Systemic Stability Regulation: Principles

We propose that each country should establish an effective, powerful systemic stability regulator that is in charge of crisis prevention, management and resolution. Using the methodology first presented by Carmichael and Pomerleano (2003) to address the role of a systemic stability regulator, this section presents a rigorous framework that systematically reviews the following four components:

• Objectives and mandates—i.e., what the stability regulator expects to achieve;
• Resources—i.e., the political backing, legal support, and human and financial resources to enable the stability regulator to carry out its objectives and mandates effectively;
• Implementation—i.e., the instruments, tools, and techniques that the stability regulator uses to achieve its objectives; and
• Structure and organization—i.e., the organizational structure of the stability regulator that is able to perform the delegated financial stability responsibilities in the most effective way.

3.1 Clear Objectives and Mandates of a Systemic Stability Regulator

Regulatory objectives and mandates are what the systemic stability regulator expects to achieve. When a systemic crisis takes place, financial authorities are forced to be intensively involved in managing and resolving the crisis. However, those actions take place after the onset of a crisis. One of the most important functions of the systemic stability regulator is to monitor, anticipate, and intervene prior to a crisis. Such an approach and methodology would aim to preserve systemic financial stability by spotting vulnerabilities in a country's financial system, so that, if necessary, actions could be taken in a timely and informed manner to prevent a buildup of systemic risk and an eventual crisis from occurring. The role of the systemic stability regulator would be to strengthen, not displace, examinations and supervision focused on individual institutions.

The major objectives and mandates can be summarized as:

• Monitoring systemic risks—such as large or growing credit exposure to real estate—across firms and markets;
• Assessing the potential for deficiencies in risk management practices, broad-based increases in financial leverage, or changes in financial markets and products, creating systemic risk;
• Analyzing possible spillovers between financial firms or between firms and markets—for example through the mutual exposures of highly interconnected firms;
• Identifying possible regulatory gaps—including gaps in the legal regime governing the insolvency of financial institutions—that pose risks for the system as a whole;
• Curtailing systemic risks across the entire financial system encompassing corporations, households, and capital inflows as well as arrangements for crisis management and financial institution resolution—through legislative action, prudential measures, advising on monetary policy, and intervention in individual institutions; and
• Issuing periodic reports on the stability of the financial system.

The stability regulator needs to have a clear mission mandate addressing expectations and responsibilities. It must conduct a macro-financial surveillance and take a macroprudential approach to supervision that addresses risks to the financial system as a whole in an effort to enhance economy-wide financial stability and prevent systemic crises. This would include the monitoring of corporate finance and household debt, which have implications for monetary policy and financial stability, as well as international banking flows which bear on systemic stability due to the risks of sudden stops.⁶

The stability regulator would also organize the immediate response to a crisis, the strategy for coordinated financial and corporate sector restructuring, and the orderly resolution of failed corporations and financial institutions. The stability regulator is thus charged with express responsibility for containing systemic risks in the financial system.

3.2 Sufficient Regulatory Resources to Fulfill Responsibilities

The systemic stability regulator needs sufficient political, legal, legislative, human and financial resources to carry out its objectives and mandates effectively. It would need substantial analytical capabilities and resources to identify the types of information needed, collect the required information, analyze the information obtained, and develop and implement the necessary policy, supervisory and regulatory response. The stability regulator should be allowed to obtain information from assessments and programs of the central bank (if the central bank does not have the full responsibility of systemic stability regulation) and other financial supervisors whenever possible. It would further need broad authority to obtain information—through data collection and reports or, when necessary, examinations—from a range of financial market participants, including banking organizations, securities firms, and key financial market intermediaries.

In some countries, the stability regulator might be able to rely on private companies (for example, credit bureaus and rating agencies) to collect corporate data or might assign this responsibility to bank supervisors. To collect the necessary data the stability regulator would have to operate in a system that provides the capacity to enforce compliance or exact a commensurate penalty when companies are found to be in violation of laws. This includes the authority to craft an orderly resolution of systemically important financial firms and benchmarks to limit leverage. Essentially, the stability regulator would require knowledge and expertise across a wide range of financial firms and markets to offer a comprehensive and multi-faceted approach to systemic risk.

