Macro-prudential policy needed to dampen financial sector's pro-cyclicality features and help global economic recovery

As a part-time financial columnist for China Daily since August 2010, I am encouraged to provide monthly personal views to the newspaper even though I have moved to a new position.

At the just-concluded annual session of the National People's Congress, the Chinese government pledged a new policy for macro-prudential regulation. As a response to the global financial crisis, macro-prudential regulation policies have been established or planned in more and more countries over the past few years.

Although the concept of macro-prudential, as opposed to micro-prudential, regulation was first suggested in the 1970s by the Cooke Committee, the precursor to the Basel Committee on Banking Supervision, it had not received sufficient attention until the recent crisis.

Traditionally, financial regulation focuses on individual institutions to ensure that they can manage their risks, yet experience has repeatedly shown that this is not enough to prevent a financial crisis. Something that appears to be rational for an individual bank may actually bring about disaster if it becomes widespread collective behavior, possibly even threatening the system as a whole. The perceived safety of individual companies could result in a failure to detect and eliminate emerging threats to overall financial stability.

For example, the securitization of the US subprime loans seemed safer to individual banks while the assets were backed by rising housing prices. But the risks accumulated and spread across the entire financial system, eventually becoming the trigger of the financial crisis.

The favorable environment in which inflation is curbed or economic growth fine-tuned through monetary policies might not be enough to maintain financial stability. Therefore, there is a blank space left to monetary policy and other macroeconomic policies. This is one of the lessons drawn from the crisis and, hence, there is a need to create a macro-prudential regulatory framework as a new policy field to fill the gap.

The main goal of macro-prudential regulation policies is to reduce and avoid system-wide financial risks, focusing on the interactions between financial institutions, financial markets, financial infrastructure and the real economy. That is to say, their aim is to strengthen the resilience of the financial system to economic downturns and other adverse shocks, and actively limit the build-up of systemic financial risks.

Of course, many public policies may influence financial stability, but not all such policies could be regarded as macro-prudential. The key issue is in the dimension of time, to try to mitigate a financial system's pro-cyclicality, meaning the tendency of financial variables to fluctuate around a trend during the economic cycle.

In economic upswings, usually marked by ample credit availability, rapid increases in asset prices and higher leverage financial institutions tend to overexpose themselves to financial markets to make profits. If they do not build sufficient buffers in good times, in times of economic downturns institutions may adjust risk appetites, cut positions in markets and reduce credit to the real economy, which could, in turn, affect asset prices and induce widespread financial distress amplified by substantial deleveraging.

To dampen pro-cyclicality, macro-prudential regulations have developed a number of counter-cyclical measures, both price- and quantity-based. For instance, one policy might set an additional capital buffer for banks; the buffer can be raised when times are good and lowered when they are bad. Another example is that, if housing prices seem to be rising too fast, the supply of mortgages should be limited by lowering the loan-to-value ratio.

Counter-cyclical changes in risk weights on banks' exposures to certain sectors, such as real estate, can be used to protect the financial system against the build-up of credit risk during periods of excessive credit growth or asset price booms. In addition, liquidity requirements can better address the risks related to over-reliance on wholesale short-term funding.

A good understanding of systemic risk and its forms is at the core of macro-prudential regulation policymaking. It is difficult to judge in advance whether a rise in asset prices is a bubble, and to work out when to move a capital buffer up or down. Furthermore, it is an extremely difficult job to draw a complete picture of potential "lines of dominos", where the default of one institution could bring down others, and eventually trigger a system-wide crisis.

Therefore, macro-prudential regulation must rely on the continuous and rigorous monitoring of financial institutions, markets and the economy at large so as to detect potential vulnerabilities. It requires developing early warning indicators and a broad range of financial stability indicators in risk analysis and identification process based on solid statistical information and market intelligence efforts.

A strong governance framework arranged with clear and specific mandates assigned to various authorities is crucial in implementing effective macro-prudential regulation. This can ensure accountability and transparency. As most of the policy tools in the context of macro-prudential regulation, such as changes in capital ratio, loan loss provisions ratio or loan-to-value ratio, should be applied to individual institutions, there is a need for coordination in the use of those tools by sharing information, which should be supported by the framework clearly allocating responsibilities. Macro-prudential regulation policies are not intended to be a substitute for micro-prudential ones.

Obviously, macro-prudential policies and monetary policies have shared a common nature of "leaning against the wind", but they are isolated and could indeed complement one another. Macro-prudential measures cannot take the place of monetary policy in affecting aggregate demand and inflationary expectations.

Given its function as a lender of last resort, the central bank can provide emergency liquidity assistance to a bank that falls into difficulties, preventing the negative impact on both the banking sector and the real economy. Hence, central banks play a key role in managing systemic financial crises.

Macro-prudential regulations could be called both a science and an art. For it to function, a wide range of reliable data must be carefully analyzed; yet on the other hand, it requires experience and a degree of personal judgment to decide when action should be taken.

China's financial industry has revealed some pro-cyclicality features in common with other countries, so it is time for the country to implement macro-prudential regulations.

Being both a new policy area and an item on the world agenda, macro-prudential regulations are still at an early stage. It is imperative to continue existing international cooperation to enhance the ability, effectiveness and efficiency in this key area, thus better serving the global recovery.

(China Daily 03/23/2013 page6)