Need for Macroprudential Regulations on Financial Institutions

The global nature of the 2007–08 financial crisis highlighted the need for macroprudential regulations. Traditional prudential regulation concerns the factors that affect the stability of individual institutions, while the newly emphasized aspect of prudential regulation—macroprudential regulation—concerns the factors that affect the stability of the entire financial system.

One need for implementing macroprudential regulations is that the presumption that regulators can safeguard the entire system by securing individual institutions is not necessarily true, as indicated by the 2007–08 crisis. Another observation is that excessive risk taking was suspected from rising leverage levels despite the fact that the risk-weighted capital ratios were maintained at the required regulatory level.

Financial problems that primarily stem from the temporary liquidity issue could lead to solvency issues. The general understanding regarding “insolvent” financial institutions is that the going concern value of such institutions does not exceed the expected value of their liabilities. Under a stressed market condition, liquidity issues affect valuation and, sometimes, liquidity is highly related to the solvency of particular institutions. This is especially true if the concerned institution is highly leveraged.

I am also reminded of the lessons learnt from the 1998 experience of Long-Term Capital Management. When one institution holds a sufficiently large position, it can create common exposures that put the system at risk, and when transactions occur bilaterally, as they do in OTC markets, the failure of one individual or institution can, through linkages across firms and markets, generate joint failures.¹⁴

Proposals to mitigate the risks arising from common exposures focus on the implementation of a systemic capital charge (SCC). Implementing such a scheme requires a measure of systemic risk and an understanding of the marginal contribution of each institution to the overall system. As discussed by Brunnermeier et al. (2009), the nature of the regulation applied to an individual financial institution crucially depends on how “systemic” its activities are, with regard to its size and degree of leverage, and the interconnectedness to the rest of the system. One way to mitigate the possibility of systemic risk is for bigger or more interconnected players hold more capital and have lower leverage; this is in effect, taxing size to create a level playing field from a system-wide perspective. Again, the challenge lies in choosing the appropriate measures of effective size or interconnectedness.

All these concerns justify introducing some form of regulation for financial leverage, one measure of which would be the non-risk-based measures suggested in the G-20 statements issued in April 2009. In this regard, it should be emphasized that a change in leverage appears to be a more relevant indicator than the level of the leverage itself, since the latter differs significantly according to the business models of the different types of financial activities (Table 5). A well-designed approach should be adopted toward the dynamic change in leverage. Failed, merged, or supported institutions, such as Bear Sterns, Lehman Brothers, Merrill Lynch, Citigroup, and UBS, have shown significant increases in their gross leverage ratio. Although this measure by itself is obviously not enough to monitor the soundness of financial activities of each institution, it apparently provides some additional information about the risk profile of the financial institutions.

In a complicated financial system, it is unrealistic to expect that only one specific measure such as risk-weighted capital ratio could detect any risk of financial fragility. I definitely need a mix of several measures focusing on the soundness of the system to cover all types of financial institutions. Table 5 [ PDF 21.9KB | 1 page ] suggests the possibility of an additional complementary measure to gauge the riskiness of the institutions although further research is required to estimate the appropriateness and feasibility of its implementation.

A macroprudential policy generally refers to the policy tools that are confined to financial regulations and that do not include monetary policy. Specifically, tools control the capital adequacy ratio, growth of loan extensions, and restrictions on an institution's portfolio. For a national economy, credit growth may be constrained against the historical averages, and/or relative to the gross domestic product (GDP). In this regard, the figures to measure the aggregate leverage of the total domestic banks should be carefully monitored for detecting the signs of a systemic crisis.

An example is shown in Table 6 [ PDF 81.3KB | 1 page ] that is compiled from the Irish macroeconomic data. In Ireland, as Table 6 shows, the leverage ratios of the aggregated major banking sector increased from 11.9 in 2000 to 21.6 in 2008 as the boom accelerated. The ratio of the major banks' total assets to nominal GDP also rose from 1.8 times to 5.35 times between 2000 and 2008. Since the current Irish financial crisis was basically brought about by the classical bust of the property bubble and not by a new innovative product such as CDOs, this type of leverage figures may be useful to check the typical bubble-bust type of crisis. It is not clear whether this could be applied to the US case where the types of financial institutions are more diverse.

It is important to note that one of the most pressing tasks is the proper consolidation of the balance sheets of financial institutions. The 2007–08 financial crisis clearly exposed the risks created by the shadow banking system that was spun off by regulated institutions. Therefore, the first order of business in improving capital management is to bring all of these entities, including structural investment vehicles and the like, within the regulatory framework to ensure that appropriate capital is held against all obligations of the financial institutions. This will provide a more accurate picture of an institution's exposures.

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