L6: DEALING WITH CAPITAL FLOWS: THE ROLE OF MACROPRUDENTIAL POLICY

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1 L6: DEALING WITH CAPITAL FLOWS: THE ROLE OF MACROPRUDENTIAL POLICY JVI COURSE ON MACROECONOMIC POLICIES IN TIMES OF HIGH CAPITAL MOBILITY MARCH 21-25, 2016 Asel Isakova, Economist, JVI The views expressed in this presentation are those of the author and do not necessarily represent those of the Joint Vienna Institute (JVI) or JVI policy. This presentation is the property of the JVI. Any reuse requires the permission of the JVI. ALBANIA ARMENIA AZERBAIJAN BELARUS BOSNIA AND HERZEGOVINA BULGARIA CROATIA CZECH REPUBLIC ESTONIA GEORGIA HUNGARY KAZAKHSTAN KOSOVO KYRGYZ REPUBLIC LATVIA LITHUANIA FYR MACEDONIA MOLDOVA MONTENEGRO POLAND ROMANIA RUSSIAN FEDERATION SERBIA SLOVAK REPUBLIC SLOVENIA TAJIKISTAN TURKEY TURKMENISTAN UKRAINE UZBEKISTAN

2 Outline Macroprudential Policy: Introduction Tools of Macroprudential Policy Use of Macroprudential Policy: Cross-Country Evidence 2

3 Pre-crisis consensus on macro policies 3

4 Crisis has changed the consensus calling for a dedicated policy Despite good macroeconomic management and results this policy framework was unable to prevent the build-up of systemic financial risk The crisis has shown that a dedicated policy rather than a policy mix is necessary to contain systemic risks Thus, macroprudential policy was assigned a role of overseeing the whole system aisakova@jvi.org 4

5 Crisis has changed the consensus 5

6 Poll No 1. What is a systemic risk? 1. A risk associated with a failure of a large financial institution 2. A risk associated with a failure of any individual entity, group or component of a system 3. A risk of a collapse of the whole financial system or entire market aisakova@jvi.org 6

7 Motivation for macroprudential policy Linkages between macroeconomic and financial market developments create a number of externalities Certain externalities give rise to procyclicality and systemic risk: Externalities related to strategic complementarities: build-up of vulnerabilities during the expansionary phase of financial cycle Externalities related to fire sales and credit crunches: drying up of finances, deterioration of balance sheets, especially during contraction Externalities related to interconnectedness: propagation of shocks and contagion aisakova@jvi.org 7

8 Macrofinancial linkages and externalities Firms Households Build up of vulnerabilities (systemic risk) during boom: corporates Banks Government highly leveraged banks highly indebted households and growing indebtedness in foreign exchange Rest of the world Households Firms 8

9 Macrofinancial linkages and externalities Firms Households Government Credit crunch, balance sheet problems in banks: Low liquidity coverage Rising NPLs Capital losses Banks Households Firms Rest of the world 9

10 Macrofinancial linkages and externalities Firms Households Interconnectedness: Government Realized systemic risk Defaults Economic recession Banks Households Firms Rest of the world 10

11 Thus, macroprudential policy should address Objectives and tasks of macroprudential policy are: (i) to increase resilience of financial system to shocks (ii) to contain build-up of systemic vulnerabilities over time (time dimension) (iii) to control build-up of risks linked to interlinkages (structural/cross-sectoral dimension, strategically important financial institutions) Macroprudential policy uses primarily prudential tools to limit systemic risk 11

12 Capital inflows and buildup of systemic risk Procyclicality in domestic financial sector can interact with capital flows When local funds are exhausted, banks turn to international sources Presence of foreign banks further increases financial cycle (70% of market in EMs) Capital flows (through banks) lead to financial sector vulnerabilities: Balance sheet vulnerabilities currency mismatch, maturity mismatch Credit risk due to lending in FX to unhedged borrowers Bank leverage and loan-to-deposit ratios rise Deterioration of lending standards 12

13 Policy options to manage capital inflows Real exchange rate appreciation; Overheating of the economy and inflation Macroeconomic Concerns Macro policies: Exchange rate; Reserves; Monetary-Fiscal policy mix Capital Inflow Surge Impose/Intensify Capital Controls Financial Stability Risks Prudential policies: Strengthen/Introduce prudential measures Source: Ostry et al., 2010, Capital Inflows: The Role of Controls, IMF Staff Position Note, 10/04. Credit boom; Price bubbles; Unhedged FX currency exposure of banks and borrowers; FX lending to unhedged borrowers, etc. 13

