Towards a macroprudential policy framework : using the lessons from the global financial crisis to create a stable financial system

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Towards a Macroprudential Policy Framework

Using the lessons from the global financial crisis to create a stable financial system

“When written in Chinese, the word ‘crisis’ is composed of two characters —

one represents danger and the other represents opportunity.”

John F. Kennedy

Bob van Moerkerk (5870860)

bobvanmoerkerk@hotmail.com

Master's Thesis Economics

International Economics and Globalization

Faculty of Economics and Business (FEB)

Supervisor: drs. N.J. Leefmans

2

nd

reader: dr. K. Mavromatis

14-08-2014

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1. Introduction

What began as an increasing number of defaults on subprime mortgages in the US in August 2007, culminated into a global financial crisis of historic proportions. Financial markets were completely paralyzed and many large financial institutions faced bailouts or defaults. The total damage has been estimated to be a staggering US $3.4 trillion in the global financial sector, another US $2.2 trillion in the real economy and a massive US $8 trillion in stock market wealth (IMF, 2009; Brunnermeier, 2009). Global economic growth rates plummeted and millions of people lost their job. It represented the largest economic contraction in nearly a century and its dramatic impact was felt almost anywhere in the world. The worldwide panic in financial markets and the magnitude of the losses unmasked major fragilities in the financial system. We must turn the crisis into a valuable lesson for future generations and design a policy framework which minimizes the probability of a crisis of similar intensity from occurring.

This research aims to provide insights into this issue. The main research question will therefore be: How should the financial system in the US be transformed in order to make it more stable? A wide range of proposals has been published in academic literature, each suggesting policy solutions to one or more shortcomings of the current financial system. However, there is no overarching framework that encompasses all suggested measures to reform the financial system structurally. Furthermore, there is no consensus about the final shape of the policy framework that is to be designed. This research aims to provide a clear overview of the lessons we (should) have learned from the previous crisis and the related changes that need to take place in terms of regulation, monetary- and fiscal policy. Also, it compares this ‘ideal picture’ with the measures that have actually been taken by the authorities in the US. How far are we on the road to a stable financial system? While the financial crisis was a global one, this research focuses on the US financial system as it was the epicentre of the crisis.

Learning from recent events means that we must first understand how developments in the financial system slowly made it increasingly fragile. First, the US financial system has been in a phase of major structural change for over the past three decades (Borio, 2007). Deregulation and the enormous rise of securitization have transformed the face of financial trade drastically, resulting in a non-transparent web of large, highly leveraged and interdependent financial institutions, relying on short-term financing (fig. 1). The evolvement of both the financial system and its complex products turned idiosyncratic risk into systemic risk, making conventional risk assessment obsolete and, more importantly, highly inadequate (Bean et al, 2010; Rajan, 2006). Finding regulatory tools to measure and manage systemic risk in the financial system is therefore one of the focal points of this research.

Second, the Federal Reserve was conducting a very expansionary monetary policy after the burst of the dot.com-bubble in the early 2000s (Bean et al, 2010). Given the main focus on inflation and

Figure 1: The mutual exposure of the 24 largest UK banks by 2009 Q2. Each node represents a bank, with its size reflecting both the size of the level of exposure from other banks to that institution and vice versa. The thickness of each connecting two nodes represents the level of bilateral exposure. Source: Bean et al (2009)

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3 output when conducting monetary policy, the relatively stable inflation rates and high rates of economic growth did not induce the authorities in the US to tighten monetary policy during the years preceding the crisis in which imbalances in the financial system were growing rapidly (Bean et al, 2010; Bernanke, 2010). Many economists argue that monetary policy was too expansionary and significantly contributed to the crisis as it exacerbated excessive availability of cheap credit, ever-riskier investment behaviour by banks and other investors and the inflation of asset and house prices (Borio and White, 2003; Bean et al, 2009; Brunnermeier, 2009). Price and output stability and financial stability are apparently not two sides of the same coin.

The new structure of the financial system and its products and the loose monetary policy all contributed to a period of unprecedented prosperity (Bean et al, 2010). However, they simultaneously contributed to the buildup of systemic risk, causing this prosperity to rest on increasingly weaker fundamentals. When the crisis eventually erupted, many European nations and other advanced economies had high debt levels and massive unfunded future liabilities which impaired their ability to use fiscal stimuli (Blanchard, 2010).

The crisis has proven that the Basel II Capital Accord did not deliver. Therefore, it has provided fertile ground to rethink the policies which aim to stabilize the financial system. The majority of policymakers and economists argue in favour of the creation of a ‘macroprudential policy framework’. This new policy framework is based on a new way of looking at financial stability. Regulatory and supervisory institutions should shift their orientation from one that is ‘microprudential’, i.e. a point of view which focuses on individual institutions, towards one that is more ‘macroprudential’, i.e. an economy-wide perspective that focuses on the stability of the entire financial system (Borio, 2003; Galati and Moessner, 2013). While these two perspectives currently coexist in regulatory arrangements, the macroprudential orientation should be strengthened in order to achieve financial stability in the long run (Blanchard et al, 2010; IMF, 2011; Schoenmaker and Wierts, 2011).

Two important lessons from the crisis support this shift in orientation, both based on a different way in which systemic risk is created in the financial system. First, the development of the financial system into a highly interdependent web of financial institutions has resulted in a situation in which the failure of a single financial institution can cause a cascading failure among other financial institutions. Problems at one financial institution thus create systemic risk. This refers to the cross-sectional dimension of systemic risk and captures the distribution of systemic risk across the financial system at one point in time. Only the macroprudential view recognizes the fact that the interconnectedness of the financial system is an important contributor to systemic risk (Borio, 2003). Second, the financial crisis unmasked major weaknesses in the financial system that had been developing in the prosperous years preceding the crisis. Vulnerabilities in the financial system tend to build up during favourable economic conditions in which economic agents underestimate risk, loosen their lending standards and take on too much debt. Risk perceptions are countercyclical, i.e. they fall during an economic boom, but given the growth of imbalances and fragilities in the financial system during an economic boom, exactly the opposite holds true. This refers to the time dimension of systemic risk. The time dimension of systemic risk has been overlooked in the past and forms an essential factor in the macroprudential framework (Borio, 2003; Galati and Moessner, 2013).

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4 Macroprudential regulation’s most important task is to ensure the stability of the financial system by discouraging the buildup of systemic risk, both along the cross-sectional and time dimension. In addition, it should contain built-in defence mechanisms that prevents the aggressive unwinding of a downturn and its devastating effects on the rest of the economy. This research sets out a wide range of regulatory macroprudential tools which has been suggested in academic literature. Because the expansionary monetary policy during the years preceding the crisis also contributed to the buildup of systemic risk, there seems to be a strong case for the involvement of monetary policy in the macroprudential policy framework. However, whether monetary policy should be actively used with the objective of discouraging the buildup of systemic risk is still a matter of academic debate. Therefore, this research describes the options for monetary policy to counter systemic risk and the discussion regarding its future course. While fiscal policy did not directly contribute to the fragile state of the financial system before the financial crisis started, its role in ensuring the stability of the financial system consists mostly of having the ability to step in with fiscal stimuli when pre-emptive macroprudential measures did not suffice.

