Causes of procyclicality in the banking sector

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1 Managing Procyclicality of the Financial System: Experiences in Asia and Policy Options Dr. Tarisa Watanagase Deputy Governor, Bank of Thailand November 22, 2004 Hong Kong, China Good afternoon. The topic of this seminar managing pro-cyclicality of the financial system - is an important and challenging issue for central bankers and academics alike. Recurring episodes of financial sector crises in the 80 s and 90 s and its widely acknowledged role in exacerbating both cyclical upturns and downturns, requires us to contemplate practical countermeasures to mitigate pro-cyclical tendencies in the financial sector. In most emerging markets including Thailand - managing pro-cyclicality of the financial system is synonymous with managing pro-cyclicality of the banking sector. Our banking system is by far the most significant element of our financial sector; and it is the means to channel funds to the real sector. Thus, for most emerging market central banks, our ability to properly control banking sector pro-cyclicality has profound implications for the well being of our real economy. My remarks today will focus on three main issues. First, I will briefly outline the causes of pro-cyclicality in the banking sector. Second, I will propose some preemptive measures that we can adopt to counter pro-cyclical tendencies. I will close by offering a few thoughts on the appropriate role of central banking authorities-- particularly in emerging markets -- in countering financial pro-cyclicality. Causes of procyclicality in the banking sector Financial pro-cyclicality arises whenever normal fluctuations in the business cycle are exacerbated, by market participants tendency to behave in a uniform manner as business cycles change. There is also a propensity for regulatory policies, supervisory practices, and governmental safety net arrangements to reinforce and/or magnify this herd-like tendency of bank intermediaries. Let me spend a few minutes exploring these issues in greater detail. A post-mortem evaluation of economic booms and busts in various parts of the world reveals that market participants understanding of, and appetite for, risk shifts with changes with the economic cycle. During an economic expansion, bankers are prone to excessive optimism and may be inclined to justify the feasibility of increasingly higher-risk or even otherwise nonbankable loan proposals, due in part to inflated collateral values, seemingly unlimited potential of their borrowers, and the intense competition among financial intermediaries. Against this background, even the most prudent lender may be tempted to relax its loan underwriting criteria and reduce its lending rates charged to high-risk borrowers or risk losing market share to its 1

2 competitors. On the regulatory side, bank supervisors may also get caught up in this euphoria and thus are unable to identify and/or raise concerns, particularly since the banks financial condition appear seemingly strong, with robust earnings and low levels of problem loans. Governmental safety net arrangements such as deposit insurance (and/or blanket guarantee regimes) although designed to foster financial stability further encourages the leveraging of the balance sheet by enabling banks to take on more risk with less capital, thereby contributing to rapid loan growth and the ensuing swings in loan quality. When the economic downturn occurs, bankers optimism turns to pessimism; loan quality problems accumulate; and inadequate reserve levels become apparent. At this stage, bankers may significantly tighten lending standards and may become reluctant to lend even to creditworthy borrowers. Bank supervisors have a tendency to share in this pessimism and may demand significantly higher reserves due to known asset quality deterioration. They may also require additional capital based on a pessimistic view of the bank s overall risk profile and future prospects. Collectively, these factors lead to a contraction in bank lending to the real sector and an increase in the risk premia charged to otherwise credit-worthy borrowers, which in turn, further exacerbates the economic downturn. While the nuances of each financial sector crisis differ, one widespread problem is that both market participants and bank supervisors tend to underestimate risk during economic upturns where there are seemingly no problems- ; and then become overly pessimistic during economic downturns - where everything becomes a problem. An interrelated issue is the pro-cyclical bias of certain prudential requirements, such as asset classification and provisioning and capital adequacy rules, which serve to further accentuate economic booms and busts. Policy Options Let me now turn to the difficult task of proposing practical suggestions on how we can modify our existing regulatory policies and supervisory practices so that it counters pro-cyclical tendencies in the banking sector. In most emerging markets, a whole host of issues such as the dominance of the banking sector, the lack of any other viable intermediary, the limitations of monetary policy instruments to fully counter pro-cyclical imbalances, and the evolving nature of the risk management practices of our regulated banks - require policymakers to use a more activist prudential agenda to combat pro-cyclicality concerns. Simply put, the banking system is too important for emerging market economies to take a more subtle wait and see approach to this endeavor. It is noteworthy that any regulatory and supervisory policy modifications that are driven by pro-cyclicality considerations, should also seek to preserve the fundamental integrity of the safety and soundness component of the prudential framework. 2

