This paper reviews policy tools that have been used and/or are available for policy makers in the region to lean against the wind and review relevant country experiences using them. The instruments examined include: (i) capital requirements, dynamic provisioning, and leverage ratios; (ii) liquidity requirements; (iii) debt-to-income ratios; (iv) loan-to-value ratios; (v) reserve requirements on bank liabilities (deposits and nondeposits); (vi) instruments to manage and limit systemic foreign exchange risk; and, finally, (vii) reserve requirements or taxes on capital inflows. Although the instruments analyzed are mainly microprudential in nature, appropriately calibrated over the financial cycle they may serve for macroprudential purposes.
I. Policy Instruments to Lean against the Wind in Latin America1
Emerging market economies (EMEs), including Latin America, currently face a juncture of easy external financing conditions that are conducive to credit exuberance, asset price bubbles, and excess demand booms, which increase the risk to a sudden reversal (IMF, 2011c). Appropriately managing the procyclicality of the financial system is thus a policy priority to avoid the emergence of financial excesses and vulnerabilities in the banking sector and, more generally, in other segments of the economy (Eyzaguirre et al, 2011; IMF, 2010a,b,c and 2011a,e).
However, the use of traditional macroeconomic policy instruments to confront such external environment may run into limits. For instance, monetary policy can be constrained as interest rate hikes to contain financial exuberance are likely to trigger more capital flows, which would stimulate financial and economic excesses. Foreign exchange intervention is likely to have only temporary effects and may, at the same time, impose large quasi-fiscal costs (IMF 2011c). 2 Traditional instruments may also be inefficient to confront particular financial risks that build up in a boom.
In this context, macroprudential (MaP) tools and regulations constitute a complement to traditional macroeconomic policies. MaP policies along with prudent monetary and fiscal policies and microprudential (MiP) policies help manage the financial cycle and reduce the probability of boom-bust cycles. They also help avoid the accumulation of vulnerabilities that expose the financial system to additional stress in the down part of the cycle, e.g., due to fire sales or other events related to the increased interconnectedness of the financial system (IMF, 2010a, 2010c; Eyzaguirre et al, 2011).3 In some instances, MaP instruments may also complement some of the effects of monetary policy.
Despite the broad agreement on adopting a MaP approach for managing systemic risk, policy design is evolving and its implementation remains challenging. Many issues are under discussion, including the definition of systemic risk, how to track it, the level of granularity, the balance between rules and discretion, institutional arrangements and mandates, coordination and cooperation in supervision at the national and international levels (see IMF, 2010c and 2011d). Furthermore, there is a need to understand better when to use these tools and how they work in practice. This entails understanding how to design and calibrate them and, more importantly, identify their costs, benefits, and effectiveness. Nonetheless, many EMEs, including those of Latin America, have already employed different tools with MaP purposes, particularly to dampen the cycle and the associated risk taking. The authorities are actively engaged in deciding which tools to rely upon.
The notes in this volume review policy tools that have been used and/or are readily available for policy makers in Latin America. Each note describes how a specific instrument can serve MaP purposes, and reviews relevant country experiences—from the region or elsewhere (up to March 2011). Although not fully comprehensive, cross- country experience illustrates actual practices and, in some instances, serves as a gauge of their possible effects based on such experiences. Furthermore, some of the instruments are MiP in nature (see footnote 1), and may serve as an useful tool to achieve MaP goals when appropriately calibrated over the financial cycle. Specifically, the set of instruments examined include: (i) capital requirements, dynamic provisioning and leverage ratios; (ii) liquidity requirements; (iii) debt-to-income ratios; (iv) loan-to-value ratios; (v) reserve requirements on bank liabilities (deposits and nondeposits); (vi) instruments to manage and limit systemic foreign exchange risk; and, finally, (vii) reserve requirements or taxes on capital inflows.