The ability to accurately measure the main sources and general level of systemic risk is an essential feature of the macroprudential framework for two reasons. First, macroprudential policy tools aimed at countering the buildup of systemic risk along the cross-sectional dimension are designed to affect each financial institution individually to a degree which depends on their individual contribution to systemic risk. The most promising indicator for measuring an individual financial institution’s contribution to systemic risk is the SRISK Index which has been developed by Brownlees and Engle (2012). Second, the authorities must be able to assess the probability of a future financial crisis by looking at the growth of financial imbalances over time. When this probability is high, regulatory tools can be put in place which target the increase in systemic risk across the time-dimension. Borio and Drehmann (2009) provide a forward-looking indicator with this objective in mind.

To assess the progress we are making towards a more stable financial system, this research will compare the measures that need to be undertaken with the policy measures that have been implemented and those that have been approved of in the US. All policy fields, namely regulatory, monetary and fiscal, will be included in this analysis. Also, it gives insights into the changes in the institutional setting of the US. To what degree does it resemble the ideal setting as suggested in academic literature? The complete analysis provides a clear picture of whether or not we have succeeded in designing a macroprudential policy framework in the US that is capable of ensuring the stability of the financial system in the future.

The structure of the remaining part of this research is as follows. Section 2 will provide an analysis of the different factors that contributed to the crisis, how they arose and evolved and the valuable lessons they provided for future policy. Section 3 defines the concept of macroprudential policy, its main elements, scope and institutional setting. Section 4 puts theory into practice. How can systemic risk be quantified and what are the available regulatory tools for the authorities to minimize this risk? The concrete policy tools for monetary- and fiscal authorities in the new policy framework will be assessed in section 5. Section 6 briefly summarizes the measures that have actually been implemented (or approved of) by the authorities thus far. These will be compared with the ideal picture sketched in the preceding sections to get an insight into the progress we are making towards a world that is financially less volatile. Finally, conclusions are set out in section 7.

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2. Lessons learned from the global financial crisis

While the global financial markets are recovering, economic growth in Europe is still fragile and the growth rates of BRIC-countries are not nearly as high as in the years preceding the crisis. Millions of people still do not have a job. The question is whether the world will ever experience the pre-crisis growth rates again without serious changes to the financial system that supports it. Future generations should never have to experience similar turmoil. Rather, they should benefit from a stable financial system that spares them from the devastating volatility that characterized the last few decades. We should turn the experience of the crisis into a valuable lesson. As former White House Chief of Staff under President Obama, Emanuel Rahm, stated: “You never let a serious crisis go to waste” (Rahm, 2008). Because regulatory, monetary (optional) and fiscal authorities all should be involved in the new policy framework, the lessons from the crisis in order to ensure the stability of the US financial system will be subdivided among these policy fields in subsections 2.1, 2.2 and 2.3 respectively. These lessons provide the basis for the macroprudential policy framework and the macroprudential policy tools which will be discussed in section 3, 4 (regulatory tools) and 5 (monetary and fiscal tools) respectively.

2.1 Lessons for regulatory authorities

The 9 lessons for regulatory authorities from the recent global financial crisis will be subdivided under two separate headings, namely under the cross-sectional dimension and the time dimension of systemic risk. This distinction has been proposed by Borio (2003) and is, among others, used by the IMF (2011). Subsection 2.1.1 outlines 8 lessons that relate to the cross-sectional dimension of systemic risk. Subsection 2.1.2 sets out several developments in the US financial system during the years preceding the global financial crisis that relate to the time dimension of systemic risk. These can all be linked to one single lesson. Most of the lessons are strongly related because the underlying developments complexly interacted and enforced each other. In order to keep the analysis as clear as possible, they will be presented individually.

2.1.1 Lessons related to the cross-sectional dimension of systemic risk

There are 8 lessons related to the cross-sectional dimension of systemic risk which are described below.

1. The self-stabilizing capabilities of financial markets are limited. Therefore, regulation and supervision in the US financial sector should be tightened – The last four decades have been

characterized by deregulation in the US financial system, backed by the dominant laissez faire paradigm. Markets had an increasing confidence in the Efficient Market Hypothesis, based on rational expectations by economic agents, in which the authorities had to keep their hands off the markets in order to maximize the gains from the self-stabilizing and growth enhancing capabilities of the financial markets. However, deregulation has significantly contributed to the excessive growth of financial institutions. For example, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 meant the official demise of the Glass-Steagall Act of 1933 which ensured the strict separation of investment and commercial bank activities in the US. The Riegle-Neal Interstate Banking and

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6 Branching Efficiency Act of 1994 overturned the McFadden Act’s prohibition on interstate branching which enabled banks to acquire banks in other states. These regulatory changes facilitated a consolidation wave across the financial system and created increasingly large and complex organizations that were engaging themselves in ever-riskier lending and investment practices (Berger et al, 1995; Mishkin, 2013). This is only one example of the adverse effects from deregulation on the stability of the financial system. Volcker, former chairman of the Federal Reserve, claimed: "It is clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations and market efficiencies" (Volcker, 2011).

Also, the integrated nature of the system had turned idiosyncratic risk into systemic risk. In crisis periods, an institution must not only beware of its own counterparty risk, but also of its counterparties’ counterparties’ balance sheets etc., making it practically impossible to comprehend and monitor. Furthermore, the complexity of financial products itself grew rapidly. By putting the loans in special purpose vehicles (SPVs), assets were moved from the balance sheet, thereby further impairing the transparency of the system. This created a contradicting situation in which risk assessment became more important but at the same time increasingly harder. Conventional risk assessment had become obsolete and, more importantly, highly inadequate. Equivalently, regulation could not keep up with developments in the industry (Gorton and Metrick, 2010; Brunnermeier, 2009). Given the limited self-stabilizing capabilities of financial markets, tighter regulation and supervision in the US financial system are needed.

2. The shadow banking system must become part of the regulatory reach of the authorities – The

shadow banking system consisted of nonbank financial institutions like money market mutual funds and hedge funds which provided financial intermediary services like banks but were not regulated like banks. They were not funded by deposits and could not borrow at the Federal Reserve when they were in need of funds, creating the need to sell assets for fire sale prices when they got in trouble. Shadow banks practically faced no regulation regarding the disclosure about the value of their assets and had virtually no loss-absorbency capital (Kodres, 2013). The rise of the shadow banking system, driven by financial product innovation and financial deregulation, facilitated the transformation of the financial system into a web of highly complex, opaque and interconnected web of bank and nonbank institutions that were no longer in competition, but relied on each other. Especially the rise of securitization changed the face of financial trade significantly (Adrian and Shin, 2010). An indicator for the massive rise in derivatives is the size of the collaterized debt securities (CDS) market which by 2007 had an estimated value of over US $60 trillion, approximating annual global GDP (BIS Quarterly Review, 2010). Despite the size of the shadow banking system and its critical role in the credit markets, it was not subject to the same capital requirements and other regulation that would strengthen its foundations (Gorton and Metrick, 2010). The authorities should regulate all institutions that perform financial intermediary services on an equal basis.

