Macroprudential Structures

Macroprudential supervision arises out of a combination of rather old practices and new perspectives. An important element of the old practices is the role of central banks in preserving financial stability. Padoa-Schioppa (2003) argued that the role of central banks in financial stability is part of their “genetic code.” He noted that European central banks acted as lenders of last resort by the end of the nineteenth century. Along those lines, the US Federal Reserve was created in large part to provide the US with a lender of last resort after the 1907 panic. Central banks' power to act as lenders of last resort also allowed them to exercise some influence over banks' behavior by (implicitly) threatening to deny such loans.

Central banks' role in preserving financial stability was augmented with the addition of statutory responsibility for bank supervision. The Federal Reserve obtained microprudential supervisory powers over some commercial banks when it was created, and over banking groups starting in 1956. Ryback (2006) noted that central banks often became bank supervisors in many parts of the world as countries adopted banking laws in the second half of the twentieth century. The result was that macroprudential agencies were given authority over microprudential regulation.

Ryback (2006) argued that macroprudential regulation has reemerged as a separate concern over the last 10–15 years for several reasons. The first factor in the reemergence was the Asian financial crisis of 1997–1998, which demonstrated that a nation's banking system could be exposed to a shock that is not readily observable by looking at individual banks. In that case, the banks were indirectly exposed to foreign exchange risk as a result of the corporate customers borrowing in foreign currencies, even though their receipts were largely in the domestic currency. Second, central banks came to appreciate that their capability to meet monetary policy goals depended not only on the stability of the banking system, but also on developments in the nonbank financial sector, especially the bond markets. Third, the shifting of microprudential responsibility from central banks to newly created regulators brought into the open central banks' continuing responsibility for financial stability. For example, Laker (2006) noted that the creation of the Australian Prudential Regulation Authority led the Reserve Bank of Australia to create a financial stability area to conduct analysis and research on financial stability issues.

The current round of financial instability has forcefully reemphasized the weakness of the older approaches. A strong bank sector is a necessary condition for financial stability, but it is not a sufficient condition. Weaknesses in the nonbank financial sector are both a potential direct threat to financial stability from its own impact and an indirect threat to stability through its impact on the banking system.

Given the desire to reduce the costs of financial instability and restrict moral hazard, there is increased interest in creating a macroprudential supervisor. This supervisor would have new powers to examine and regulate previously less-regulated financial firms, possibly combined with some regulatory power over firms already subject to microprudential supervision.

This section analyzes the role of macroprudential supervision in managing systemic risk. The messages are twofold: There is much that can and should be done, but there are limits, and promising to do too much could be worse than doing nothing. This section starts with some ideas on what is relatively easy, continues with a discussion of the more difficult tasks, and concludes with some warnings about the current limits of what is feasible in macroprudential supervision.

3.1 Macroprudential Information Gathering

Central banks are already gathering and processing some publicly available information as part of their regular financial stability reviews.⁸ This analysis is likely to improve over time as economists develop a better understanding of the causes of financial instability.

Macroprudential authorities should obtain broad powers to examine the financial system to better understand linkages within the system and potential weak spots. One of the first responsibilities of a macroprudential supervisor should be to address weaknesses in the financial system that could turn what should be an isolated problem within the financial sector into a systemic problem. That is, the macroprudential supervisor should make sure that the financial plumbing system is in good order. This system includes payment and settlement systems, which are already a concern of the central banks in many countries. But it also includes issues associated with the infrastructure for all types of financial transactions. For example, during much of this decade, market participants had huge backlogs of trade confirmations in the credit default swap (CDS) markets. If left unaddressed, this could have further added to the recent turmoil in financial markets. Fortunately, financial supervisors were able to force market participants to address this problem, although in some cases their leverage for doing so came from their microprudential authority over important dealer firms.⁹ A macroprudential supervisor should have the authority to conduct thorough reviews of systemically important markets, including firms not subject to microprudential regulations, and impose regulations as necessary to address weaknesses.