3 Against this background, I have separated the proposed pro-cyclical countermeasures into two broad categories: (1) Enhance risk-based supervision; and (2) Proactive use of prudential tools. The proper implementation of a risk-based supervisory framework combined with the flexible use of blunt prudential requirements, provides a promising approach to countering pro-cyclicality in emerging market economies. (1) Enhance risk-based supervision: Let me first spend a few minutes outlining the importance of risk-based supervision and its critical role in countering banking sector pro-cyclicality during good times; and minimizing pro-cyclical tendencies during bad times. The concept of risk-based supervision and its counter cyclical virtue- is easier to digest within the context of economic booms. One of the primary objectives of risk-based supervision is to identify gaps in risk management policies and practices before such weaknesses adversely affect earnings and capital. Therefore, if risk-based supervision is properly implemented, it has the potential to address the preventive leg of the financial pro-cyclicality debate e.g. the inability of banks and bank supervisors to properly identify risks during boom times. In addition to enhanced supervisory oversight, the risk-based framework also encourages banks to enhance their own risk management capabilities. The risk-based philosophy entails a shift away from a rigid, rules based approach to regulation and supervision, and towards what economists refer to as incentive compatible prudential standards. By incentive compatible, I am referring to broad, principles based standards that encourage banks to develop and continuously update their internal risk management systems to ensure that it is commensurate with the scope and complexity of its operations. Interestingly, the proper implementation of risk-based supervision can also play an important role in minimizing pro-cyclical behavior during economic downturns. How is this possible? It is because the fundamentals of risk-based supervision are deeply rooted in the notion of following an evenhanded course that is premised on sound judgment and critical analysis. In other words, the risk-based philosophy requires bank supervisors to be skeptical of conventional wisdom in good and bad times- and never be excessively optimistic or pessimistic. At the end of the day, risk-based supervision can be a powerful tool to counter procyclical tendencies due to its focus on steering a balanced course, with a particular emphasis on a forward-looking, longer-term analytical framework, rather than solely a point-in-time evaluation. Of course, the requisite knowledge, skills, and abilities needed to properly implement risk-based supervision can only be achieved with time. At the Bank of Thailand, we have steadily embraced the risk-based philosophy during the past several years. We have revamped our supervisory framework to provide a more structured and riskoriented approach to the on and off-site examination process, while encouraging our front-line supervisors to think analytically and in a balanced manner - rather than simply rely on rules based compliance criteria. Nevertheless, we are fully aware that it remains a work in progress. 3