3. The authorities should prevent systemically important financial institutions (SIFIs) from becoming too big to fail (TBTF) – Many financial institutions had become so large and/or

interconnected that a bankruptcy of such an institution would have disastrous consequences for the rest of the financial system and the real economy. These costs would outweigh the costs of saving them with excessive sums of taxpayers’ money, forcing the authorities to step in when panic engulfed the financial markets. The bankruptcy filing of SIFI Lehmann Brothers has shown us the

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7 dramatic consequences of ex ante letting financial institutions become TBTF and ex post the lack of a resolution mechanism to dismantle a SIFI with the aim of minimizing its effects on the rest of the economy (IMF, 2011).

4. The ability to absorb losses by

financial institutions should be

improved – Institutions were expanding

their balance sheets on a massive scale with their composition becoming increasingly risky. This is where the importance of capital adequacy comes into play. However, the process of securitization required financial institutions to circumvent these regulations, creating a surge in debt on ever-thinner capital cushions. The ability to absorb an adverse shock was very

limited, let alone a massive shock as large as the recent financial crisis. Furthermore, according to the Basel II regulations, the required capital for an AAA-rated security was not even half that of a regular commercial loan. This enabled banks to double their balance sheets in the three years preceding the crisis while the required level of capital rose only slowly (Acharya and Richardson, 2009). At the end of 2007, the 5 largest financial institutions had an average leverage ratio of 30:1 (Acharya and Richardson, 2009). Figure 2 shows that SIFIs have consistently decreased the base for the calculation of their capital requirements. The ratio of risk weighted assets to the total value of assets has been cut in half during the last two decades (Slovik, 2012). There is a strong case for leverage restrictions and increasing the capital requirements for all financial institutions.

5. Banks must decrease their reliance on short-term debt and their risk exposure to a liquidity dry-up with its harsh consequences for the real economy – All financial institutions suffered from a

severe maturity mismatch which made them vulnerable to disruptions in credit markets. The credit crisis ignited a run on the shadow banking system, forcing the involved entities to deleverage on a massive scale by selling their long-term assets at fire sale prices. The financial system was unable to withstand the self-enforcing downward spirals of credit and asset prices. The credit crunch paralyzed the financial system completely and severely affected the real economy (Gorton and Metrick, 2012). All financial institutions should therefore decrease their reliance on short-term funding and have the capacity to withstand disruptions in the credit market.

6. Transparency in the system must be enhanced and consumers must be better informed about the risk they are posed to - The run on short-term funding was exacerbated by the complexity of the

financial system and its products. Even investors who did not fear insolvency by the institution joined the run as it may have been in their individual interest. This coordination problem increased because the opaqueness of the system prevented agents from assessing the true risk of the intermediary. Even institutions that had no significant exposure to subprime mortgages were subject to investors who pulled back as their confidence in the financial system in general had deteriorated (Bernanke, 2010; Gorton and Metrick, 2010). The effect was exacerbated by the lack of confidence in the

Figure 2: The drop in the ratio of risk-weighted assets to total assets during over the period 1990-2010. Source: Slovik (2012)

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8 reliability of ratings (Brunnermeier, 2009). A higher level of transparency through higher standards for market disclosure will improve the knowledge about the institutions balance sheet and its products.

7. Excessive risk-taking by fund managers and bankers must be curtailed by putting restrictions on executive compensations and their trading activities – The compensations and bonuses for fund

managers and bankers were dependent on short-term profits the firm made, rather than the long-term profitability of their actions. They were incentivized to engage in risky trading with more potential for higher yields as their compensation did not become negative in the event of losses. Nor did they experience the need to discount for the maturity mismatch in case of a sudden liquidity dry-up (Brunnermeier, 2009). In line with this argument, there is a strong case for constraining proprietary trading by banks, i.e. financial trading activities by banks using their own money instead of that of depositors with the aim of increasing the banks’ profits. There is widespread consensus that proprietary trading contributed significantly to the excessive risk-taking behaviour in the financial sector and the culture of earning short-term profits without looking at the long-term consequences (Whitehead, 2011). Restrictions on executive compensations and their trading activities discourages excessive risk-taking.

8. Lending standards in the mortgage market were far too low and need to be strengthened –

Homeownership promoting policies by the government and predatory lending practices by financial entities gradually resulted in the deterioration of lending standards in the mortgage market. Homeowners had to put down only 2% of the total cost of a house on average, a tenth of what had to be paid beforehand ten years earlier. This inherently created moral hazard problems and gave homeowners with payment problems the incentives to just ‘walk away’ when the turmoil in the US housing market unfolded (Lindsey, 2007). Tighter lending standards in the housing market lowers the probability of the massive amount of defaults on mortgages which ignited the financial crisis in the US.

These 8 lessons give an insight into the variety of factors which created the high level of systemic risk in the financial system along the cross-sectional dimension. Understanding these lessons is essential for the development of effective macroprudential regulatory tools which aim to prevent the concentration of systemic risk in individual financial institutions (e.g. decrease their reliance on short-term debt), financial markets (e.g. improved lending standards in the mortgage market) and the financial system itself (e.g. the equal basis on which traditional banks and shadow banks should be regulated).

2.1.2 Lessons related to the time dimension of systemic risk

The measures that should be introduced to counter the buildup of systemic risk over time can all be linked to a single lesson. They all refer to the procyclicality of the actual level of systemic risk and the countercyclical risk perceptions of economic agents.

9. Risk perceptions behave as if risk falls during booms and rises during downturns. However, given the buildup of imbalances in the financial system over time, exactly the opposite holds true. Therefore, macroprudential policy tools should discourage the buildup of financial imbalances over

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time and encourage the use of defence mechanisms that prevents the aggressive unwinding of these imbalances during a downturn.

Several factors contributed to the overly enthusiastic atmosphere in the financial system during the years preceding the crisis. The US was experiencing its longest extended period of economic growth in history, characterized by low inflation, high productivity growth, low unemployment rates and decreased volatility of the business cycle. This supported the trust in the self-stabilizing and economic growth enhancing capabilities of the financial system. Second, securitization enabled banks to transfer the credit risk from their balance sheets to third parties. Third, hedging instruments like credit default swaps (CDSs) secured the bank from potential losses on CDOs and other derivatives. Fourth, SIFIs had an implicit government guarantee from being TBTF (Mishkin, 2013; Bernanke, 2010; Acharya and Richardson, 2009).

