Financial stability and macroprudential policy – an experiment at the expense of banks?
Macroprudential policy – a clumsy term, but a hugely important task. People can largely agree on what macroprudential policy is supposed to achieve: its overarching goal is to ensure financial stability. And financial stability is absolutely essential if an economy is to thrive, investment is to flow and capital movements are not to come to a standstill. Without financial stability – as the crisis of 2008/2009 showed – everything else is nothing.
Three institutions
What’s less clear, by contrast, and regulated differently across Europe as a result, is the question of who is responsible for macroprudential policy, what their toolbox looks like, and how far their radius of responsibility extends. In Germany, there is no single institution responsible for monitoring financial stability. There are three of them. In 2013 the German Financial Stability Committee (FSC) was established, on which the Federal Financial Supervisory Authority (BaFin), the Bundesbank and the Federal Ministry of Finance are equally represented. The FSC is based at the Finance Ministry, which provides the committee’s chair. It meets on a quarterly basis and issues warnings and recommendations that are adopted unanimously and then implemented by the institutions to which they are addressed.
Three institutions, that means threefold expertise of the highest level – but do these three cogs really mesh in such a way that they produce a policy that is coherent and appropriate for the German financial centre? This is open to question since certain conflicts of interest between those involved are obvious. But that’s not the only thing which is highly problematic from a banking perspective: the FSC seems to have focused its attention solely on the banking sector. The upshot is that stabilisation measures first and foremost target banks, further complicating their already difficult situation. If the end result were greater stability, it would be justified, but there’s a big question mark hanging over this, too.
The countercyclical capital buffer
Take the countercyclical capital buffer. The idea behind it is comparatively straightforward: in times of excessive lending growth, banks should build up an additional capital buffer to increase their loss-absorbing capacity. In times of crisis, banks are expressly allowed to draw on the buffer to help cushion their losses. The aim is to avoid the threat of a credit crunch. The level of the buffer is set by BaFin. After the FSC recommended increasing the buffer in the first half of 2019, BaFin raised the level from 0 to 0.25 per cent as of 1 July 2019.
Even this step was controversial, but the possibility of a further hike cannot be ruled out – at least not if you accept the argument of the Bundesbank in its most recent Financial Stability Report of 21 November 2019. The report gives the German financial sector good marks overall. But it warns once again that the risks in the German financial system are rising. There is concern that banks may be overestimating the value of collateral for loans, especially real estate collateral, due to the significant increase in prices for flats, houses and land in recent years. The Bundesbank’s conclusion: to guard against risks to financial stability, there’s a need for capital buffers that can absorb losses.
There are sound arguments against activating the countercyclical capital buffer again – the same ones, in fact, that applied last summer when it was first activated. The rise in real estate prices, for example, has already slowed thanks to the increase in new building and the high level of prices already reached. Apart from that, there’s no sign whatsoever that capital is being misallocated to build flats nobody needs. On the contrary, there’s still too little construction going on. A countercyclical capital buffer that succeeds in slowing down lending will only exacerbate the problems in the real estate and housing markets.
Banking sector in the spotlight
At least as important in this context: once again it’s the banking sector, and the banking sector alone, that’s in the macroprudential policy spotlight. And this despite acknowledgement both at national level and by the International Monetary Fund (IMF) that banks have become considerably more stable as a result of numerous regulatory reforms. The IMF, in particular, has said it sees the threats to financial market stability outside the banking sector.
The attempt to safeguard financial stability solely by strengthening the liabilities side of banks’ balance sheets is also problematic because this requires robust indicators for measuring macroprudential risk and robust evidence of the correlation between risk and regulatory capital. But this is precisely where macroprudential policy is still in its infancy. Even more than ten years after the financial crisis, macroprudential policy is still feeling its way forward with untested instruments in territory that is largely unchartered. Nor, incidentally, is much known about the effectiveness of the countercyclical capital buffer: we simply don’t have enough empirical knowledge about time lags and possible spillovers into the credit cycle.
A macroprudential policy focused almost exclusively on banks is like a drunk searching for his house key under a lamp post. Not because that’s where he lost it, but because it’s easier to search where it’s light. So is the search confined to banks just because they’re familiar, because they’re visible and because it’s simply too dark elsewhere? Whatever the reason, it’s the banks that end up landed with the costs.
Macroprudential policy versus monetary policy
The lopsided nature of the macroprudential policy pursued to date, with its sights on banks alone, is not structurally determined. A greater focus on other financial market players would be possible and would also lead to a more balanced policy. But there’s another area where contradictions and inconsistencies are inevitable – namely where monetary policy and macroprudential policy interact without any coordination and without it being clear where one begins and the other ends or what connection there is between the two in the first place.
To put it in a nutshell: the ultra-expansionary monetary policy in the euro area has led to extremely low interest rates, which has in turn increased the demand for riskier assets. In other words, the high prices in some asset markets in the euro area are partly due to ECB policy, so monetary policy is at least partly responsible for the increase in systemic risk in financial markets.
It’s a confusing situation: on the one hand, monetary policy has encouraged the flight into high-risk investments while at the same time radically eroding the banks’ earnings base, with negative interest rates, in particular, exerting strong cost pressure. On the other hand, macroprudential policymakers (including the Bundesbank) are trying to contain the resulting risks to stability by activating the countercyclical capital buffer, which will put further strain on banks’ earnings. An early monetary policy correction could have made this conflict much less costly.
The division of labour between monetary and macroprudential policy needs to be rethought. The question even arises: might monetary policy not be the better macroprudential policy to deal with growing risks to stability? Especially since the connection between financial and price stability is obvious: on the one hand, financial stability makes it easier to maintain price stability and, on the other, financial stability benefits from price stability. For monetary policy, this would mean that it should continue to focus fully on the objective of price stability. But financial stability would need to be a relevant factor to be considered in the design and proportionality of policy measures.
Transparency needed
For the time being, however, reality looks different. Whereas monetary policy has generally accepted targets, which are communicated in a comparatively transparent manner, the discussion before and after the activation of the countercyclical capital buffer reflects the teething problems still troubling macroprudential policy. The FSC could well be called a “secret committee” because neither the dates of its meetings nor their agendas are made public. Nor is there a regular press conference after meetings. How this is supposed to create confidence in macroprudential policymaking remains anyone’s guess. If macroprudential policy is to gain general acceptance, greater transparency and an understanding of the rationale behind decisions are absolutely indispensable.
Like their monetary policy counterparts, macroprudential policymakers should publicly explain their thinking by providing “forward guidance”. Only then will it be possible to have a substantive conversation about the development of systemic risks. An open and transparent macroprudential policy would change the demands on the players involved. A collective underestimation of risk due to the lengthy period of low interest rates would then doubtless have to be substantiated by publicly available and plausible facts.