01

0 Q

32

01

0 Q

42

01

1 Q

12

01

1 Q

22

01

1 Q

32

01

1 Q

42

01

2 Q

12

01

2 Q

22

01

2 Q

32

01

2 Q

42

01

3 Q

12

01

3 Q

22

01

3 Q

32

01

3 Q

4

Return on Assets

Saudi Arabia U.S. Swaziland China UK

Systemic Risk Assessment: The System from With-in

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175.7

138.9133.7120.6117.7

104.3

68.459.154.4 53 51 50.147.841.236.6

0

50

100

150

200

Banks Credit (Private Sector) to GDP, 2012

11.914.414.414.714.715.415.716.116.416.416.917.017.918.0

21.2

0

5

10

15

20

25

Au

stra

lia

Can

ada

USA

Mal

aysi

a

Jap

an

Om

an

Turk

ey

Ch

ina

Sin

gap

ore UK

Swit

zerl

and

Bra

zil

Sau

di A

rab

ia

Ku

wai

t

UA

ECapital Adequacy Ratio (CAR), 2013

Source: IMF

Source: World Bank

Source: World Bank

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Claims on Private Sector

59.3Cash10.6

Foreign Assets11.1

Claims on Government & semi Government

5.0 SAMA Bills9.5

Other Assets4.5

Distribution of Bank Assets (%), 2013

38.546.2

39.5 34.4 36.6 40.1

86.378.1 71.9 70.4 73.8 76.5

2008 2009 2010 2011 2012 2013

Bank Credit to GDP Ratio

Credit-to-GDP Ratio Credit-to-Non-Oil GDP Ratio

Source: SAMA

Source: SAMA

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7.6 7.36.0

3.8 3.73.1 2.6 2.6 2.5 2.3 2.0 1.5 1.3 0.9 0.8 0.6 0.5

Global NPL ratios, 2013

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

NPL Ratio

Source: SAMA

Source: World Bank

So … where is the risk?

1. Oil Market Volatility

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0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

0.00

20.00

40.00

60.00

80.00

100.00

120.00

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

Oil price Vs. NPLsoil prices NPL

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

0.00

20.00

40.00

60.00

80.00

100.00

120.00

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

Oil Pric Vs. Credit Growth

Oil price credit growth

Source: SAMA

Source: SAMA

2. The capital market

Excessive risk taking due to record low interest rates

Too much leveraging in the equity market

A chance for Asset Price Bubble

Sectoral Correlation

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-0.3-0.2-0.100.10.20.3

00.5

11.5

22.5

3

No

v-05

Mar

-06

Jul-

06

No

v-06

Mar

-07

Jul-

07

No

v-07

Mar

-08

Jul-

08

No

v-08

Mar

-09

Jul-

09

No

v-09

Mar

-10

Jul-

10

No

v-10

Mar

-11

Jul-

11

No

v-11

Mar

-12

Jul-

12

No

v-12

Mar

-13

Jul-

13

No

v-13

Mar

-14

Jul-

14

No

v-14

Equity Vs. Real Estate

real estate growth Tasi growth

Source: SAMA

Issues & Challenges

Designing a Practical MP policy (1)

• Selecting the appropriate tools– Many or few instruments?

– Sector or Institution specific (or both)

– Price or Quantity based tools (or both)

• Addressing country-specific factors– What sectors are most important:

• Housing market is more important in advanced economies LTV is more effective

• Capital flow is more important in emerging economies

– What macro variables are relevant for financial stability

• Addressing pro-cyclicality– The use of counter-cyclical tools

– Use of dynamic, time-varying MP regulation

– Understanding economic Vs. financial cycles34

Designing a Practical MP Policy (2)

• Closing regulatory gaps– Limiting the size of shadow banking

– Boundary issues (avoid conflicting with some institutions’ objectives such as SCIs)

• Closing data gaps:– Good collaboration between institutions and regulators

– Clear definitions of terms and ratios

• Good MP institutional/governance framework– Clarity in regulatory scope, roles, and responsibilities

– Understanding of policy interactions

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Challenges

1. Stability or Efficiency:- MP measures may restrict growth and developments (or may not !!!)

- Are we over-reacting to the GFC? Is it really the time for more regulation?

2. MP Governance- Who is in charge of MP

- How can ensure coordination between different regulatory authorities

3. Calibration & Modeling difficulties- Hard to quantify the impact of MP policy as crises are rare events

- Data gaps – a need for granular, high frequency, and market based

data

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References

• Bank for International Settlements (1986): Recent innovations in international banking, report prepared by a study group established by the central banks of the G10, Basel, April (Cross Report)

• --- (1992): Recent developments in international interbank relations, report prepared by a working group established by the central banks of the G10 countries, Basel, October (Promisel Report)

• Crockett, A (2000): “Marrying the micro- and macroprudential dimensions of financial stability”, BIS speeches, 21 September.

• Haldane, A (2013): “Macroprudential Policies – When and how to use them”, IMF conference, 16-17 April.

• International Monetary Fund, 2011a, “Macroprudential Policy: An Organizing Framework” (Washington: International Monetary Fund).

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