However, this enthusiasm was partly unjustified as vulnerabilities and systemic risk in the financial system were increasing. First, the trust in the stabilizing forces of the financial market caused financial institutions to gradually lose their focus on proper risk assessment. The increased delinking of borrowers and investors due to the lengthened intermediation chain worsened agency problems significantly. Lending standards fell and the banks' incentives to put effort in screening and monitoring the loans were heavily impaired. (Acharya and Richardson, 2009; Berger, 1995; Brunnermeier, 2009; Knight, 2007). Institutions started to rely more heavily on credit rating agencies (Bernanke, 2010; Claessens et al, 2010). However, rating agencies suffered from a conflict of interest as they had an incentive to give high ratings (Mishkin, 2013). Second, the transfer of securities into SPVs kept the risk for the originating institution unchanged in reality. If the SPV would have funding problems, it would use the back-up credit line with the ‘sponsoring bank’, effectively returning the troubled loans back on the banks’ balance sheet (Acharya and Richardson, 2009; Brunnermeier, 2009). Third, there was a major flaw in the thought that CDSs would protect investors against losses on CDOs. All major players had written huge quantities of insurance against a systemic decline, provided by e.g. AIG. A situation had been created in which the problem insured against, a systemic turn in sentiment/economic performance, resulted in these insurers being unable to give the insurance in case the problem would materialize (Bernanke, 2010). The insurance was worthless as large correlated losses rendered the pockets of insurance companies not deep enough (Bean et al, 2010). Finally, the collapse of Lehmann Brothers and its devastating effects on the rest of the economy has shown that too much confidence in being TBTF is unjustified.

The distance between the actual level of systemic risk and that perceived by banks and other economic agents was rising quickly. The TED spread, the difference between the interest rate on riskless US Treasury bills and US interbank loans, had been at historically low levels preceding the crisis while systemic risk was very high (Shin, 2011). This is the crucial paradox which is captured by the time dimension of systemic risk. During favourable economic conditions, vulnerabilities tend to build up as economic agents underestimate risk, loosen their lending standards, loose their focus on the proper monitoring of loans and risks and take on too much debt. These factors result in the inflation of financial asset and house prices and excessive credit growth. This is not solely a characteristic of the recent financial crisis but has been a repeating pattern for the last few decades. Drehmann et al (2012) refer to this pattern as the financial cycle. The financial cycle can be measured using data on credit, the credit-to-GDP ratio, residential property prices and financial asset prices.

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10 The credit-to-GDP ratio resembles the increase in leverage and thus the ever-weaker fundamentals of the financial system over time (decreased capacity to withstand financial distress). The variable of asset prices captures the growth of asset price misalignments which often precede a financial crisis. The upward spiral of asset prices which often characterize an economic upturn reflect the increasingly optimistic atmosphere among investors during such a period. The inclusion of property prices into the analysis is justified given its importance in the recent financial crisis and the majority of other crises of the last few decades. Figure 3 shows that the financial cycle is a repeating pattern of up- and downturns. It has increased in amplitude and length and thus has an increasing impact on the real economy since the mid-1980s; the start of the transformation of the US financial system (Drehmann et al, 2012).

Figure 3: The financial and business cycle in the US from 1970 - 2011. The financial cycle is measured using quarterly data on the credit-to-GDP ratio, residential property prices and financial asset prices. This data is aggregated and the log levels are normalized by their respective log level in 1985 Q1. The business cycle is measured using GDP. The shaded areas (dark grey) represent recessions according to the National Bureau for Economic Research (NBER). Source: Drehmann et al

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Countering the buildup of systemic risk across the time dimension is equivalent to dampening the financial cycle. Macroprudential regulatory tools aimed at targeting the buildup of systemic risk along the time dimension should discourage excessive risk-taking behaviour and credit growth and the inflation of financial asset prices (i.e. counter the buildup of vulnerabilities in the financial system during an upturn). In addition, regulatory tools related to the time dimension should aim to make recessions/crises less intense (i.e. build in defence mechanisms that prevent the aggressive unwinding of these vulnerabilities during a downturn).

2.2 Lessons for monetary policy

Besides the above-mentioned lessons for regulatory authorities, the global financial crisis has learned us 2 important lessons for monetary policy which are described below. These lessons are strongly related. The majority of economists argue that monetary policy played a prominent role in the buildup of systemic risk in the financial system in the years preceding the crisis.

1. Monetary policy was too expansionary in the years preceding the crisis. A wider set of variables should be analysed when determining the target of the policy rate, rather than focusing solely on the inflation rate and conditions in the labour market or output – Many economists argue that

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11 11 attacks and significantly contributed to the crisis as it exacerbated excessive availability of cheap credit, ever-riskier investment behaviour by banks and other investors and the inflation of asset and house prices (Borio and White, 2003; White, 2006; Bean et al, 2009; Brunnermeier, 2009). The Federal Reserve conducted an expansionary monetary policy by eventually bringing down the policy rate to 1% at the end of 2003 and keeping it constant for a year (Bean et al, 2010). The policy rate is a short-term interest rate, like the federal funds rate, which the central bank can influence through open market operations in which they change the supply of money and thus its price. Given the main focus on inflation and the labour market/output when conducting monetary policy, the relatively low and stable inflation and unemployment rates did not induce the authorities (enough) to firmly tighten monetary policy during the years preceding the crisis in which imbalances in the financial system were growing rapidly (Bean et al, 2010; Bernanke, 2010; White, 2010). In general, the behaviour of asset prices, credit availability and the composition of output (e.g. current account deficit too large or level of housing investment too high) might be such that large future macroeconomic adjustments may occur (Blanchard et al, 2010).The global financial crisis, the crises in Japan in the late 1980s and those in some East Asian countries in 1997 have demonstrated that a boom can coincide with the absence of high inflation or even a fall in the price level. Thus, capitalizing on recent experiences suggests that inaction by central banks, based on low inflation levels, can have devastating consequences (Borio, 2012).Price/output stability and financial stability are not two sides of the same coin.

2. Monetary policy should do more ‘leaning’ instead of ‘cleaning’ – There seems to be a strong case

for so-called 'leaning against the wind', i.e. countercyclical monetary policy, rather than focusing only on price and output stability and intervening after economic sentiment has turned (Mishkin, 2013). The 'Jackson Hole' consensus or 'Greenspan Doctrine' was the leading paradigm of US monetary policymakers in the years preceding the crisis. One of the implications of this paradigm prescribed that asset markets are efficient at pricing and distributing risk and financial innovations positively affect welfare. Although asset prices might be subject to overenthusiastic investors, the role of monetary policy to curb these developments was limited. Therefore, the best monetary policy could do was crisis management after sentiment had turned (Bean et al, 2010). However, the economic and social costs of cleaning up the mess after the recent crisis were of such magnitude that supporting this laissez-faire policy any longer seems unreasonable (Cleassens et al, 2011; Mishkin, 2013).

