Federal Reserve Bank of Kansas City
What Can Financial Stability Reports Tell Us About Macroprudential Supervision
Jon Christensson, Kenneth Spong, and Jim Wilkinson Banking Research Department
Federal Reserve Bank of Kansas City
Presentation to the Research Conference on “Government intervention and moral hazard in the financial sector”
Norges Bank September 2, 2010
The views presented here do not necessarily represent the views of the Federal Reserve Bank of Kansas City or the Board of Governors of the Federal Reserve System
Federal Reserve Bank of Kansas City
• The financial crisis is spurring many reform ideas.
• One key idea is macroprudential supervision.
• Most central banks already perform a similar role through their financial stability reports (FSRs).
• Our paper looks at what FSRs can tell us about macroprudential supervision.
What Can Financial Stability Reports Tell Us
About Macroprudential Supervision
Federal Reserve Bank of Kansas City
• Overview of macroprudential supervision and FSRs
• Summary of the financial crisis
• Review of FSRs in five countries – UK, Sweden, the Netherlands, Spain, and Norway
• Evaluation of FSRs and their implications for macroprudential supervision
Outline of our Paper
Federal Reserve Bank of Kansas City
• Its goal is to ensure stability of financial system in its entirety – Crockett (2000) and Borio (2003)
• A systematic approach as opposed to an idiosyncratic one
• More attention to largest institutions, counterparty risk, and imbalances and shocks to economy
• New tool kit – indicators based on financial data, market prices, gaps, etc., and macro stress tests
What is Macroprudential Supervision?
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• Countercyclical regulatory policy – build up more capital, reserves, and liquidity in prosperous times
• Control of contagion risk – stronger supervision of systemic firms, significant counterparty
exposures, and financial infrastructure
• Discretionary policies – timely actions to address imbalances and large risk exposures developing in the financial system
Policy Steps under Macroprudential Supervision
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• Goal of FSRs is to promote financial stability by identifying risks, imbalances, and adverse trends that might threaten the financial system.
• Ideally, FSRs provide timely information that allows public authorities, financial institutions, and market participants to understand and
respond to such risks and imbalances.
• In 2005, almost 50 central banks published FSRs (Čihák 2006).
What are Financial Stability Reports?
Federal Reserve Bank of Kansas City
• Most FSRs look at three broad categories of
risk: (1) macroeconomic conditions or sectoral imbalances, (2) financial sector risks, and
(3) external or global risks.
• Among the approaches or tools FSRs use are financial indicators or ratios, market-based
indicators, qualitative indicators and analysis, and scenario and stress testing.
What are Financial Stability Reports?
Federal Reserve Bank of Kansas City
• Long period of prosperity led to a substantial underestimation of the inherent risks in many financial activities.
• Initial impetus was declining house prices in US and some other countries and collapse of subprime mortgage market.
• These events cast doubt on the value of many financial instruments and the condition of
financial institutions.
Overview of the Financial Crisis
Federal Reserve Bank of Kansas City
• Through a variety of channels, the crisis
spread globally, creating liquidity, capital, and public confidence problems and leading to
breakdowns in financial markets and bailouts of large institutions.
• The deterioration in financial markets further contributed to more general economic
problems.
Overview of the Financial Crisis
Federal Reserve Bank of Kansas City
Countries Effect on the Economy (OECD statistics)
Effect on the Financial
System Policy Actions
United Kingdom
6 Quarters of GDP decline, Unemployment increased
from 5% to nearly 8%
Significant losses at FIs, funding concerns, collapse of
several large FIs
Takeover of some FIs, central bank rate lowered and lending
liberalized, fiscal stimulus
Sweden
3 Quarters of GDP decline, Unemployment rose from
about 6% to 9%
Liquidity and longer-term funding issues, increase in
bank loan losses
Repo rate cut to .25%, state guarantee of bank liabilities,
more treasury bills issued
Netherlands
5 Quarters of GDP decline, Moderate rise in
unemployment
Losses on mortgage-related securities, collapse of Fortis
Fortis takeover, bank debt guarantees and capital
injections
Spain
6 Quarters of GDP decline, Unemployment increased
from 5% to 20%.
