The institutions of the European Union play an important role not only with respect to the legal acts they can apply, but also in terms of external control. The primary objective of the MNB is to achieve and maintain price stability, and it employs monetary policy instruments to achieve this goal. However, without prejudice to this primary objective, the MNB maintains the stability of the financial intermediary system, and supports the enhancement of the resilience of the financial system and its sustainable contribution to economic growth.
The macroprudential policy of the MNB, aimed at maintaining stability across the financial intermediary system, is conducted in consistency with these objectives. Within the organisation of the MNB, the Monetary Council MC establishes the strategic framework regarding macroprudential policy, while the body responsible for the actual definition and achievement of specific macroprudential policy objectives is the Financial Stability Board FSB.
In addition to macroprudential analytical and regulatory tasks, the FSB is responsible for tasks related to microprudential policy and consumer protection, and for decisions relating to the supervisory and resolution authority tasks. Moreover, the FSB provides, as appropriate, the tripartite forum composed of the MNB's organisational units performing the central banking and supervisory duties and the ministry in charge of the regulation of the capital and insurance markets, where preparations for and — if needed — the management of crises is conducted.
The Hungarian financial stability institutional system. The management of systemic risks essentially consists of three main phases. The first step in the regulatory cycle is risk analysis, as part of which the MNB identifies existing and potential systemic risks. The selected policy response is evaluated in the next phase, also taking into consideration internal and external information.
A scheme of objectives is defined in each phase, based on which decisions regarding macroprudential policy are made. This paper interprets financial instability as the widespread disruption of financial flows. Ferguson's definition is unsatisfactory because it confuses cause divergence of prices from fundamentals with effect the resulting distortion of financial markets, credit availability, and aggregate spending.
But a definition of this kind is helpful because it emphasizes that for a financial event to by systemic it must have a major impact on household and corporate expenditure and also because it reminds us of the possibility that systemic financial problems can affect many forms of financial intermediation, not just bank lending.
They can also arise in foreign-exchange markets and in the markets for government bonds, corporate bonds, equities, and derivatives. The definition used here is based on the definition of a systemic event financial or non-financial provided by Besar et al.
Systemic events need not just be financial Besar et al. Any widespread disruption to financial flows would count as a systemic event according to their definition. CoVar is defined as the covariance of the returns on an institution's portfolios with the returns on other institutions, conditional on a systemic financial event having taken place.
This can be measured using CoVar. But it is not easy to make the concept of CoVar operational, since we need both to identify the magnitude of the external shock that will create endogenous risk and then quantify the resulting increase of correlation. With this relatively narrow definition, how then do we model and understand financial instability? Just as we need to add frictions to standard models in order to create a role for monetary policy, we also have to introduce the possibility of contractual incompleteness and contractual failure, in order to create the possibility of financial instability.
If inter-temporal financial contracts are always available and always fulfilled, then there is no need for financial intermediaries or financial intermediation and no possibility of widespread disruption of financial flows. Individual borrowers might make mistakes about prospective incomes and the inter-temporal allocation of their expenditures.
But such outcomes would not create any disruption to financial flows nor be of any macroeconomic concern. This indicates that we can think of a sequence of models, of increasing complexity, successively allowing for nominal rigidities and financial frictions.
The first and most basic model is the pure flex-price equilibrium, the standard setting for thinking about general equilibrium and an appropriate model for thinking about real issues, such as long-run productivity growth and the trend of potential output. This is the standard Arrow-Debreu general equilibrium set-up, although it can be extended to incorporate a role for public policy, for example through the introduction of public goods or of investment externalities.
The standard model can be generalized by introducing wage and price frictions and possibly also financial market frictions , resulting in a model in which nominal variables matter, one with more realistic macrodynamics and a role for expectations, and one in which inflation needs to be kept under control.
It is in this setting—that of dynamic stochastic general equilibrium—that monetary policy is no longer neutral and a policy regime such as inflation-targeting can be analysed.
But in this setting financial flows and financial intermediary balance sheets do not have any independent macroeconomic impact. It is possible to extend such models to incorporate financial flows and financial institution balance sheets, but there is no possibility of disruption of financial flows.
The third set of models not only has wage and price frictions, but also a more explicit modelling of financial intermediation with the possibility of financial instability: of widespread disruptions of financial flows, and of system-wide liquidity crises and solvency crises.
This is the setting where the possibility of endogenous risk arises and further macroprudential policy instruments may have a role. Introducing these processes into models of macroeconomic behaviour is a largely undeveloped field of economic modelling.
In order to model a disruption of financial flows, it is not enough just to introduce financial contracts or financial institutions into standard models as for example in the financial accelerator of Bernanke et al.
Microfinancial frictions of this kind create a linkage between the private-sector corporate or household net worth or the value of collateral assets and the cost of external finance, but the resulting external finance premium itself behaves in an orderly manner, altering smoothly down and up in economic expansions and recessions.
Similarly modelling macro-banking instability requires more than introducing a banking sector into standard dynamic macroeconomic models. What, then, can trigger widespread disruption of financial flows? As documented by Reinhart and Rogoff , virtually all financial crises have been associated with large-scale and ultimately unsustainable increases of indebtedness. Widespread availability of credit can lead to substantial rises and subsequent correction of asset prices.
Shiller makes a more general case for believing that wider social and cultural mechanisms can also fuel asset price bubbles. But asset price rises do not always cause financial instability.
Calvo and Loo-Kung have even argued that asset price bubbles and economic fluctuations are economically beneficial, encouraging socially worthwhile innovation in booms and allowing the removal of unwanted capacity in downturns. In any case, the correction of such departures from fundamentals need not necessarily have much impact on financial flows and expenditure for further discussion see Collyns et al.
Yes, the emergence and subsequent correction of asset price bubbles is likely to have a substantial distributional impact, with major losers those who have bought into the bubble at a late stage as well as major gainers those who have bought early. But there is little clear evidence that stock prices, for example, whether rising or falling, have any major direct impact on financial flows or aggregate demand.
But property prices in comparison to stock prices typically rise and fall relatively gradually. Once again this should not necessarily lead to disruption of financial flows. There was no obvious reason to expect the magnitude of disruption to financial flows and expenditure that was to take place in and , once US house prices began to fall. What mechanisms then lead to the end of a credit and asset price boom triggering a widespread disturbance of financial flows, especially of bank credit?
How are these mechanisms to be analysed? Such studies focus on the fact that systems which appear to be in a stable equilibrium state can collapse after what seems to be a small shock. This is a property of complex adaptive systems in various contexts, including ecology and epidemiology. For applications to banking see, for example, Nier et al.
His discussion emphasizes two aspects of network interconnections in the financial sector, namely complexity and lack of diversity. Connections within the international financial system have become increasingly complex over time and characterized by the increasing importance of a small number of nodes large global institutions that are connected to a large proportion of other nodes other financial institutions. Also and increasingly, the portfolios of financial institutions have become less diverse, with the transfer of risk resulting in large common exposures.
He argues that the risk of destabilizing reaction can be reduced by various measures, including putting in place a system to map the global financial network, appropriate control of the failure of large, interconnected institutions, and more widespread implementation of central counterparties and intra-system netting arrangements, to reduce the financial network's dimensionality and complexity. While the importance of network interactions as a source of financial instability is now widely recognized, modelling and quantifying these phenomena is a considerable challenge.
Standard macroeconomic modelling relies on linearization around steady-state solutions. This is a natural approach to the modelling of monetary transmission but unhelpful for understanding financial instability, because the mechanisms that disrupt flows of financial intermediation are inherently non-linear, having little impact on a small scale but becoming much more powerful on a larger scale. The resulting models have inherent limitations.
Financial instability is not only triggered by network complexities, but also by the reversal of an unsustainable build-up of debt and asset prices. This implies that assessing the risks of such a crisis taking place requires us simultaneously to model both financial networks and macroeconomic balance sheets and asset pricing.
Despite recent advances and many new insights, this remains a largely undeveloped field of economic modelling and is a long way from providing a reliable basis for forecasting and risk-quantification. While we do not have precise models, we can examine retrospectively the macroeconomic mechanisms and network vulnerabilities that resulted in the massive disturbance of financial flows in the recent crisis. The discussion here focuses on the network vulnerabilities within the financial sector rather than on the global imbalances of savings discussed in more detail by Collyns et al.
At the heart of the crisis was the rapid growth and extensive securitization of US sub-prime residential mortgage lending. Milne a , Table 2. There were a number of closely related mechanisms that amplified the impact of sub-prime losses on the global financial system. Here are three such vulnerabilities.
The first was the high degree of financial institution leverage, relative to the magnitude of their risk exposures. Financial institutions engaged in wishful thinking, using apparently sophisticated statistical models and risk-transfer techniques to persuade both themselves and financial regulators that the potential risk exposure was low and they could operate with relative low levels of capital.
But these models were estimated using relatively short runs of data from an atypical and relatively benign period. Then, when the unexpected risks materialized, they were unable to absorb them without reducing lending or selling assets.
A major contributing factor to this excess leverage was the widespread underestimation of correlations in the loans underlying the new structured credit securities, used to finance the global credit expansion. Banks holding these securities, as well as the rating agencies, insurance companies, and regulators assessing their risk, all made the same mistake.
They failed to appreciate that in the event of a large common shock, many tranches of these securities, that in more normal economic circumstances would be expected to repay in full, would default and return little or nothing to investors. Their assessment of this correlation risk was based on data drawn for a period of only a few years, a period in which correlations of house prices and mortgage and other loan defaults were relatively low for example, there was no nationwide fall in US house prices.
The re-assessment of correlation of default revealed that many of these securities were much riskier than previously thought, and created a loss of investor confidence in the entire asset class. The second vulnerability was unstable short-term funding. Instead of bank lending being financed by retail deposits, or from the issue of long-term securities bonds and equity , banks relied on short-term, unsecured wholesale borrowing or on the packaging of loans into securities so that they could be financed through collateralized borrowing in repo markets or through the issue of asset-backed commercial paper ABCP by off-balance-sheet vehicles.
