Systemic risk:
Macroprudential, our unlovely new buzzword

The Holy Grail for bank regulators is a system to predict and forestall another banking crisis. They think they’ve found it with macroprudential policy. Will Cain isn’t so sure.

Government is the art of looking for trouble,” Groucho Marx once pithily observed, “finding it, misdiagnosing it and then misapplying the wrong remedies.”

He might have been talking about the art of regulation. For there’s no shortage of experts, it seems, who, rather like Groucho, are distinctly sceptical about whether macroprudential regulation will prove to be the right or wrong cure for the world’s fragile financial system.

Some think foretelling systemic risk is “like seismologists trying to predict the day and the magnitude of an earthquake along a fault line”. Others scoff that we’re striving for early warning of impending crises with models that are scarcely any better “than could have been produced with a dartboard and a suitable target”.

In spite of this weight of doubt, though, ‘macroprudential’ has become the new banking buzzword in the last 12 months and now seems set to become the finance industry’s new layer of regulation.

The Bank of International Settlements (BIS) is one of the strongest proponents of this new tier of banking regulation. In a February working paper, it argues that the recent financial crisis highlights the need to go “beyond a purely micro approach to financial regulation and supervision”, and cites the growing volume of policy speeches, research papers and conferences now examining a macro perspective.

The paper quotes Adair Turner, chairman of the Financial Services Authority, calling for a new set of macroprudential policy tools to enable the authorities more directly to influence the supply of credit. “These tools are needed,” he says, “because credit/asset bubble price cycles can be key drivers of macroeconomic volatility and potential financial instability.”

The Basel Committee on Banking Supervision, a division of the BIS, proposes in the Basel 3 capital rules announced last September that, as well as increasing the amount and quality of capital held, it would also add a new counter-cyclical capital buffer to banks’ capital requirements.

This amounts to between 0 and 2.5 per cent of a bank’s assets but would only need to be carried by banks where regulators believed excess lending was leading to the build-up of pressures in the general economy which amounted to “systemic risk”.

This buffer is designed to smooth out extremes in economic and credit cycles by leaning against the prevailing economic conditions. If it is implemented, it would require all banks operating within a regulator’s remit to raise additional capital of up to 2.5 per cent of risk-weighted assets within 12 months of its order. This, as well as reducing banks’ ability to lend in the future, provides an immediate signal to the market that the action is being taken to head off overheating economies and asset bubbles.

The BIS’s definition of macroprudential regulation, then, is a set of additional tools to control financial regulation at an economy-wide rather than individual institution level.

Its working paper* explains the key difference between macroprudential and microprudential regulatory objectives. The aim of macropudential policy is to avoid the macroeconomic costs linked to financial instability.

Microprudential policy focuses primarily on consumer protection to investors, depositors and regulation of individual banks.

But not everyone is convinced about the need for this extra layer of regulation.

One agnostic is Professor Ian Harper, a director of Australia-based consultancy Access Economics and a member of the Wallis committee that redesigned Australia’s financial system in the late 1990s.

He sees little difference between the introduction of macroprudential regulation and the prudential policy tools already available to regulators across the world. While no formal mechanism exists in Australia to regulate in the way the BIS suggests, he argues the Australian Prudential Regulatory Authority (APRA) is able to increase capital ratios for individual banks and to make lending directives, though this is conducted through private rather than public disclosure.

Harper also argues that macroprudential regulation is nothing new. One of the primary concerns of existing monetary policy is to try and stabilise the economy and financial system by manipulating the interest rate, keeping inflation in check and preventing the growth of imbalances. But, since central bankers were unable to predict the financial crisis, he says, it’s unlikely any sort of macroprudential authority would have been able to either.

“There is an inconsistency,” he declares. “We can’t predict the future with any great accuracy. We know when the tinder is dry but what we don’t know is when someone’s going to flick a match in there or there’s going to be a lightning strike which sends the whole place up.”

This is the inherent tension, he argues, with macroprudential regulation: it requires that regulators can accurately predict what will happen, something they have repeatedly proved unable to do.

An International Monetary Fund report published in February** highlights this challenge. It examines two models’ ability to predict economic crises: the IMF’s own Developing Countries Studies Division (DCSD) and the Kaminsky, Lizondo and Reinhart (KLR) model.

It concludes that both models were statistically significant predictors of crises – but only to the degree that “they are likely better than could have been produced with a dartboard and a suitable target”.

Overall, it concludes, “these results reinforce the view that Early Warning System (EWS) models are not accurate enough to be used as the sole method to anticipate crises. However, they can contribute to the analysis of vulnerability in conjunction with more traditional surveillance methods and other indicators.”

Charlie Bean, the Deputy Governor of the Bank of England, is also a sceptic.

“The moral from this [the financial crisis] is that one should not expect to be able to predict the timing and scale of these sorts of events with any precision.

“But financial institutions and policymakers could – and should – have been more alert to the vulnerabilities that were building during the years leading up to the crisis and therefore to the possibility of a major shock to the financial sector and to the economy more generally.

“It is somewhat analogous to seismologists trying to predict earthquakes along a fault line. It is impossible to predict the day and magnitude of a shock with any precision, but it may be possible to say something about the likelihood of an earthquake occurring within a given period from seismic measurements and indicators of latent stress.”

* Macroprudential Policy – a literature review
**Assessing Early Warning Systems: How Have They Worked in Practice

Back to Special Report contents
Back to Magazine contents