From Fragmentation to Financial Integration in Europe

Chapter 20. Macroprudential Oversight and the Role of the European Systemic Risk Board

Charles Enoch, Luc Everaert, Thierry Tressel, and Jianping Zhou
Published Date:
December 2013
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Thierry Tressel and Jianping Zhou 

The role of macroprudential policy is to identify and reduce risks to financial stability that arise along both a time dimension and a cross-sectional dimension. Macroprudential policy relies on prudential instruments to (1) limit the buildup of financial imbalances, (2) address the market failures related to risk externalities and interconnectedness between financial institutions, and (3) dampen the procyclicality of the financial system.

Currently, national authorities in the European Union (EU) are responsible for macroprudential oversight of each national financial system, but adequate frameworks are still lacking in many EU countries. Coordination and internalization of cross-border spillovers is achieved at the EU level by the European Systemic Risk Board (ESRB) through a (nonbinding) “act or explain” mechanism. In December 2011, the ESRB issued recommendations on the macroprudential mandates of national authorities. Subsequently, guidance for establishing common macroprudential toolkits was issued in June 2012.

Macroprudential policies at a national level need to be effective and efficient as well as aligned with the overall objectives of the internal market while protecting financial stability. This approach suggests that the set of available instruments should be comprehensive enough to address multifaceted macroprudential concerns at the national and EU levels, but efficient coordination is also needed to limit possible negative externalities or unintended effects, including on the integrity of the single market.

Coordination of national macroprudential policies is especially important in the EU, given its highly integrated economic and financial markets. Such coordination would help identify correlated risk exposures of major EU financial institutions. Coordination is also important for minimizing negative spillover effects of national policies, reducing the possibility of regulatory arbitrage, and fostering policy effectiveness. But the ESRB still lacks formal modalities to coordinate macroprudential policy at the EU level.

The implementation of the Single Supervisory Mechanism (SSM) will have important implications for the institutional setting of macroprudential oversight in Europe. Within the Economic and Monetary Union, it is advantageous to assign macroprudential policy to both the European Central Bank (ECB) and national authorities, because strong monetary policy and macroprudential policy frameworks can be mutually reinforcing, and the ECB will internalize cross-border effects within the banking union. The established independence of the ECB would help build up a strong institutional framework for macroprudential policy and capacity to implement macroprudential instruments without undue political interference. National authorities should be provided a similar degree of operational independence and powers. The ECB and national authorities should be responsible for a wider range of macroprudential instruments, going beyond those included in the Capital Requirements Regulation (CRR) and Capital Requirements Directive IV (CRD IV) (collectively, CRR/CRD IV).

Methods for coordination between the ESRB as the EU macroprudential oversight body and the SSM among the participating countries need to be devised. The ESRB would need to have legal powers and sufficient resources to be effective. Whereas the SSM will comprise the euro area and any opt-in countries, the ESRB encompasses the entire EU. Within the countries of the SSM, the ECB will appropriately have macroprudential powers and will closely coordinate with national macroprudential authorities. The ESRB should interact with the ECB on macroprudential toolkits when it takes on macroprudential responsibilities, as it will continue to do with national supervisors. The ESRB should be able to exercise its powers and issue recommendations to the ECB as it does to national authorities. To be effective, the ESRB would also need to improve its capacity for effective identification, analysis, and monitoring of EU-wide systemic risks, supported by timely access to information on financial markets as well as on individual financial institutions. The coordinating role of the ESRB should be further enhanced through closer cooperation with the European Supervisory Authorities (ESAs) because the ESRB’s scope goes beyond the banking sector to cover the entire financial system, including all financial institutions (such as insurance and pension funds, market infrastructure, and so forth) and financial markets and products.

Introduction to the European Systemic Risk Board

EU context. The ESRB was set up in January 2011 following the 2009 de Larosiere report, which resulted in the establishment of the European System of Financial Supervision, a network of national supervisors working in tandem with the new European Supervisory Authorities (ESAs) and the ESRB. The reorganization of the European financial architecture was a response to the weaknesses in the EU financial supervisory framework that was exposed by the 2008 financial crisis, particularly with respect to the supervision of cross-border banks. Despite the highly integrated and interconnected financial systems and the importance of cross-border financial activities in the EU, supervisory and regulatory frameworks had remained fragmented along national lines. Moreover, there was little or no emphasis on macroprudential oversight and on a more integrated approach to financial stability, as each national central bank (and the ECB) produced its financial stability analysis independently.

Systemic crisis in the euro area. The ESRB began operations shortly before the euro area was engulfed by a systemic crisis arising from bank and sovereign risks interacting with architectural weaknesses. Uncoordinated actions resulted in a deep fragmentation of the EU financial system. Against this backdrop, the ESRB had to balance and prioritize activities between systemic risk warnings and policy recommendations on regulations and to correct medium-term risks while developing a macroprudential toolkit for the EU–an important task for the EU macroprudential oversight body. Given the deeply interconnected nature of the EU financial system, the ESRB has a role to play in promoting a more integrated approach to systemic risk and macroprudential policies, although the creation of the banking union will require a well-designed division of labor between the ESRB and the SSM.

The ESRB operates under a set of constraints that may hamper its effectiveness. Constraints originate from the supranational dimension of the ESRB, resulting in a complex decision-making process, and its lack of binding powers. Resources are provided by the ECB and national authorities to support the activities of the ESRB. The ESRB has access to disaggregated data through the ECB and the ESAs, but no direct access to supervisory data. This may adversely affect its ability to assess systemic risks that may arise from large cross-border and interconnected financial institutions.

The chapter is organized as follows. The next section is devoted to a description of ESRB activities and an assessment of its effectiveness. The third section explores the choice of macroprudential toolkits for EU countries. The fourth section explains how the macroprudential institutional landscape should be organized, including by giving a strong role to the ESRB in coordinating the use of macroprudential instruments across the EU and sectors of the financial system. It also discusses the respective roles of and interactions between the ESRB and the SSM when the latter starts operating.

A Review of the ESRB

The Role of the ESRB: Mandate, Tasks, and Organization

Role of the ESRB. As recommended by the de Larosiere report, the ESRB is responsible for macroprudential oversight of the financial systems and institutions within the EU to prevent or mitigate systemic risks, to avoid episodes of widespread financial distress, to contribute to the smooth functioning of the internal market, and to ensure a sustainable contribution of the financial sector to economic growth.1 Given the highly integrated and interconnected nature of the EU financial system, the ESRB also has a natural role in ensuring effectiveness, convergence, and coordination of macroprudential policies to protect the integrity of the single market and to protect financial stability at the national and supranational levels.

Mandate, tasks, structure, and policy instruments of the ESRB. The ESRB is performing its mandate under a set of institutional constraints set out in EU regulation. The ESRB has a complex organizational structure that results from the need to ensure high-level policy representation of 27 member states (Figure 20.1). The ESRB has no legal personality and is dependent on the ECB, which provides administrative, logistical, statistical, and analytical support to the ESRB. The powers of the ESRB are nonbinding and the impact of its policy instruments depends on the effectiveness of an “act or explain” mechanism. The ESRB is accountable to the European Parliament, as stated in its regulation.

Figure 20.1Organizational Structure of the ESRB

Source: Bundesbank Monthly Report, April 2012.

Note: ASC = Advisory Scientific Committee of the ESRB; ATC = