Macro ‐ Prudential Policy: th d b t the debate and some d implications for New Zealand implications for New Zealand Prasanna Gai Prasanna Gai University of Auckland
NZ financial stability (IMF May 2011) NZ financial stability (IMF, May 2011) – Banks’ key vulnerabilities are their exposure to highly indebted Banks’ key vulnerabilities are their exposure to highly indebted households and farmers together with their sizable short ‐ term offshore borrowing. Prudential measures and market pressures have led to a reduction in banks’ sizable short ‐ term wholesale borrowing. g – New Zealand’s large net foreign liabilities expose it to a possible rise in long ‐ term interest rates as a result of high funding requirements of g f g f g q f banks and sovereigns in advanced economies. – The authorities should continue to strengthen their stress testing of g g f banks and consider the merits of gradually raising bank capital to levels well above the Basel III requirements. – Staff recommended explicitly including funding risk in future scenarios, encompassing a disruption to bank funding and a large increase in longer ‐ term interest rates. The latter could come from a rise in global rates and an increase in New Zealand banks’ risk premium rates and an increase in New Zealand banks risk premium.
NZ bank funding NZ bank funding
Roadmap Roadmap • The state of the macro ‐ prudential policy debate Th t t f th d ti l li d b t • Some challenging issues S h ll i i – Do solutions like the CFR reduce financial instability? – How do financial shocks translate into real activity? – Do stress tests properly handle systemic externalities? – How do we attenuate risk illusion? • Concluding observations
State of the debate (1): the meaning of macroprudential policy • Commonly interpreted as system ‐ wide prudential policy policy • Care about the dynamic resilience of the financial system • Two aspects: procyclical (time series) and resilience (cross ‐ sectional) ( ) • Traditional macro policy instruments may have a role • Traditional macro ‐ policy instruments may have a role to play
State of the debate (2): cycles in financial variables • Key exemplar: The leverage ‐ margin ‐ liquidity cycle in financial (and housing) markets ↑ optimism →↑ asset prices and financial market liquidity →↓ haircuts, margin requirements →↑ leverage • Why? – Advent of market ‐ based intermediation – Prevalence of universal banking – Richer interlinkages between retail banks, i ‐ banks, broker ‐ dealers dealers
State of the debate (3): system resilience • Financial systems display characteristics of a i i l di l h i i f complex adaptive network – robust ‐ yet ‐ fragile, pre ‐ disposed to tipping points – feedback behaviours that amplify initial shocks (liquidity hoarding and asset firesales) (li idit h di d t fi l ) – sensitive to diversity (risk management and search for yield) yield) • Significant real consequences when they break Si ifi t l h th b k down
The basic externality (1) The basic externality (1) • Individual agents do not take the spillover effects Individual agents do not take the spillover effects – on system stability – of their financial actions into account, e.g. – firesale externalities – liquidity hoarding(*) – location/size in the network – “local think” or ignorance of tail events – (over ‐ )borrowing • Spillover effects on resource allocation are also ignored ignored.
The basic externality (2) The basic externality (2) • Solutions are Pigouvian in spirit – taxes or l i i i i i i constraints (static, state ‐ contingent, time ‐ varying) – systemic capital/liquidity surcharges – levy on non ‐ core deposits – changes to haircuts g – core funding ratios • Quantities or prices?
CFR and dynamic resilience (1): probability of funding contagion 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 0 10 20 30 40 50 60 70 80 90 100 Average degree (i.e. connectivity) Frequency of systemic hoarding (Geometric baseline) Extent of systemic hoarding (Geometric baseline) Frequency of systemic hoarding (Geometric with Core Funding Ratio) Extent of systemic hoarding (Geometric with Core Funding Ratio)
CFR and dynamic resilience (2): time ‐ varying policy 1 1 0.9 0.8 0.7 systemic hoarding 0.6 0.5 Frequency of s 0.4 0.3 0.2 0 2 0.1 0 25 25 20 20 15 15 10 10 5 5 0 0 Initial aggregate haircut (h) Baseline Under Core Funding Ratio
Financial crises and real activity (1) Financial crises and real activity (1) Changes in per Capita Variables for the 2007 ‐ 2009 Recession Ch i C i i bl f h 200 2009 i (percent) Output Consumption Investment Employment Hours United States ‐ 7.2 ‐ 5.4 ‐ 33.5 ‐ 6.7 ‐ 8.7 Canada ‐ 5.1 0.9 ‐ 15.3 ‐ 0.3 ‐ 4.8 New Zealand ‐ 5.3 ‐ 3.4 ‐ 20.9 ‐ 1.5 ‐ 5.9 Source: Ohanian (2010), Bank of Canada, RBNZ.