3.3 Effective Implementation by the Systemic Stability Regulator

The systemic stability regulator should possess the entire implementation arsenal—the instruments, tools, and techniques to be used to achieve its objectives and mandates. These include macroprudential supervisory tools to reduce systemic risk, such as the ability to impose capital and liquidity requirements, limit leverage ratios, loan-to-value ratios and debt-to-income ratios, as well as setting the policy interest rate and introducing (or revising) legislation concerning insolvency regimes for nonviable financial firms.

The systemic stability regulator would need to set the standards for capital, liquidity, and risk management practices for financial firms, given the importance of these matters for the aggregate level of risk within the financial system. A comprehensive list of macroprudential measures is discussed in Borio and Shim (2007). Table 1 [ PDF 44.8KB | 1 page ] offers a partial list of such measures.

Boris and Shim (2007) suggest that macroprudential actions may be taken in a gradual, sequenced manner in the face of a buildup of vulnerabilities and systemic risk. For example, once a sign of built-up vulnerabilities is identified, a stability regulator would need to issue warnings. When vulnerabilities worsen but the problem is largely limited to a certain sector of the economy—such as commercial real estate and household mortgages—targeted tools could be mobilized, including sector-focused stress tests, tightening lending and underwriting standards, and limiting loan-to-value ratios and/or debt-to-income ratios. If the problem were to become more generalized and threaten systemic stability, then raising minimum capital requirements could be called for; and if the problem were built through markets and unregulated institutions, as opposed to banks, then tightening monetary policy by raising policy interest rates could be more effective.

Inadequate information, in part due to limited data capture—inadequate efforts and excessive parsimony in expenditures on human resources and databases—is possibly the biggest obstacle to adequate monitoring, analysis, and macroprudential supervision.

3.4 Effective Organization of a Systemic Stability Regulator

The organizational structure of the systemic stability regulator must be designed in the most effective way possible to carry out the delegated responsibilities of financial stability. The focus of the stability regulator should be on the macro-financial surveillance of the system, which is an analysis of an economy's macroeconomic and financial developments, as well as macroprudential supervision which is a top-down approach that helps assess sources of economy-wide risks. Such an organization would require political independence, credibility, and transparency as well as an adequate level of staffing, who possess knowledge, expertise, and experience across a wide range of financial institutions and markets.

An important issue is whether the systemic stability regulator should be a single entity or a collective effort among different national financial authorities, each with a different specific responsibility. Key financial authorities include: the central bank, financial supervisor(s), and the finance ministry. The central bank is critical to financial stability as the monetary policymaker to set the policy interest rate in response to the emergence of systemic vulnerabilities as well as the outbreak of a crisis, and as the lender of last resort to protect a country's payments system. A finance ministry should also be involved in stability regulation as crisis resolution invariably entails fiscal outlays—whose costs should be made transparent and accounted for explicitly in the fiscal budget.

First, a fully consolidated stability regulator, combining all the functions of central banking, financial supervision and regulation, and treasury—as in the case of Singapore—could be the ideal arrangement from the perspective of maintaining financial stability.⁷ This option requires the establishment of a new national agency in charge of systemic stability regulation, absorbing all the macroprudential functions and monetary policymaking from other authorities. However, because of the heightened emphasis on central bank independence, this model is not a realistic option for many developed countries.

The second option would be for the central bank to play the systemic stability regulator function by taking over macroprudential supervisory and regulatory powers. However, an argument can be made that a central bank is not in the best position to take sole responsibility of maintaining financial stability—as this responsibility requires much broader expertise and culture than traditional central banking. This arrangement could also expose the central bank to the risk of political interventions once the eruption of a crisis requires management and resolution policies.

The third option would be to establish a coordinated systemic stability regulatory council, comprising the finance minister, the central bank governor and the head(s) of national financial supervisors. An independent, powerful working group that supports this council, may be chaired by a reputable expert (like former Federal Reserve Chairman Paul Volcker) and include finance and central bank deputies, head(s) of supervisors and other relevant parties as active members, with authority to engage in crisis prevention, management, and resolution. The working group would provide recommendations for policy actions to the council which would make the ultimate decision. In this instance a country's central bank may assume a secretariat role, given its usual advantages in analysis of macro-financial surveillance for systemic stability.

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