14 Macro- vs microprudential policy: time dimension Upswing: both policies encourage build-up of buffers Boom and peak: microprud policy does not intervene, macroprud encourages buildup of buffers Phases of the credit cycle Recovery: both policies agree on build-up of buffers again but opinions may differ in timing and intensity Downturn: tensions arise microprud policy to ensure stability of individual firms; macroprud to stabilise the whole system 14

15 Macroprudential and monetary policy New paradigm: both are used in countercyclical management (one for price stability, another for financial stability) Potential side effects : policy rate can enhance risk taking incentives of economic agents (cost of borrowing, loose credit conditions, exchange rates and FX borrowing) Overcoming side effects : e.g. accommodative monetary policy can be counterbalanced by tighter macroprudential measures aisakova@jvi.org 15

16 Macroprudential measures and capital flows In the times of capital inflow surges, macroprudential tools are usually not sufficient to slow down the inflows macroeconomic adjustment might be needed or other capital flow management measures The aim of macroprudential tools is to create buffers in the financial system against shocks caused by possible capital flow reversals 16

17 Capital flow management (CFM) and macroprudential measures (MPM) CFMs and MPMs are similar but their primary objectives do not necessarily overlap CFM and MPM tools may overlap: capital flows are the source of systemic financial sector risk and tools used to address those risks can be seen as both CFMs and MPMs An important distinction is between MPMs and CFMs: CFM aims at limiting capital flows Macroprudential measures seek to limit systemic risks (that may be related to capital inflows) 17

18 Outline Macroprudential Policy: Introduction Tools of Macroprudential Policy Use of Macroprudential Policy: Cross-Country Evidence 18

19 Operationalizing macroprudential policy is challenging 5 steps to Operationalize Macroprudential Policy Source: IMF policy paper (2013) aisakova@jvi.org 19

20 Assessing systemic risk requires effective monitoring Monitoring systemic risk needs to consider: Growth in total credit and macroeconomic drivers of imbalances Financial linkages b/w financial and real sector and the rest of the world Structure of financial system and linkages within and across key classes of intermediaries and market infrastructures 20

21 Strong increase in credit can be a signal of a systemic risk Empirical evidence on best indicators of a crisis over 1-3 years: growth in credit to private sector credit gap Not all credit booms end in bust if justified by fundamentals can contribute to healthy financial deepening Important to consider macro environment that gives rise to credit aisakova@jvi.org 21

22 Illustration: Financial cycle and macroeconomic development Financial cycle (credit and property prices) The Financial and Business Cycles in the U.S. Business cycle (GDP) 22

23 Macroprudential indicators: Example of New Zealand Formalized macroprudential framework with a MoU between RBNZ* and MoF in 2013 RBNZ uses various indicators to monitor systemic risk: house price inflation, debt service ratio, farm price inflation (lending to agriculture 15% of total lending) *Reserve Bank of New Zealand Source: Reserve Bank of New Zealand, Macroprudential statistics, December al-stability/macro-prudentialindicators aisakova@jvi.org 23

24 Macroprudential toolkit: types by objectives In the time dimension In the cross-section dimension Countercyclical capital buffers and provisions Sectoral tools Liquidity tools Tools aimed at SIFI Increase resilience to shocks Contain risks in particular sectors Contain funding risks Capital surcharges 24

25 Countercyclical capital buffer (CCB) Proposed by the Basel committee within Basel III accord that was developed in response the recent financial crisis: time-varying capital buffer on top of minimum capital requirements (max 2.5%) Aims to make banks more resilient against imbalances in credit market May help to reduce procyclicality of bank lending: build-up of additional capital in a boom may diminish banks willingness to lend excessively Should be released promptly in times of crises and should be complimented with other macroprudential tools aisakova@jvi.org 25

26 CCB: an illustration A bank should comply with certain regulatory requirements and hold capital: CAR = CCCCCCCCCCCCCC RRRRRRRR WWWWWWWWWWWWWWW AAAAAAAAAAAA Then CCB is an additional requirement between 0 and 2.5 % aisakova@jvi.org 26

27 Hypothetical path of the CCB for Spain Only domestic exposure Figure: Simulated Countercyclical Capital Buffer (In % of risk weighted assets) International exposure aisakova@jvi.org 27

28 Reciprocity principle in determining CCB Each jurisdiction determines the CCB for credit exposures to counterparties in its country Internationally active banks CCB is calculated on a consolidated basis according to geographic location of its exposures Home supervisor is not allowed to impose a buffer requirement for credit exposure to a foreign country that is below the requirement of the host supervisor aisakova@jvi.org 28