4 (2) Proactive use of prudential tools: As we move into our discussion of using flexible prudential requirements to counter pro-cyclical tendencies, it is critical to keep in mind that its effectiveness hinges upon the quality of risk-based supervision. This is primarily because it is easy for banks to get around any rules-based prudential requirements, regardless of whether it s used for safety and soundness purposes or designed to counter pro-cyclicality concerns. Thus, the quality of day-to-day supervision is inextricably linked to the reliability of prudential requirements used to counter pro-cyclicality concerns. Numerous prudential requirements may be used to counter pro-cyclical behavior in the banking sector. Obviously, the proactive use of prudential measures works best when there is close interaction and two-way exchange of information between supervisory and monetary authorities. Let me briefly highlight a few of these prudential requirements as examples: Vary capital buffer with changes in economic cycle: The main concept here is that banks should be required to hold capital in excess of regulatory minimum during good times, so that it can be drawn down, if needed, during bad times. Although conceptually appealing, the determination of how much buffer capital is enough, is a matter of judgment and can lead to disagreements between bank management and bank supervisors. In emerging markets, the most practical solution, perhaps, is to explicitly require two sets of ratios: (a) a minimum capital ratio; and (b) a minimum targeted capital ratio that is set at a pre-defined level above the regulatory minimum. During good times, all banks may be expected to adhere to the targeted capital ratio; and in economic downturns, bank supervisors may exercise some discretion on how much buffer capital is needed. Increase the regulatory credit risk-weights assigned to certain high-risk assets/sectors: If bank supervisors see a rapid accumulation of credit concentrations in certain high risk sectors during boom times, consideration may be given to increase the Basel I risk-weights from 100% to a higher risk-weight function (say 150% or 200%). While the risk-based capital ratios would remain unchanged, the methodology used to calculate risk-based capital would be altered, resulting in an increase in the actual level of capital held by banking organizations. Adopt forward-looking provisioning requirements: Provisioning requirements should strike the proper balance between establishing minimum regulatory safeguards versus principles based concepts that require banks to assess, and supervisors to review, the adequacy of provisions based on debtors ability to repay over an appropriate time horizon. In addition, forward-looking provisioning requirements should also consider qualitative issues, such the extent of loan concentrations, the quality of loan underwriting standards, and the quality, type, and marketability of collateral. If supervisory and monetary authorities raise concerns about inflated asset values, the minimum haircuts assigned to collateral (if considered during the provisioning process), can be increased. 4

5 Prescribe loan-to-value (LTV) ratios for the property sector: Another rules-based, but less interventionist tool, is to provide supervisory prescribed LTV guidelines for the property sector, particularly in situations where supervisors are concerned about rapid increases in property values. At the Bank of Thailand, we introduced maximum LTV ratios for the high-end residential real estate market beginning in December, Conclusion Countering pro-cyclicality in the banking sector is indeed a formidable and a particularly important challenge. Developing practical solutions to counter procyclical imbalances necessarily requires close policy coordination and two-way flow of information between the monetary and supervisory functions. There is scope to use proactive prudential tools for macroeconomic stabilisation in conjunction with traditional monetary policy instruments. As recent experiences in many countries suggest, traditional monetary tools are not effective in tackling sectoral imbalances such as an overheated property market - that could eventually lead to broader macroeconomic instability. In this case, the void could be filled by our menu of prudential tools targeted at that particular sector. The fundamental issue is that we must have a deep understanding of broader macroeconomic data and trends, together with nuanced insights on the health of the banking sector in general, and individual banks in particular. Central banks, when authorized the twin roles of ensuring monetary and financial stability, are uniquely positioned to tackle these profound challenges. On the other hand, where supervision lies elsewhere outside of the central banks, effective information sharing between the supervisory and monetary authorities has been the major concern. With increased pro-cyclicality in the financial system, supervisory and monetary policy coordination will be an even bigger concern. We should also keep in mind that in emerging market economies the linkages between bank supervision and macroeconomic policy go far beyond the issue of countering pro-cyclicality. The sheer size of our banking systems and the underdevelopment of other financial markets, implies that without a safe and sound banking system, our real economies and macroeconomic stability - will be severely damaged. Second, our ability to properly implement monetary policy operations particularly since the banking sector is the mechanism through which monetary policy operates - necessarily requires practical, hands-on knowledge of individual banks and the banking system. This in-depth knowledge is only possible through our regulatory and supervisory responsibilities. In this regard, the institutional set-up for supervisory authority in an emerging market economy is an issue far more important than that in a developed one. Finally, while our supervisory responsibilities enhance our macroeconomic capacity, I firmly believe that our oversight of macroeconomic affairs strengthens and provides context to our supervisory responsibilities. For example, in designing a regulatory policy, we need to balance safety and soundness elements with the potential detrimental effects of excessively conservative regulations to the overall economy. 5

6 In this regard, I am fully aware of the argument made by some academics that there are potential conflicts of interest between the monetary and supervisory roles of a central bank. However, these concerns can be alleviated through well-defined rules and processes. In the final analysis, there are simply too many compelling reasons for emerging market central banks to maintain their oversight role of the banking system. The stakes are simply too high to think otherwise. 6