This volume aims at being a timely compilation of practices on the use of instruments that could help lean against the wind. The notes are descriptive in nature, and are not aiming at establishing a policy guide on the use of such instruments. This explains the bottom-up approach of describing and examining individual instruments and country experiences, rather than a top-down approach that would require a careful analysis of how MaP policies interact with traditional policies, such as monetary and/or fiscal policy. The IMF is currently engaged in building up a consistent framework to analyze these issues (see IMF 2011a,d). Furthermore, the set of policies examined here need to be examined within a broader menu of policy options, including establishing the appropriate priorities and taking into account country’s specific conditions. Some of these broader issues have recently been examined in other IMF documents (Eyzaguirre et al, 2011; IMF 2011e; and Ostry and others, 2011 and 2010).
It is worth clarifying that systemic risk has been defined as the risk of disruption to financial services that is caused by an impairment of all or parts of the financial system and has the potential to have negative consequences on the real economy (IMF, 2010c and 2011d). It has two dimensions: (i) a cross-sectional dimension; and (ii) a time dimension. The first takes into account the distribution of risk across the financial and economic system, thus reflecting externalities across the system (e.g., common exposures, interconnectedness, or contagion). The second considers how system-wide risk evolves and is accumulated over time, taking into account the pro-cyclicality of the financial system.
From a Latin American perspective, addressing procyclicality is currently the main priority, given the pressures associated by large capital inflows. Latin American economies have not been negatively affected by the global financial crisis in a significant way; they have recovered very quickly; and are already evidencing overheating pressures due, in part, to strong domestic demand dynamics in an environment of easy global financial conditions. This combination of factors is already leading to substantial credit growth in some countries, high asset prices, and raising concerns about the need to avoid financial excesses (See IMF, 2011c). Nonetheless, it is also important to pay attention to the lessons derived from the financial crisis in assessing and managing common exposures and interconnectedness in the financial system, especially because the presence of foreign banks in the region is significant. In this respect, more work will have to be done in monitoring and managing the risks emerging from systemically important financial institutions (SIFIs)—including “too-big-to-fail” institutions—and in extending the perimeter of regulation to avoid the parallel development of a shadow financial system.
The analysis in this volume discusses how these instruments can help contain the accumulation of vulnerabilities that could arise in a context of easy global and domestic financial conditions (Table 1).4 In the upswing, the instruments examined can constrain or act as a speed limit on credit growth—both across the system or in specific sectors of the economy—avoid excessive leverage of banks and debtors; and tilt the financing structure of the financial system toward more stable and longer-term sources. In other instances, they increase the cost of foreign financing for banks and make domestic investment opportunities less attractive to foreign investors. Moreover, they help manage credit, liquidity, solvency, and/or foreign exchange credit risks. These features reduce the vulnerability of the financial system to reversals in capital flows. In some instances, the instruments examined also aim at building buffers in good times which can be deployed in bad times. More generally, by helping manage the credit and asset price cycles, they can be an effective complement to monetary policy, even in inflation targeting regimes.