Whether the abovementioned lessons should be turned into concrete monetary policy changes is still a matter of academic debate. The main point of this debate is whether monetary policy should have a second objective of financial stability, next to its first objective of price stability (and output stability/low unemployment). For now, this research has outlined the optional policy changes for monetary policy. Monetary policy authorities could help to counter the buildup of systemic risk by conducting countercyclical monetary policy. In that case, the target for the policy rate should be dependent not only on the level of inflation and developments in the labour market, but also on the level of other variables, like credit and property price growth. Section 5 elaborates on this discussion and suggests a course for future monetary policy which is in line with the current stance of the IMF (2014) and Bernanke (2010) regarding this issue.

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2.3 Lessons for fiscal policy

Finally, there are 2 lessons for fiscal policy that would enhance the stability of the financial system. While fiscal policy did not directly contribute to the fragile state of the financial system before the financial crisis started, its role in ensuring the stability of the financial system consists mostly of having the ability to step in with fiscal stimuli when pre-emptive macroprudential measures did not suffice.

1. Governments should have more 'fiscal space', i.e. the potential to intervene when the situation asks for it – Many European nations and other advanced economies entered the crisis with high debt

levels and massive unfunded future liabilities which impaired their ability to use fiscal policy. Despite the deep recession, they were forced to cut government spending and increase taxes. The massive fiscal problems in many of the Euro zone members were of such magnitude that they were forced to ask for assistance from the IMF and the ECB. On the contrary, many developing countries did not face these problems and were able to intervene aggressively without impairing the sustainability of their sovereign debt (Blanchard et al, 2010).

2. More automatic stabilizers should be used in fiscal policy to decrease the reliance on discretionary fiscal policy which is often too slow to fight a (normal) recession – Automatic

stabilizers create buffers during booms which can be used during downturns without impairing the budget deficit too much and increase the sovereign debt level (Blanchard et al, 2010). They should dampen the effects of the business cycle on the public deficits. The use of automatic stabilizers helps to keep the public deficit and sovereign debt level under control such that the authorities are able to stimulate markets when it is needed. Section 5.2 describes some examples of automatic stabilizers that have been suggested in academic literature.

This section has provided a short overview of the many lessons the financial crisis has taught us. Now it is time to turn these lessons into concrete policy actions. How can we ensure the stability of the financial system, based on macroprudential fundamentals? Section 3 describes the concept of a macroprudential policy framework. What does it entail, why is it essential and what are its scope and institutional setting? The lessons will be linked to concrete macroprudential policy tools which have been suggested in academic literature in section 4 and 5. Finally, section 6 aims to compare this ‘ideal policy framework’ with the measures that have been approved of in reality to see our progress towards a stable financial system.

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3. Towards a macroprudential policy framework

The recent financial crisis has proven that there were some major omissions in the regulation of the financial system which resulted in the buildup of systemic risk. Section 2 has provided an overview of the lessons from the global financial crisis in order to achieve stability in the US financial system. The most important lesson is the recognition of a lacking overarching policy framework responsible for systemic financial stability (IMF, 2014). Therefore, the majority of policymakers and economists argue in favour of the creation of a macroprudential regulatory framework which is based on a new way of looking at financial stability. Regulatory and supervisory institutions should shift their orientation from one that is ‘microprudential’, i.e. a point of view which focuses on individual institutions, towards one that is more ‘macroprudential’, i.e. an economy-wide perspective that focuses on the stability of the entire financial system (Borio, 2003; Galati and Moessner, 2013). While these two perspectives currently coexist in regulatory arrangements, the macroprudential orientation should be strengthened in order to achieve financial stability in the long run (Blanchard et al, 2010; FSB-IMF-BIS, 2011; Schoenmaker and Wierts, 2011). This section provides a description of the concept of macroprudential regulation, the rationale for the move towards a macroprudential policy framework, its scope and its institutional setting.

The microprudential perspective aims at limiting the risk of financial distress at individual institutions, thereby neglecting their impact on the economy as a whole. There is no consensus yet about the exact definition of macroprudential policy but in general it is designed to limit the risk of systemic crises and avoid macroeconomic costs (Borio, 2003, Galati and Moessner, 2013). Brunnermeier et al (2009) point at the key purpose of flattening the cycle of measured risk, i.e. the natural decline of risk measured during an economic boom and the rise of it during a downturn. The Bank of England (2009) interprets the aim of macroprudential policy in terms of a stable provision of financial and credit intermediation and insurance against risk, combined with the avoidance of the boom-bust cycles in the supply of credit and liquidity. General manager of the BIS, Caruana, explicitly addresses the interconnectedness and common exposure of all financial institutions, and the procyclicality of the financial system (Caruana, 2010).

Table 1 uses a clear separation between the main features of the micro- and macroprudential perspectives. Though it is hard to draw a clear demarcation line between them, it is conceptually useful to polarize the two (Borio, 2003; IMF, 2014). The microprudential approach mainly focuses on the protection of investors and depositors by ensuring the soundness of individual institutions, neglects the interconnectedness and common exposures of financial institutions and sees risk as an exogenous factor that is not dependent on (the state of) the financial system or on individual economic agents’ behaviour. The Basel I and Basel II banking regulations were predominantly based on a microprudential rationale; to ensure the stability of the system, it is sufficient to safeguard its components (bottom-up) (Borio, 2003; Mishkin, 2013; Schoenmaker and Wierts, 2011).

On the contrary, macroprudential policy deals with systemic risk and tries to avoid macroeconomic costs in terms of output. Correlations among different institutions are very important in understanding systemic risks and these risks are endogenous, i.e. generated by the financial system itself and by the collective behaviour of economic agents (the procyclicality in the financial system in terms of risk). The focus is therefore top-down, meaning that by creating a safer system, individual

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14 institutions will become more robust as well and the effects on the real economy from a hampering financial system can be avoided (Borio, 2003; Mishkin, 2013; Schoenmaker and Wierts, 2011).

Table 1: Comparison of the macro- and microprudential approach. Source: Borio, 2003.

The rationale for the change towards a macroprudential policy framework is supported by 3 main arguments. First, financial crises have severe macroeconomic costs which justifies a proper macroprudential framework. Reinhart and Reinhart (2010) have stated that unemployment rates stay persistently higher and economic growth does not recover to pre-crisis levels for a decade after a financial crisis. These developments, the bail-out of banks and other fiscal stimulus programs have severely increased the indebtedness of governments worldwide. Furthermore, as the Japanese ‘Lost Decade’ illustrates, financial crises can cause the effectiveness of monetary and fiscal policy to numb (Borio, 2003). The impact of a financial crisis on economic activity is far greater than was realized before (Mishkin, 2013). While microprudential policy aims to protect depositors from direct losses, it does not spare them the indirect losses from financial distress and the fall in economic activity. Macroprudential regulation has the objective to protect all economic agents (Borio, 2003).

Second, the crisis has shown us that the web of linkages between both financial institutions and financial markets worldwide serves as a transmission channel of risk in times of crisis. Consequently, the risk of the financial system overall is a lot higher than the accumulated total of the individual institutions’ risks (Kim, 2011). Therefore, authorities must widen their scope because by focusing solely on the soundness of individual entities they neglect the fact that the banks’ risk-taking behaviour causes negative externalities on the financial system which they do not internalize. Equivalently, macroprudential tools enable the authorities to curb banking practices that would cause systemic risk to build up, even if it appears to be prudent from the individual banks’ perspective (Blunden, 2007; Schoenmaker and Wierts, 2011). For example, a bank can sell an asset if its risk increases. If a large number of other banks pursue the same strategy, though well intended from a microprudential perspective, the asset price will collapse and the banks are forced to take on additional measures to rectify the situation. This leads to a downward spiral of asset prices, fire sales and increased volatility (risk) in financial markets, turning the initial intention of risk reduction at the micro-level into increased systemic risk (Borio, 2003; Schoenmaker and Wierts, 2011). This situation directly refers to the cross-sectional dimension of systemic risk which is only recognized by the macroprudential view.

Third, the nature of financial instability and risk in the financial system are such that a microprudential approach is inherently insufficient to limit the probability of a financial crisis to occur (Galati and Moessner, 2013). The most common explanation for systemic risk is one in which widespread distress in the financial system arises primarily from problems at individual institutions.

Macroprudential Microprudential

Proximate objective limit financial system-wide distress limit distress of individual institutions

Ultimate objective avoid output costs consumer (investor/depositor) protection

Model of risk (in part) endogenous exogenous

Correlations and common exposures across institutions

important irrelevant

Calibration of prudential

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15 These problems than spread through the system via contagion mechanisms such as interlinkages of balance sheets and overreactions by economic agents from information asymmetries. Risk is treated as exogenous with respect to the initial shock but the amplification mechanisms are endogenous. Thus, the initial shock is unexpected and is amplified by the endogenous reactions of market participants. This view on systemic risk combines features of both the micro- and macroprudential perspective but does not account for the buildup of the fragilities in the system underlying the initial shock (Borio, 2003).

Although there are examples of systemic risk arising from processes of this kind, the majority of major crises worldwide arose primarily from common exposures to macroeconomic risk factors across individual institutions. This essential feature is overlooked in the common view. Crises resulting from common exposures to macroeconomic risk factors across individual institutions vary in many aspects but they can be generally characterized by a buildup phase in terms of a booming economy, the under-pricing of risk, a credit boom and rapidly rising asset prices. Eventually, a trigger exposes the masked imbalances in the overstretched financial system and causes the latter to contract. The trigger can be financial in nature (e.g. an asset price correction) or residing from the real economy (e.g. a sudden burst of an investment bubble). In general, the system did not build up sufficient buffers to withstand a financial crisis and, given the strong link between the financial and business cycle, the real economy will be severely affected subsequently (Borio, 2003).

The last three decades have been characterized by financial crises that resulted from similar patterns in the financial system. These include, among others, the prolonged crisis in Japan (common exposure to risk of falling commercial real estate prices), the East-Asian crisis that started in 1997 (common exposure to foreign exchange risk) and the global financial crisis of 2008-2009 (among others, common exposure to falling house prices). In short, instead of focusing on the trigger of a crisis, it is more important to understand how vulnerabilities build up over time which is to an important extent endogenous (Borio, 2003). Vulnerabilities in the financial system tend to build up during favourable economic conditions in which economic agents underestimate risk, loosen their lending standards and take on too much debt. Risk perceptions are countercyclical, i.e. they fall during an economic boom, but given the growth of imbalances and fragilities in the financial system during an economic boom, exactly the opposite holds true. In line with the macroprudential perspective, it is the buildup of fragilities during favourable economic conditions (procyclicality of risk) that need to be countered in the first place in order to ensure stability in the financial system (Borio, 2003). This directly refers to the time dimension of systemic risk and the dampening of the financial cycle and is therefore an essential factor in the macroprudential framework (Borio, 2003; Galati and Moessner, 2013).

For these three reasons, there is a strong case for designing a policy framework that rests on macroprudential foundations. The macroprudential policy framework’s most important task is to ensure the stability of the financial system by discouraging the buildup of systemic risk, both along the cross-sectional and time dimension. The necessity to stabilize the financial market becomes especially clear when considering the magnitude of the costs from the recent financial crisis.

When the pre-emptive macroprudential measures did not suffice and a crisis occurs, the macroprudential policy framework should have a defence mechanism in place, consisting of policy tools, that aims to decrease the intensity of the crisis and its effects on the rest of the economy.

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16 There is no consensus whether countercyclical monetary policy should support the macroprudential regulatory measures in discouraging systemic risk from building up. The use of fiscal stimuli should be at the disposal of the macroprudential authorities when regulatory (and possibly countercyclical monetary policy) tools could not prevent a crisis. The macroprudential policy framework thus consists of macroprudential regulation, monetary policy (optional) and fiscal policy.

Given the objective of the macroprudential policy framework to discourage system-wide financial distress by countering systemic risk, it is obvious that its scope should be system-wide as well (Borio, 2003). It should cover all potential sources of systemic risk in the financial system. This means that all financial institutions that provide credit, liquidity, maturity transformation and/or other intermediation services, regardless of their legal form, should be on the radar of the responsible authorities. Thus, the privileged regulatory position of the entire shadow banking system should come to an end (IMF, 2014).

The IMF (2014) suggests an institutional architecture with a major operational and analytical role for the Federal Reserve, supported by a separate committee that is represented by all the policy fields involved and is responsible for decision-making and coordination across the different policy fields. This research does not elaborate on the institutional structure of the macroprudential framework1_. Figure 3 provides an overview of the direct (solid lines) and indirect (dotted lines) objectives and ultimate goals of monetary policy (when included in the macroprudential policy framework) and macro- and microprudential regulation.

Policy Objective Ultimate goal (Level of impact)

Monetary policy Price (and output) stability

Stable economic growth (economic system)

Macroprudential Financial stability

regulation

Microprudential Soundness of financial Protection of consumers regulation institutions (individual institutions)

Figure 3: An overview of the direct (solid lines) and indirect (dotted lines) objectives and ultimate goals of monetary, macro- and microprudential policies. Source: Schoenmaker and Wierts (2011)

The financial crisis has provided fertile ground to redesign the policies that were in place before the crisis to ensure financial stability. The move from microprudential regulation towards macroprudential regulation is justified by recognizing the cross-sectional and time dimension of systemic risk. The macroprudential policy framework is completed with the inclusion of monetary (optional) and fiscal policy. Its scope should be system-wide and its institutional architecture should consist of major operational and analytical role for the Federal Reserve, supported by a separate committee that is represented by all the policy fields involved and is responsible for decision-making and coordination across the different policy fields.

1_{IMF (2014) and Schoenmaker and Wierts (2011) analyse the ideal institutional architecture for the} macroprudential policy framework in more detail.

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17 With the theoretical outline of the macroprudential policy framework in place, it is time to proceed and turn theory into practice. What regulatory policy tools are at hand to make the financial system safer and more stable in the spirit of the macroprudential perspective? Section 4 explores the different indicators for systemic risk and sets out a wide range of regulatory tools to address it. Section 5 describes the changes that need to take place in monetary and fiscal policy with the macroprudential view in mind. This makes it possible to make the comparison between the policy changes in the US that should be taken and those that have been taken in order to give insights into the progress we are making towards a world that is financially less volatile.

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4. Regulatory macroprudential tools

The recent crisis has sparked an active debate in the academic literature regarding the use of macroprudential regulatory tools. Despite the urgency to shift towards a macroprudential framework, the related research and data are still limited which results in the absence of a clear consensus on which instruments yield the best results (Galati and Moessner, 2013). In general, a macroprudential regulatory policy framework should encompass a system of early warning indicators of an increased level of risk in the financial system and an accompanying set of effective policy instruments that can address the vulnerabilities rapidly (Shin, 2011).

Section 4.1 outlines the suggestions made in the literature to address the cross-sectional dimension of systemic risk. Subsection 4.1.1 elaborates upon the indicators which can signal the level of cross-sectional systemic risk and subsection 4.1.2 describes which macroprudential regulatory policy tools can be used to control for it? Likewise, section 4.2 captures the time dimension of systemic risk.

4.1.1 Measuring the cross-sectional dimension of systemic risk

To counter the buildup of systemic risk along the cross-sectional dimension, two important questions need to be answered. First, how should the level of cross-sectional systemic risk in the financial system be measured? Second, is it possible to measure the contribution of an individual institution to systemic risk? The latter is essential because the macroprudential regulatory tools aimed to prevent the buildup of systemic risk along the cross-sectional dimension are designed to affect each financial institution individually to a degree which depends on their individual contribution to systemic risk (Shin, 2011). The official statement by the FSB (2010) is: “Financial institutions should be subject to requirements commensurate with the risks they pose to the financial system.” The authorities must thus be able to allocate the general level of system risk in the financial system to individual financial institutions. The contribution of a financial institution to systemic risk indicates the institution’s systemic importance. When a bank is systemically important, its failure could trigger a financial crisis. Thus, it contributes to systemic risk. This section provides an overview of the different factors that constitute systemic importance of a financial institution and the most important indicators for cross-sectional systemic risk, both for individual institutions and the entire financial system.

The systemic importance of a financial institution is often related to its size. This can be easily assessed using e.g. the value of its assets or its market value. However, the size of an institution alone does not always indicate systemic importance. For example, the demise of the Amaranth Advisors hedge fund in 2006 meant one of the largest trading losses and hedge fund collapses in history but did not cause any major adverse externalities to the financial system in the form of systemic risk (IMF, 2014; Schoenmaker and Wierts, 2011). Drehmann and Tarashev (2011) describe systemic importance as the extent to which a financial institution propagates shocks across the financial system and is vulnerable for shocks originated elsewhere in the banking system. Therefore, it is directly related to the level of interconnectedness of the bank with other institutions. In sum, the three factors that constitute the banks’ individual contribution to systemic risk (or its systemic importance) are its size, its interconnectedness with other financial institutions, the degree to which it propagates shocks across the financial system (e.g. through risky investment behaviour) and its ability to withstand a shock originated elsewhere in the financial system (indicated by e.g. leverage

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19 or maturity mismatch). The overall level of cross-sectional systemic risk in the financial system consists of the sum of the individual institutions’ contributions to systemic risk and the degree of common exposures in the system (FSB, 2010; Shin, 2011). The example of AIG during the recent financial crisis showed that systemic risk arose when the majority of financial institutions were commonly exposed to losses on CDOs. The decline in the value of CDOs resulted in the demise of AIG which had to bailed out by the authorities to prevent a cascading failure in the financial system (Bean et al, 2010).

The most promising indicator for measuring an individual financial institution’s contribution to systemic risk and the overall level of cross-sectional systemic risk is the SRISK Index which has been developed by Brownlees and Engle (2012). The SRISK index is based on the ‘participation approach’(PA)2_{. The PA calculates the degree of systemic importance of a financial institution by} measuring a banks’ participation in adverse systemic events. It incorporates all factors that constitute systemic risk and calculates systemic importance by using a banks’ expected capital shortage during a system-wide crisis in which the aggregate losses in the financial system exceed a certain critical threshold. Equivalently, it measures the amount of capital that needs to be injected in a firm in order to meet certain minimal capital requirements. The SRISK index is a function of a banks’ size, degree of leverage and Marginal Expected Shortfall (MES). The MES incorporates volatilities, correlations/interconnectedness, tail risk and common exposures and calculates the expected losses incurred by equity investors in financial institutions during a systemic event. The higher the SRISK of a firm, the more it contributes to the undercapitalization of the financial sector in a crisis and the higher its systemic riskiness/importance.

A few favourable characteristics make the SRISK index the most promising indicator of cross-sectional systemic risk. First, the SRISK index has proved to be a useful indicator for systemically risky firms (one and a half year preceding the fall of Lehmann Brothers, 9 institutions out of the SRISK top 10 turned out to be troubled institutions) and thus has prediction power. In addition, SRISK values can be aggregated easily across different institutions or across the entire industry to measure the overall level of cross-sectional systemic risk. The sum of all SRISK indices represents the potential capital shortage the government may be forced to recapitalize during a systemic event. Also, it is expressed in monetary terms which makes it easy to interpret. Finally, because the SRISK is composed of different variables which can be interpreted as risk indicators themselves (size, leverage and MES), it is expected to yield a balanced indicator of systemic risk for both individual institutions as well as for the entire financial system (Brownlees and Engle, 2012).

Using a minimum capital requirement of 8% and a drop in market value beyond 40% over 6 months (which approximately matches the recent global financial crisis), Brownlees and Engle (2012) calculated the aggregate SRISK index for the top 96 financial institutions in the US, divided over four subgroups of the financial sector; Broker-dealers, Depositories, Insurance and Others (figure 4: from bottom to top). The aggregate capital shortfall of the financial sector in the pre-crisis period (before September 2007) already amounted to approximately US $200 bln. The majority of this shortfall originated from broker-dealers (relatively big size, highly leveraged, and high MES) and others of which Fannie Mae and Freddie Mac were the largest contributors. Figure 4 accurately reflects both

2_{The PA has been used for other indicators of cross-sectional systemic risk by Acharya et al (2009) and} Drehmann and Tarashev (2011).

