Macro-prudential policies could ‘become part of the problem’, says BIS’ Borio

Weight of expectation on macro-prudential policies to address financial system stresses may be too great, says BIS economics head Claudio Borio; stress tests ‘woefully deficient’ in predicting crises

Central bankers and other policy-makers are in danger of placing too much expectation on the ability of macro-prudential frameworks to address future stresses in the financial system, Claudio Borio, head of the Monetary and Economic Department at the Bank for International Settlements, warns in an article published in Central Banking journal today.

Macro-prudential frameworks have come to the fore since the advent of the global financial crisis and are viewed as an important addition to prudential regulatory and supervisory arrangements that previously were too heavily focused on individual institutions. Instead of targeting institutions on a standalone basis, via a ‘micro-prudential' approach, ‘macro-prudential' frameworks look at the impact of regulating an institution in the context of the broader sector as well as the cycle – to ‘see the wood from the trees'.

But Borio, a long-time proponent of macro-prudential frameworks since well before the global financial crisis, is concerned that too much reliance may fall to these tools and techniques, many of which have yet to prove themselves as fit for purpose. "There is no doubt macro-prudential frameworks must be part of the solution to the perennial quest for the so far elusive goal of lasting financial stability," he says. "Adopting a more systemic orientation in prudential arrangements is essential. But intellectual pendulums have a habit of swinging too far."

Borio says there is a risk of "entertaining unrealistic expectations" about what macro-prudential schemes can do on their own. "If these expectations become entrenched in policy, there is even an outside risk that, far from being part of the solution, macro-prudential frameworks could, paradoxically, become part of the problem," he says in the article, '(Too) great expectations?', which analyses the objectives, strategy, tools and governance of various aspects of macro-prudential frameworks, both nationally and internationally.

There is no universally agreed definition for the range of tools included in the macro-prudential toolkit. But new banking regulations will calibrate standards with respect to cross-sectional issues, such as the systemic footprint of individual institutions (for example, via capital surcharges for systemically important banks, as well the time dimensional development of system-wide risks (for example, via counter-cyclical capital buffers).

If these expectations become entrenched in policy, there is even an outside risk that, far from being part of the solution, macro-prudential frameworks could, paradoxically, become part of the problem

Other macro-prudential tools include the creation of ‘living wills' to enable large counterparties to fail, central counterparty clearing for derivatives trades to address ‘too interconnected to fail' and leverage ratios, such as loan-to value ratios and debt-to-income ratios, to constrain the activities of market participants.

Central clearing progress "disappointing"
Borio said addressing the cross-sectional dimension raises "thorny issues". "For instance, the pace at which central clearing has gained ground has proved disappointing. At the same time, there are legitimate concerns about the danger of concentrating too much risk in central clearing counterparties. As a result, a lot of work has been done to develop adequate recovery and resolution procedures for these key players," he said.

But Borio believes addressing the time-dimensional aspect of macro-prudential policy is more complex, and while it may be realistic to be able to increase the resilience of the financial system, constraining booms will be much harder: "My reading of the growing empirical evidence is that the effectiveness of macro-prudential measures in achieving this more demanding objective is limited, especially for the typical range of variation in the instruments," says Borio. "Indeed, the recent activation of the Basel III countercyclical capital buffer in Switzerland seems to have had little impact on pricing and credit extension. It is no coincidence that the explicit objective of this buffer, as clarified in the Basel III framework, is to increase resilience, not to restrain the boom: restraining the boom is regarded simply as a desirable side benefit if it materialises."

Stress tests 'woefully deficient'
Borio said the use of macro stress tests are "very useful" for crisis management and resolution, and "bridging the hugely different perspectives of macroeconomists, prudential supervisors, risk managers and bank managements". But he said that as early-warning devices to identify vulnerabilities in tranquil times, "they have so far proved woefully deficient".

"Their effectiveness is undermined by limitations of the modelling technology, not least the ability to capture sudden changes in behaviour and, by the context, the ‘this-time-is-different' syndrome. No macro stress test, in fact, identified the serious vulnerabilities that ushered in the financial crisis. While improvements have been made, there is a risk of putting too much faith in the tool's remedial properties," Borio said.

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