|Policy tool||Recent examples or|
|• Countercyclical capital requirements||Basel III; Brazil (Auto loans-December 2010)||Buffer ranging between 0-2.5% to be introduced when aggregate credit is growing too fast.|
|• Dynamic provisioning||Bolivia (2008), Colombia (2007), Peru (2008), and Uruguay (2001)||Countercyclical tool that builds up a cushion against expected losses in good times so that they can be released in bad times.|
|• Leverage ratios||Basel III||Constrain the leverage in the banking sector, to mitigate the risk of the destabilizing deleveraging processes; and supplement the risk-based measure with a simple, transparent, independent measure of risk.|
|• Loan-to-value (LTVs) ratios||Canada (Mortgage market-April 2010, March/April 2011)||Regulatory limit to moderate cycles in specific sectors by limiting loan growth and leaning on asset demand.|
|• Debt-to-income (DTIs) ratios||Korea (August 2010-March 2011)||Measure to limit the leverage of borrowers and manage credit risk.|
|• Liquidity requirements||Colombia (2008); New Zealand (2010); and Basel III.||Tools to identify, measure, monitor and/or control liquidity risk under conditions of stress.|
|• Reserve requirements on bank deposits||Peru (January and April, 2011); Brazil (December 2010); China (January -March 2011); and Turkey (2009–2011)||Counter-cyclical tool that acts as i) speed limit on credit; ii) tool for credit allocation; and; iii) complement to monetary policy to achieve MaP goals.|
|• Tools to manage foreign exchange credit risk||Peru (July 2010), Uruguay;||Tool to internalize foreign exchange credit risks associated with lending to un-hedged borrower.|
|• Limits to foreign exchange positions||Colombia (2007); Korea (limits on forward contracts-June 2010); Israel (restrictions on banks derivatives transaction-2011)||Measures to manage foreign exchange risk in on and off balance sheet FX-denominated assets and liabilities. Also useful for dealing with surges in capital inflows which may pose systemic risks to the financial system when they create “bubbles” in certain economic sectors.|
|• Reserve requirements on financial external liabilities||Peru (2010-11)||Measure to limit short-term borrowing by the financial system. It applies to external liabilities with maturity of less than 2 years.|
|• Tax on capital inflows||Brazil (IOF tax-2010-11)||Non-quantitative tool to increase the cost of foreign financing and make domestic investment opportunities less attractive.|
Given that there is no single MaP instrument able to address all aspects of systemic risk, a combination of different tools, tailored to country-specific needs, is required. For instance, some tools address specific risks (e.g., liquidity or credit), or sometimes are targeted at specific sectors (e.g., housing or foreign exchange market). Although most tools focus on regulating the banking system, risks are also likely to shift to the nonregulated financial system, signaling the need for an encompassing macro-financial management approach. Furthermore, evidence regarding the effectiveness of these tools needs to be refined and explored further, in part because these measures are not taken in isolation. A common issue across instruments is the lack of adequate theoretical frameworks to evaluate their effectiveness, in particular in a general equilibrium setting.
While the review of country experiences using MaP tools is useful, it is unclear how these instruments are calibrated, suggesting that some degree of judgment and trial and error may be required in their use. Furthermore, the authorities must be ready to evaluate the cost of these policies and assess whether the regulations have the effect of shifting activities to the nonregulated financial system. Equally important is the need to examine trade-offs (e.g., the need to ensure that financial deepening continues) and the risks of imposing an excessive burden on the financial system. The authorities must not lose sight that the measures also bring along costs and distortions.
Going forward, the authorities will have to close information gaps, develop a robust analytical toolkit, and put in place an effective institutional framework—both at the micro-and macro-prudential level (see IMF, 2011d). To make MaP policy truly operational and effective, the authorities will need to carefully evaluate areas that require better information to assess underlying systemic risks—for example, in the housing and corporate sectors, or in the derivatives markets (see Cubeddu and Tovar, 2011). Special instruments will need to be developed, and regulatory governance will have to focus on the development of MaP regulations, while modifying MiP regulations to take account of the regulatory reforms worldwide. Finally, there will be a need to assess effectively new financial products and technologies.
Prepared by Gilbert Terrier, Rodrigo Valdes, and Camilo E. Tovar.
By delaying exchange rate adjustment, foreign exchange intervention may itself trigger more capital flows if it creates expectations of exchange rate appreciation. This highlights the challenges faced by traditional macroeconomic instruments, which may be themselves a source of heightened risk.
The distinction between MaP and microprudential (MiP) policies is best drawn in terms of objectives. MiP policy aims to reduce the probability of default of individual institutions, taking systemic risk as given; while MaP policy aims at preventing the economic and social costs of systemic financial distress, taking into account feedback effects that the behavior of individual institutions have on each other, and on the whole economy.
This table only summarizes recent changes in policies. It does not take stock of existing policies that may already be in place and be already tight.