Much of this intermediation operated through a parallel system of banking and ended up in the trading portfolios of the large investment banks, such as Bear Stearns, Merrill-Lynch, UBS, and others; in the investment portfolios of many European banks with an excess of retail deposits to invest; and also held by the two giant US government-sponsored enterprises, Fannie Mae and Freddie Mac.
The third vulnerability was the unappreciated extent of counterparty risk. For securities held in trading books or as investments, it became standard practice to purchase insurance against the possibility of either mark-to-market or cash-flow credit losses. On the face of it, it seemed like prudent housekeeping, to hedge risks and to lock in profits. But in practice the insurance was illusory because the sellers of this insurance, while claiming large profits from the premiums they received, had far too little capital to honour their promises in the event of a large aggregate shock.
Several other factors increased the susceptibility to systemic financial collapse. In the crisis all of these processes appear to have been at work, leading to a cumulative collapse in liquidity and sharp falls in the valuations and trading volumes of the new structured credit instruments. The resulting weakening of bank balance sheets also led to reduced lending and so worsened the macroeconomic downturn and further undermined bank balance sheets.
These feedback loops culminated, after the failure of Lehman Brothers in September , in the collapse of wholesale money markets and a major global contraction in both credit availability and in household and consumer expenditure. According to the IMF , the resulting impairment and write-downs on bank credit exposures will rise to 2. The initial disturbance and its global financial impact are illustrated by Figures 1 and 2 updated from Milne, a.
Figure 1 shows the peaking and then steady decline of US house prices, and how this in turn triggered, first, a collapse in the price of sub-prime mortgage-backed securities measured by the ABX indices and subsequently of bank share prices. Figure 2 shows how this also produced major stresses in short-term money markets, as revealed by the spreads, between unsecured and collateralized 3-month borrowing rates.
Eventually these stresses have abated, helped by government and central bank support for the financial system and exceptionally loose fiscal and monetary policy, but still normal relationships between interest rates have not been fully restored. There have been many policy proposals for preventing a recurrence of anything comparable to the recent global financial crisis. Among the most prominent have been the Geneva Report Brunnermeier et al.
The Geneva reports focuses on the tendency for both internal risk controls and regulatory capital requirements to become increasingly lax in credit booms, and the tendency for maturity mismatch and leverage to increase in periods of credit expansion. Download Citation Data. Share Twitter LinkedIn Email. Working Paper DOI As another example , in a microprudential framework, the ability of a bank to increase its capital to meet regulatory requirements is seen as favorable, without regard to how this is accomplished.
But a bank that needs to increase its capital ratio measured as a percentage of its asset can either raise new capital or decrease assets loans. When bank losses are increasing because the economy is weak and bank capital ratios are falling, the difference between the two approaches is consequential.
If every firm were to decrease assets instead of rais e capital, th at action would lead to a substantive contraction of credit and cause the economy to weaken further. A macroprudential approach, in contrast, would assess and control for the mechanism that banks would implement to reach their required capital ratio , essentially encouraging them to raise capital rather than pull back on lending.
The annual supervisory bank stress tests performed by the Federal Reserve have both microprudential and macroprudential elements. At their core, they ensure that each bank has sufficient capital to survive a very deep recession.
But banks also are required to assume they will continue to lend in that recession and cannot plan to meet capital requirements by shrinking their assets. Moreover, the stress tests specify macroeconomic scenarios to be more severe when the economy is expanding to offset a natural tendency to predict losses will be low because recent default rates have been low.
A recent paper looks at how the macro scenarios and assumptions about dividends and share repurchases in the stress tests work to reduce procyclicality of capital requirements. L imiting material vulnerabilities in the financial system is especially important now in the U.
Monetary policy works by in creasing borr owing, but it may also incentivize greater risk-taking by banks and other lenders as rising asset prices and low volatility relax capital requirements and risk management standards. When protections against the costs of excessive risk-taking are in place, monetary policymakers have more freedom to set policy without raising the risk that they may be contributing to an unraveling of the financial system and a deep recession down the road.
Macroprudential tools can be structural or cyclical. Structural policies are implemented to build lender or borrower resilience to adverse events at any point in the business cycle. For example, the additional capital charges for G-SIBs are a structural tool. In other countries, l imits on loan-to-value ratios LTVs or debt service — to — income ratios DSTIs for mortgage borrowers are example s of structural tool s that have been applied to borrowers.
These limits can be macroprudential when they are intended to not only protect an individual borrower from too much debt, but to protect home values in neighborhoods from falling sharply because many borrowers have trouble making th eir payments at the same time.
Bank borrowers for p roperties with high values could get mortgages with LTV ratios ranging from 40 percent to 60 percent , while they could get mortgages with higher LTV ratios, up to 70 percent, for properties with low values. Cyclical policies are aimed at increasing resilience in anticipation of an economic downturn to lessen the reduction in the supply of credit once the downturn materializes.
The countercyclical capital buffer CCyB is an example of a cyclical policy.
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