29 Reciprocity principle: an illustration A Country A: CCB = 2% Bank 1 A = 100% domestic Bank 2 A = 60% domestic Country B: CCB = 1% Bank 1 B = 20% domestic Bank 2 B = 50% domestic B aisakova@jvi.org 29

30 Poll No 2. Exercise: calculate CCB for Bank 1A and Bank 2A Option 1 2% for both Option 2 2% and 1.6% Option 3 2% and 3% aisakova@jvi.org 30

31 Reciprocity principle: an illustration A CCB calculation: Country A: CCB = 2% Bank 1 A = 100% domestic Bank 2 A = 60% domestic Bank 1 A = 2% * 100 % = 2% Bank 2 A = 2% * 60% + 1% * 40% = 1.6% Bank 1 B = 1% * 20% + 2% * 80% = 1.8% Bank 2 Country B = 1% * B: 50% + 2% * 50% = 1.5% CCB = 1% Bank 1 B = 20% domestic Bank 2 B = 50% domestic B aisakova@jvi.org 31

32 Limiting sectoral imbalances and risks If risks are building up in a particular sector (e.g. consumer loans, corporate exposures, etc.), then sectoral instruments are appropriate tools Sectoral tools can affect credit demand (limits on mortgage loans) or credit supply (sectoral capital requirements) Various tools can be used: Loan-to-Value limits (LTV), Debt-to- Income limits (DTI), sectoral capital requirements (e.g. housing loans, FX lending to unhedged borrowers) aisakova@jvi.org 32

33 Limits on LTV and DTI: demand-side considerations Lowering limits on LTV ratio can tighten constraints of targeted borrowers and thus limit housing demand in targeted segments of the real estate market Limits on LTV and DTI ratios can enhance financial institutions resilience to house price shocks These measures have been found successful in containing mortgage loan growth, speculative real estate transactions and house price acceleration 33

34 Loan-to-Value Ratio: Case of Hong-Kong Banking system assets 750% of GDP Residential mortgage lending a source of largest risk for Hong-Kong banks: 20% of total lending in 1991, 37% in 2002 Property prices in Hong-Kong exhibited strong cyclical patterns Source: IMF Working paper 15/123 aisakova@jvi.org 34

35 Loan-to-Value Ratio: Case of Hong-Kong (cont.) Hong-Kong Monetary Authority (HKMA) does not conduct independent monetary policy In 1991 introduced LTV of 70% to strengthen banks resilience to asset price volatilities Since 1997 LTV of 60% for luxury properties (HK$ 12 million) After Asian crisis, 70% LTV is kept, however introduced mortgage insurance program (MIP) to promote wider home ownership allowed 90% LTV for certain buyers After 2009, sharp increase in property prices, strong capital inflows, LTV was gradually decreased to 50-60% depending on value of property In November 2010 introduced Special Stamp Duty (SSD) of up to 15% on residential properties resold within 24 months of purchase 35

36 Liquidity tools to deal with funding shocks Excessive credit expansion is often funded by short-term wholesale funding as stable deposits tend to grow slower Banks in small open economies depend on short-term (often FX) wholesale funding building a maturity and currency mismatches Basel III includes measures such as Liquidity Coverage ratio (LCR) and Net Stable Funding Ratio (NSFR) aisakova@jvi.org 36

37 Liquidity measures: Case of Korea From 2005 banks rapidly increased short term non-core FX borrowing creating FX mismatches: the crisis stopped the surge as wholesale funding market froze Macroprudential Stability Levy (MSL) was adopted in August 2011 as a proportion to each bank s marginal contribution to systemic risk, i.e. daily average balance of non-deposit FX liabilities of maturity up to a year Korea also introduced caps on the loan-to-deposit ratio (2012) and ceilings on banks FX derivative positions aisakova@jvi.org 37

38 Liquidity measures: Case of Korea (cont.) MSL was effective; banks reliance on short-term FX funding decreased Figure: Measures in Korea had a desirable effect on short-term FX funding (In % and US$ bn) Banks short term FX liability dropped by 9.3 per cent (US$ 14.4 billion) in 2012 q3 aisakova@jvi.org 38

39 Foreign Currency Lending FX loans (In per cent of total) Source: National statistics 39

40 FX lending to households The risk to financial stability is high in countries with a large share of FX loans to unhedged borrowers: households and small firms FX loans to households (In per cent of total FX) Source: National statistics aisakova@jvi.org 40