Liquidity and real estate lending problems, two takeovers of savings banks
Fiscal stimulus, deposit and debt guarantees, and bank
capital injections
Norway
Several Quarters of mild GDP declines, Moderate increase in
unemployment
Funding problems for banks relying on foreign sources,
declines in bank earnings
Central bank policy rate lowered significantly and lending increased, capital injections, bond exchanges
Table 1A - Effect of the Financial Crisis
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Country Low interest rates/spreads
Increasing Asset Prices
Increasing Debt Levels
Trade Imbalances
Risks from the
U.S. Other Risks
United Kingdom
“if risk premia rose abruptly, asset prices would
fall sharply”
July 2006 FSR
Asset prices high relative to expected income
streams
Households strong in aggregate, but signs of stress
July 2006 FSR
“there is a risk of disorderly
unwinding”
July 2006 FSR
U.S. sub-prime market not large
enough to be systemic
April 2007 FSR
Large FI’s expanding rapidly with wholesale funds
Sweden
Risk premiums historically low—
risk of rapid price corrections
Dec. 2006 FSR
Rapid increases in house prices and debt cannot
continue
Dec. 2006 FSR
Property companies’
borrowing is at a high rate
Dec. 2006 FSR
Baltic current account deficits
substantial
Dec. 2007 FSR
Weakening of US economy expected to hurt
euro area growth
June 2008 FSR
Pronounced economic slowdown in
Baltics, financial infrastructure
Netherlands
Persistent risk tolerance reflected
in low credit premiums
March 2007 FSR
House prices outpace inflation by 5%
in early 2006
Sept. 2006 FSR
Household debt high when
compared internationally
March 2007 FSR
Disorderly cor- rection of global
imbalances not implausible
March 2007 FSR
Liquidity squeeze linked
to subprime crisis
Sept. 2007 FSR
Oil prices, complex credit
products, spillovers from U.S. and others Spain Added to a greater
risk appetite
May 2006 FSR
Trend of house price growth
still high
Household debt levels are a
concern,
U.S. negative savings rate and
trade deficit
Slowing real estate activity in
the U.S.
Use of whole- sale funding to replace deposits
Norway
Risk premiums historically low – increases vulnera-
bility to shocks
Dec. 2006 FSR
Growth in debt and asset prices may be source
of instability
June 2006 FSR
Household debt and house prices
at historically high levels.”
June 2006 FSR
Global trade and capital flow imbalances are
increasing.
June 2006 FSR
US housing market is a
source of uncertainty.
Dec. 2006 FSR
Commercial property, lower
capital under Basel II, avian
flu
Table 1 --What Risks Did the Countries Identify?
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Countries Financial Indicators and Ratios
Market Based Indicators
Qualitative Indicators, Surveys, and Specialized Data
Other Tests
United Kingdom
Ratio and trend analysis of global, corporate, household, and financial sectors
Extensive use of a range of market based data
Data on large FI counterparty exposures,
market and systemic risk surveys
Projected market values of mortgage-backed securities, modeling household distress, etc.
Sweden
Ratio and trend analysis of banks and their customers -- companies, households, and foreign borrowers
Price data on equities, bonds, real estate, CDS,
etc.
Household finance data, KMV expected default frequencies, risk survey
of market participants
Major counterparty failure, household debt servicing ability
Netherlands
Charts and tables of selected economic and financial data (More are on Bank’s website)
Selected charts on equity prices, CDS,
credit ratings, etc.
Bank lending survey
Housing correction, vulnerable households, avian flu, macro model of liquidity stress
Spain Trend and ratio analysis of
financial and regulatory data Used to a lesser extent Data on all loans over
€6,000 made in Spain
Comparisons with U.S.
mortgage markets, quality of Spanish MBS
Norway
Ratio and trend analysis of companies, households, and banks
Equity and real estate prices
Bank lending and liquidity surveys, counterparty exposure
survey
Gap indicator analysis, bank failure
probabilities, house price estimates
Table 2 -- What Did the Countries Use to Evaluate Risk?