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20 the sources and level of systemic risk during the crisis years. The start of the crisis is reflected in an escalation of the SRISK index, especially after the subprime crisis surfaced in July 2007. Also, the increasing relevance of depositories and insurance in the aggregate level of risk corresponds with the SRISK index. The series peak at around US $1000 bln shortly after the Lehmann Brothers bankruptcy in September 2008 and around the same time, the SRISK of Others significantly declines after Freddie Mae and Fannie Mac were placed under government control. After the approval of the Wall Street bailout package in October 2008 by the House of Representatives, systemic risk did not rise any further. Only after the beginning of the market rally in March 2009, the US financial sector recovered slowly but steadily. Brownlees and Engle (2012) also show that the SRISK produces useful rankings for SIFIs (fig. 5).

Next to the SRISK index, the IMF (2011) sees a role for macro stress tests in the macroprudential framework. They assess how the financial system as a whole or individual institutions would react to several types of macroeconomic shocks. Other indicators have been developed which could reasonably predict the rise of systemic risk preceding the recent crisis. However, they are not as useful for policymakers as the SRISK Index as they are aimed at the system as a whole such that calibrated policy measures are harder/impossible to implement. The Bank Stability Index (or the Joint Probability of Default), the Systemic Contingent Claims Analysis (CCA), the Global Financial Stress Index (by Bank of America Merrill Lynch), the Composite Indicator of Systemic Stress (by the ECB) and the Macro Prudential Indicators (by Fitch Ratings) are amongst the most important ones (IMF, 2014). In sum, the SRISK index is a useful and balanced indicator for the overall level of cross-sectional systemic risk in the financial system and is able to allocate this risk over different financial institutions. It is a forward looking indicator and easy to interpret. Information from the SRISK index

Figure 5: The SRISK of the top 10 of US most systemically important financial institutions as of February 2014 (US $bln). Source: Volatility Lab of NYU Stern School (2014)

Figure 4: The aggregated SRISK of the top 96 US financial institutions (US $bln) subdivided from bottom to top into broker-dealers, depositories, insurance and others over the period of July 2005 – July 2010. Source: Brownlees and Engle (2012).

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21 can be complemented using macro stress tests. The next subsection gives an outline of the macroprudential regulatory tools that can address cross-sectional systemic risk.

4.1.2 Macroprudential regulatory tools to address the cross-sectional dimension of

systemic risk

Given the ability to measure the level of cross-sectional systemic risk and identify its main sources, it is time to apply the right tools to address it. The various indicators and measures that regulators can utilize to decrease the cross-sectional dimension of systemic risk are summed up in table 2.

Macroprudential regulatory tools to counter systemic risk across the cross-sectional dimension Measurement/indicator

1. SRISK index

2. macro stress tests

Tools

1. Legislation should shift its focus from being entity based towards one that is activity based

2. Systemic capital surcharge on SIFIs dependent on their SRISK

3. Resolution plans for financial institutions

4. Separation of a financial institutions in an investment- and commercial bank

5. Deposit insurance premiums dependent on level of systemic risk

6. Minimum leverage ratio

7. Higher liquidity coverage ratio

8. Improved disclosure about trading activities and risks

9. New financial products should be reviewed on their risk

10. Executive compensations growth should be limited

11. Legal restrictions on certain trading activities

12. Lending standards must increase in the mortgage market

Table 2: The macroprudential regulatory toolkit to counter systemic risk across the cross-sectional dimension

These 12 regulatory tools will be described below and linked to the related lessons from the crisis mentioned in section 2.

1. All institutions that perform financial intermediary services must be regulated on an equal basis

- The macroprudential view would prescribe that all financial institutions that contribute to systemic risk due to their systemic importance should be subject to the same prudential regulation (IMF, 2014; Schoenmaker and Wierts, 2011). The shadow bank must lose its privileged regulatory position.

2. Systemic capital surcharges – The loss-absorbency of SIFIs must exceed the minimum

requirements that apply to financial institutions that are systemically less important. SIFIs should be subject to higher capital requirements of which the level is tied to the level of systemic importance of the affected financial institution according to its market-based measures of systemic risk (SRISK or macro stress tests) (Schoenmaker and Wierts, 2011; Shin, 2011).

3. Resolution plans - These would reduce moral hazard problems and the accompanying increase in

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22 financial trouble and are there to provide ex ante conditions that allow for different options than government bail-out (Avgouleas et al, 2010; Bernanke, 2008). The idea is to counter excessive risk-taking by banks by removing the implicit safety net from a government bail-out from being too big to fail and to decrease the uncertainty and panic in such circumstances (Bean et al, 2010; Bernanke, 2008).

4. The breakup of a financial institution into a separate investment- and commercial bank - This

would reduce its size and systemic importance and thus its contribution to systemic risk (Schoenmaker and Wierts, 2011. This legal separation was ensured with the Glass-Steagall Act of 1933 but was abolished with the introduction of the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 (Mishkin, 2013). This tool would only apply to troubled financial institutions that contribute too much to the overall level of cross-sectional systemic risk.

5. Deposit insurance risk premiums might be made dependent on both the default risk of the individual institution and the negative impact that the institution’s default might potentially have on the financial system as a whole - This measure would incentivize the institutions to keep its

contribution to systemic risk in check (IMF, 2011)

6. Leverage in the system must be constrained to stop the growth and interconnectedness of financial institutions – The loss absorbency of a financial institution cannot only be improved

through higher capital requirements but also through linking the maximum level of loans a firm can make to its Tier 1 capital (common stock and retained earnings). In addition, this measure indirectly tries to address the strong positive relationship between leverage and the interconnectness of the financial system (IMF, 2011; Shin, 2011).

7. Higher liquidity coverage ratio – In order to improve the resilience of banks to systemic risk arising

from the exposure to a liquidity crunch in the financial markets and its spill-over effects to the real economy, each financial institution should hold a stock of high-quality liquid assets that can be quickly and easily converted into cash. Stress tests can scan whether the institution can meet its obligations for a certain period of time during periods of high stress and volatility (BIS, 2013).

8. Improved disclosure about trading activities and risk exposure – Higher disclosure standards

regarding risk exposures and trading activities must tackle the high level of opacity in the system and its products. This measure aims to decrease the sharp downturn caused by herding behaviour and credit rationing by financial institutions and agents resulting from a lack of information about the risk they are facing. It also serves as a disciplinary force for banks to limit their risk exposure and thus the creation of systemic risk (Barth and Landsman, 2010; IMF, 2014).

9. New financial products should be reviewed on their risk - A neutral (governmental) organization

should review the 'risk for consumption' of new financial products and obligate its issuers to communicate that risk effectively to consumers and investors (IMF, 2014). This measure would complement the effectiveness of the higher disclosure standards for financial institutions and would add to the transparency of the financial system.

Towards a macroprudential policy framework : using the lessons from the global financial crisis to create a stable financial system