A second area in which macroprudential supervision could improve on current practice is by developing a clear understanding of the major markets from the first transaction through to the ultimate bearer of the risk.¹⁰, ¹¹ The US residential real estate market provides an excellent example of how such an end-to-end analysis of markets could have identified weak practices that would combine to create a systemic problem.¹²

The story begins in 2000, with a dramatic relaxation of the lending standards in the US residential real estate market.¹³ Many of these loans depended upon continuing housing price appreciation for their repayment. If prices ever stopped rising, the holder of the mortgage was much more likely to take losses. Ashcraft and Schuermann (2008) noted that these high-risk mortgages were then packaged together, cut into tranches of varying seniority, and sold as private label residential mortgage-backed securities (RMBSs). Some of the more risky tranches of these RMBSs were also packaged together, sliced into tranches of varying seniority, and sold as collateralized debt obligations.

The more senior parts of these private label RMBSs and collateralized debt obligations (typically rated AAA) were often bought by US and European bank-sponsored vehicles such as structured investment vehicles.¹⁴ These bank-sponsored vehicles funded their assets with a thin cushion of equity and longer-term debt. But the vast majority of the funding came from the asset-backed commercial paper (ABCP) market. Investors in the commercial paper market are looking for a high degree of safety first and return second. If the safety of their investment comes into doubt, they will not roll over their investment. To satisfy these riskaverse investors, most bank-sponsored vehicles were backed by explicit or implicit promises that the sponsor would provide liquidity support if that became necessary.

Standard & Poors (2009) noted that problems arose when US residential real estate prices started turning down in late 2006 and 2007. Many borrowers, especially those who purchased the real estate as an investment, started defaulting almost immediately on their loans. As default rates climbed, investors in ABCP began to doubt the quality of the assets backing many bank-sponsored vehicles and started withdrawing from this market. Arteta et al. (2009) noted that as these vehicles lost access to the ABCP market, they turned to their sponsors for US dollar-denominated loans to provide liquidity. Gorton (2009) showed that the margin demanded on repurchase agreements using asset-backed securities also dramatically increased which further reduced the banks' liquidity.

US banks had access to additional dollar funding from domestic sources.¹⁵ European banks often lacked such access and turned to the US dollar London InterBank Offered Rate LIBOR market to obtain such funding. However, as Arteta et al. (2009) noted, the LIBOR market was not deep enough to accommodate their needs, especially given growing credit-quality concerns related to several of the borrowers. The result was a dramatic widening in the spread of LIBOR over the comparable maturity of overnight indexed swaps.

A macroprudential supervisor that observed rapid growth in the use of new residential mortgage instruments to systemically material levels could have examined the process from loan origination through to the purchase by domestic investors. As discussed by Demyanyk and Van Hemert (2008), if that had happened in the US, a review at the origination level should have noted the growing dependence of many loans on home price appreciation to provide the borrower with a means of repayment. An examination of a sample of the nodocument loans should have turned up the fact that many of these loans were living up to their names as “liar's loans.” That is, in many cases, borrowers were making material misstatements on their loan applications. A review of the securitization process should have revealed that, in many cases, the processors were focused on maximum throughput of loans and conducted few or no quality checks on the loans. Finally, it might also have raised questions about some of the practices used by the ultimate holders of some RMBSs (in particular, their reliance on vehicles that were funded primarily with ABCP with little capital).¹⁶

Following transactions through to the ultimate bearer of risk may also reveal concentrations of risk that would not be readily observable. For example, a review of the credit guarantee market (i.e., CDS plus similar contracts) might have revealed American International Group, Inc. (AIG)'s net position and the extent to which different counterparties had become exposed to AIG. Although the exposure of any individual counterparty to AIG might not be a cause for concern, the aggregate exposure of banks should have raised concerns about AIG's capability to honor its commitments in the event of a large drop in credit quality.¹⁷

Just as a microprudential supervisory focus is inadequate for understanding the risks to stability in an interconnected domestic financial system, a domestic focus to macroprudential supervision is also inadequate for understanding the risks to stability posed by an interconnected global financial system. The effectiveness of macroprudential supervision will be greatly enhanced to the extent that the supervisor understands the connections between domestic and international markets and institutions.