Financial crises and real activity (2) Financial crises and real activity (2) Quarterly Hours worked per capita Total hours worked as a ratio of the total working population Hours/quarter 400 400 380 360 340 320 300 280 260 240 220 200 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 Canada US New-Zealand Source: National Statistical Agencies Last observation: 2010Q4
Household Credit Growth year-over-year % 20% 20% 15% 10% 5% 0% -5% 1990 1990 1992 1992 1994 1994 1996 1996 1998 1998 2000 2000 2002 2002 2004 2004 2006 2006 2008 2008 2010 2010 Canada US New-Zealand Source: National Central Banks Last observation: 2010Q4
Stress testing (1) Stress ‐ testing (1) • Stress ‐ tests usually scale up adverse macroeconomic S ll l d i shocks (e.g. unemployment=10%, commercial property declines=45%) declines=45%) • But feedback effects mean that smaller shocks could • But feedback effects mean that smaller shocks could have major consequences – network domino effects network domino effects – distress firesale of assets – macroeconomic feedbacks on default probabilities from macroeconomic feedbacks on default probabilities from the withdrawal of credit – funding risks
Stress ‐ testing (2): A hypothetical exercise Euro area stress test (2010) assumed a drop in the value of major • equity indices of 20% under the adverse scenario, which translated i t into a haircut of 36% of equity exposures [ “firesales ” ] h i t f 36% f it [ “fi l ” ] Availability of credit to firms in the UK fell by 20% following y y g • Northern Rock [ “macroeconomic feedbacks” ] • LGD on interbank exposures of 100% Capital buffers vary 4 ‐ 24% LGD on interbank exposures of 100%. Capital buffers vary 4 24% • Network calibrated on 17 UK banks in the core and 240 foreign banks loans size and connections calibrated with BIS banking data banks, loans size and connections calibrated with BIS banking data. 50,000 firms, corporate PDs calibrated to Moodys data 1930 ‐ 2006. • Question: how big would an initial macroeconomic shock need to be to deliver calamitous results?
Stress testing (3) Stress ‐ testing (3)
Stress ‐ testing (4): adding funding liquidity risk 19
The problem of risk illusion (1) The problem of risk illusion (1) • Improved beliefs about macroeconomic prospects can give rise to risk illusion and p p g bring about “search for yield” like behaviour • A serious policy problem: How to limit tendencies to engage in “local think”/ “group think”? Can we encourage diversity in think ? Can we encourage diversity in business lines and risk management practices?
The problem of risk illusion (2) The problem of risk illusion (2) Shock to Slope of the Yield Curve Shock to Risk Illusion Response of Risk Illusion Response of Securitization/bank credit outstanding % % 0.0009 0 0009 0.0100 0 0100 0.0008 0.0080 0.0007 0.0060 0.0006 0.0040 0.0005 0.0004 0.0020 0.0003 0 0000 0.0000 0.0002 -0.0020 0.0001 0.0000 -0.0040 1 2 3 4 5 6 7 8 9 1011121314151617181920 1 2 3 4 5 6 7 8 9 1011121314151617181920 1 2 3 4 5 6 7 8 9 1011121314151617181920 1 2 3 4 5 6 7 8 9 1011121314151617181920 95% confidence interval 95% confidence interval Source: Authors Calculations Source: Authors Calculations
Concluding observations (1) Concluding observations (1) • The central bank as risk manager Th l b k i k Vulnerabilities highlighted by the IMF are quite real. As the global outlook worsens, macroprudential measures will be key Swap ‐ covered funding has risks will be key. Swap covered funding has risks Banks do not internalise funding liquidity risks to a s do ot te a se u d g qu d ty s s to society as a whole. CFR a wise move and should be time ‐ varying. A complementary menu of instruments could also be developed and deployed could also be developed and deployed. “War games” and (dynamic) stress ‐ testing ought to be War games and (dynamic) stress ‐ testing ought to be moved up the agenda
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