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Country Type of Model Financial Institutions
Included Assumptions Used
in Stress Tests General Results
United Kingdom
Macro forecasting model – models added for household, corporate, and
banking sectors
Major UK banks
2006 severe scenario:
1.5% decline in UK GDP 25% drop in house prices 35% drop for com. prop.
Losses equal to 15% to 30% of Tier 1 capital (Used more qualitative approach after 2007)
Sweden Loan portfolio model Four largest banks
2009:1 Test – 2 years of annual loan losses of:
1.3% on loans in Sweden 10 % on loans in Baltics 30% on loans in Ukraine
All 4 banks still meet Tier 1 capital standard, but several have large capital declines
Netherlands Macro forecasting model -- individual banks also
run stress tests
Banks, insurance companies, and
pension funds
Varies by FSR – severe test included 2-year drop in GDP of 6.3% and home prices of 30%, unemployment at 9.7%
At large banks, Tier 1 capital fell by 4% points but remained well above minimum standards
Spain Credit risk model All depository institutions
4 consecutive declines in GDP similar to 1993 levels. 2 years before previous growth rate resumes.
Considerable increase in credit risk, but “would not jeopardize the strength of Spanish institutions.”
Norway
Macro model -- models added for household, enterprise, and financial
sectors
Five or six largest banks
Varies by FSR -- most severe test similar to last crisis and assumed sharp fall in exports, oil prices, and foreign funding
Banks have a capital shortage under most severe test, but
adequate capital in other tests
Table 3 - What Stress Tests Were Used?
Federal Reserve Bank of Kansas City
• The FSRs for our five countries provide a
systematic approach to tracking key economic and financial risks and are an important step in efforts to mitigate or respond to crises – which is the role we want macroprudential
supervision to play.
• These FSRs did succeed in identifying many of the risks and unsustainable trends behind the financial crisis.
Evaluation of FSRs and the Implications
for Macroprudential Supervision
Federal Reserve Bank of Kansas City
• But some of these risks were regarded as low probability events and several identified risks did not play a direct role in the crisis.
• Identifying the timing and magnitude of these risks and their effects on the financial system proved to be a greater, if not impossible,
challenge.
Evaluation of FSRs and the Implications
for Macroprudential Supervision
Federal Reserve Bank of Kansas City
• Several of the stress tests and other tests in the FSRs succeeded in capturing the capital needs of banks and the ensuing economic downturns.
• However, banks and public authorities may
not have heeded these warnings because some were described as low probability tail events.
• A key benefit of the FSRs is that they may
have given the central banks a better picture of financial markets and the type of assistance
needed during the crisis.
Evaluation of FSRs and the Implications
for Macroprudential Supervision
Federal Reserve Bank of Kansas City
“It is difficult to estimate the probability and price the risk of all possible outcomes in
financial markets. This particularly applies to events that occur rarely and have not occurred for a long time…In the long term, public
authorities have an important role to play in maintaining a collective memory of previous crises.” – Norges Bank’s May 2009 FSR
Evaluation of FSRs and the Implications
for Macroprudential Supervision
Federal Reserve Bank of Kansas City
• This experience with FSRs carries a number of implications for macroprudential supervision.
• First, it is unrealistic to expect macroprudential
supervision to be the missing piece in our ability to prevent the next financial crisis – a role many
politicians are now giving to it.
• There are dangers both from underestimating the treat of a crisis and from overestimating and
overreacting to such threats.
Evaluation of FSRs and the Implications
for Macroprudential Supervision
Federal Reserve Bank of Kansas City
• Macroprudential supervisors will need strong evidence to overcome political, public, and
industry pressures when attempting to curtail credit booms and asset bubbles.
• There must be a close linkage between those
analyzing the macro risks and those supervising.
• It may be even more important to have
macroprudential supervision focus on creating a financial system that is more resilient and less crisis-prone in the first place.
Evaluation of FSRs and the Implications
for Macroprudential Supervision
Federal Reserve Bank of Kansas City
• Macroprudential supervision is of much interest now with such recent steps as the European
Systemic Risk Board and the Financial Stability Oversight Council in the US.
• FSRs are a worthwhile exercise in identifying and monitoring important financial trends and
emerging risks and understanding financial
markets – which will also be essential elements in macroprudential supervision.