The chain of events leading from mortgage loans in the US to the dramatic widening of LIBOR spreads in 2007 helps to illustrate this point. A domestic macroprudential supervisor in the US would have noted the dramatic rise in private label RMBSs, and an examination should have revealed some weaknesses in the underwriting.¹⁸ But a US macroprudential supervisor would also have observed that a substantial fraction of these RMBSs were being held by foreign investors, which could be taken to imply that these RMBSs would not pose a threat to US financial stability. The potential for these foreign investors to suddenly place greatly increased demands on the US dollar LIBOR market would not have been directly observable. Similarly, a macroprudential supervisor of a country whose banks were buying these RMBSs would have seen the buildup of holdings and their funding with very little capital and ABCP. But most of these RMBSs were highly rated, and these banks individually had access to lines of credit and the LIBOR market. The macroprudential supervisor could not have understood the dependence of the ratings on US residential property appreciation without a review of the US mortgage market. Nor could the macroprudential supervisor necessarily have seen that many European banks were holding their mortgage backed security investments in similar structures so that if one of them lost the confidence of the ABCP market, likely most or all of them would need alternative sources of US dollar funding.

Although macroprudential supervision done right requires a view across country boundaries, a global supervisor with such scope is unlikely to be created anytime soon. This implies that macroprudential supervision cannot reach its potential unless national supervisors work with each other. Not only must they share information, but they will also sometimes need to coordinate reviews of individual markets in order to trace the flow of financial risks from the original borrower to the ultimate holders of the risks. When additional regulation is deemed desirable, supervisors may also have to coordinate the adoption of new regulations to limit the capability of institutions and markets to avoid regulation by moving to new markets.

International cooperation between microprudential regulatory agencies happens all the time, but it is subject to some important frictions. The microprudential supervisors from different countries often have somewhat different mixes of missions that can inhibit their ability to work together. The difference in missions can be solved if countries agree that their macroprudential supervisor should have financial stability as a primary mission. Further strengthening their incentive to work together is past experience, which demonstrates that the stability of one country depends crucially on that of others, not only through direct financial links, but also indirectly through investor perceptions.

3.2 Macroprudential Regulation

There are some clear opportunities for a macroprudential supervisor to improve the regulation of the financial system. A macroprudential supervisor can extend powers already used by microprudential regulators to improve the financial systems' plumbing. A macroprudential supervisor can also bring a valuable perspective to the writing of microprudential regulations, such as the development of capital requirements that increase during good periods to build a cushion to absorb losses during weaker periods.

However, when promoting macroprudential supervision in the current environment, one must take care not to oversell its capabilities. Policymakers must be disabused of the idea that the existence of a macroprudential supervisor will guarantee that a country will never again suffer from financial instability. Most countries have had microprudential regulation of banks for decades, and some have had it for more than a century. But banks are still managed by humans who make mistakes, and banks sometimes fail. So, many governments have developed deposit insurance, special resolution regimes, and other techniques to manage the spillover from these failures to the broader society. In some important respects, macroprudential supervision is new and it will also be run by humans. Some instability is unavoidable, and potential spillovers will have to be managed. Expectations that the macroprudential supervisor will prevent financial instability are worse than misleading; such expectations will change incentives in ways that are likely to result in significant damage to the financial system.

3.2.1 Difficulty of Regulating Popular Innovations

A particular problem for macroprudential regulation is innovation, both in the form of new instruments and the expanded use of old instruments by new clienteles. The risks and the benefits of existing instruments when used in the normal way by long-standing clienteles are likely to be understood by the suppliers, users, and regulators. Moreover, these instruments have likely been tested in the legal system, and the relevant rules have largely been determined. However, there is likely to be a substantial amount of learning about innovations. In particular, the various types of risks associated with these instruments and their users may not be well understood until they have been tested by a more challenging environment. As a result, if such innovations are introduced during benign economic conditions, they may grow to the point where they raise systemic concerns without having their weak points tested.

Subprime mortgages in the US are an excellent example of an innovation that was appropriate for a limited set of mortgage loans.¹⁹ The problem with subprime is not that the loans existed. Instead, the problems were twofold: the set of borrowers given subprime loans was greatly expanded, and the risks of lending to less-credit-worthy borrowers were increased by layering risks (e.g., subprime loans were often made to buyers with little equity and little or no documentation supporting their loan applications).