41 FX lending: case of countries in Central and Easter Europe LTV and DTI for FX loans: Hungary (2010), Poland (2010, 2012), Romania (2008) Higher risk weights or capital requirements (Latvia (2009), Hungary (2008), Poland (2008 and 2012), Romania(2010)) Higher provisioning for unhedged borrowers (Romania(2008)) Limits to open FX positions or capital requirements for open foreign currency positions (Lithuania(2007), Romania(2001)) 41

42 Cross-section tools: capital surcharge Systemically important financial institutions: failure might trigger a financial crisis After crisis: Basel III new regulations target SIFIs: Introduced capital surcharges for SIBs Factors to classify SIFIs: size, complexity, interconnectedness, lack of substitutes, global activity aisakova@jvi.org 42

43 Capital surcharge: case of Denmark In Denmark, SIFIs are identified at group level once a year An institution is identified as a SIFI if at least one of the following quantitative criteria is met for two consecutive years: Balance sheet as a percentage of GDP > 6.5 per cent. Lending as a percentage of total sector lending > 5 per cent. Deposits as a percentage of total sector deposits > 5 per cent. SIFIs are subject to a SIFI capital buffer requirement of 1-3 per cent of their risk-weighted assets depending on their systemic importance aisakova@jvi.org 43

44 Poll No 3: Which measures can help reduce/slow down increasing capital inflows? 1 Limiting loanto-value ratio 2 Countercyclical capital buffer 3 Higher liquidity requirements aisakova@jvi.org 44

45 Calibrating macroprudential tools and monitoring Relative strength of different tools and their benefits are subject to uncertainty Discretionary variation of macroprudential tools can be politically undesirable while static calibration may be inefficiently tight a need for guided calibration A need to monitor migration of activity outside of reach of macroprudential tools Statistical and supervisory data needs more granularity, frequency, homogeneity and comparability aisakova@jvi.org 45

46 Outline Macroprudential Policy: Introduction Tools of Macroprudential Policy Use of Macroprudential Policy: Cross-Country Evidence 46

47 Developing macroprudential framework In many countries, the macroprudential framework is currently being built European Systemic Risk Board (EU body to discuss and coordinate macroprudential policy at an EU level) recommendation on macroprudential mandate operational framework still being debated (rules versus discretion, conditioning variables, legal underpinning, EU constraints single rulebook) With some exceptions, most of the experience with the tools based on their ad-hoc activation Emerging Europe coping with pre-crisis excessive credit growth (Croatia, Poland, Bulgaria etc.) 47

48 There is a need to assign macroprudential mandate: 3 models Model 1: Central Bank: decisions made by the Board Model 2: Dedicated committee within a central bank structure Model 3: Committee outside a central bank with participation of central bank Czech Republic Board UK Australia, France, USA aisakova@jvi.org 48

49 Home-host issues in macroprudential regulation The cross-border operations of financial institutions complicate assessment of systemic risk Affiliates in multiple jurisdictions may lead to conflicts between home and host authorities A need for coordination: multilateral (Basel), regional and bilateral Reciprocity principle for the countercyclical buffer is an important step forward aisakova@jvi.org 49

50 Overall use of macroprudential instruments Note: LTV loan to value, DTI debt-to-income, CG limits on credit growth, FL limit on foreign lending, RR reserve requirements, DP dynamic provisioning, CTC countercyclical capital requirements Source: Claessens (2014) 50

51 Empirical evidence on experiences Reducing procyclicaty: LTV and DTI, ceiling on credit growth, reserve requirements, dynamic provisioning Curbing credit booms and real estate booms: LTV, credit and interest controls, limits on open foreign exchange positions Limiting systemic liquidity risks: the case of Korea 51

52 Concluding remarks Crisis has revealed a large gap in policy making to foresee and prevent systemic risks Macroprudential policy is emerging as a new consensus to deal with the system-wide vulnerabilities Macroprudential tools may directly or indirectly affect capital inflows and can compliment capital management measures and macroeconomic adjustment Successful implementation of macroprudential measures requires multilateral coordination aisakova@jvi.org 52

53 References and suggested reading Claessens, S., 2014, An Overview of Macroprudential Policy Tools, IMF Working Paper No. 14/214 (Washington: International Monetary Fund). IMF Policy Paper Key Aspects of Macroprudential Policy : IMF Policy Paper Key Aspects of Macroprudential Policy- Background Paper : Ostry J. et al., 2011, Managing Capital Inflows: What Tools to Use? IMF Staff Discussion Note No. 11/06 (Washington: International Monetary Fund). aisakova@jvi.org 53