A supervisor focused on macroprudential issues may not take an interest in such innovations until they grow to the point where the innovation poses a threat to financial stability. However, the fact that the innovation has grown so large that it could be systemically important suggests that the customers perceive the innovation to be valuable, and the suppliers of the product find it profitable. Many innovations also provide benefits to third parties. For example, innovations that lower the cost of residential mortgages are likely to benefit the construction and residential brokerage industries. All these parties are likely to raise political objections if the macroprudential supervisor attempts to significantly raise the cost of using this innovation or place substantial limits on its use.²⁰

An excellent example of the problem of trying to stifle a popular innovation is that of money market mutual funds in the US during the late 1970s and early 1980s. Regulation Q limited the interest that US depository institutions (mostly commercial banks and savings and loan associations) could pay on small denomination deposits. Kane (1977) noted that as market interest soared above these minimum levels, less-wealthy individuals turned to money market mutual funds. The savings and loan associations that most benefited from the regulation would have liked to have gotten rid of money market mutual funds. However, political pressure from older, less-wealthy voters resulted in Congress ultimately repealing deposit rate ceilings, according to Kaufman (2006).²¹

Whether a macroprudential supervisor will be able to withstand such political pressure depends on its political power and that of those opposing the new regulations. However, the supervisor will not necessarily gain prestige from preventing crises. Suppose that the supervisor is right about the need for the regulation, and adoption of the regulation prevents the innovation from causing a period of financial instability. Those that opposed the action may respond by claiming that a lack of instability shows that the regulation was unnecessary.

3.2.2 Pressure to Overregulate Innovations

A macroprudential supervisor that recognizes the political difficulty and costs of stopping innovations after they become systemically important is likely to be tempted to try to stop innovations before they become so popular. In this case, the problem is not of underregulation but of overregulation.

Suppose that for a particular innovation, the errors of under- and overregulation are of roughly equal magnitude in terms of their impact. The impact of these errors on the macroprudential supervisor will not be equal. Errors in the form of underregulation may become observable in the form of financial instability and lead to widespread criticism of the macroprudential supervisor. On the other hand, errors in the form of overregulation that prevent an innovation from succeeding will not be readily observable because the beneficiaries of the innovation will not be able to see the benefits they might have received.²²

Examples of market innovations that were at one time controversial, yet proved to be highly successful, are the markets' foreign currency swaps and interest rate swaps. These swap contracts exploded onto the scene in the early to mid-1990s, and were not all that well understood by many supervisors. We might never have obtained the benefits from these contracts if supervisors had taken the attitude that any innovation that was growing fast and not well understood needed to be shut down.

3.2.3 Wrong Expectations May Create Moral Hazard

A further danger to macroprudential regulation is that to the extent it increases investors' confidence there will not be periods of significant financial instability. It also increases investors' incentives to take more risks. The impact of investors' concern about financial instability on their actions is illustrated by their actions in the last several years. In 2006, many investors appear to have believed that there was at most a trivial risk of financial instability in the developed countries. This lack of concern, combined with low real interest rates, led many investors to seek higher returns. In some cases these returns were obtained by investing in higher-risk assets and in others by investing in highly leveraged portfolios of seemingly safe assets funded largely with shorter maturity debt. Many of these positions proved dangerous to their holders' financial condition as markets became unstable. As a result, many investors have sought to shift their portfolios into safer assets and fund their positions with more equity and longer maturity debt.

Although some reduction in concerns about financial instability would be supportive of economic growth now, it is not in the interest of a macroprudential supervisor to encourage a rapid return to the risk-taking attitudes of 2006. Yet the very act of creating a macroprudential supervisor could move attitudes in that direction for two reasons. First, some (probably less sophisticated) investors may believe that the macroprudential supervisor will use its regulatory powers to stop potential systemic risk before it causes financial instability. Second, other (probably more sophisticated and more cynical) investors may believe that the creation of a macroprudential supervisor that oversees all parts of the financial system signals a willingness by the government to extend the safety net to any part of the financial system that might threaten financial stability.

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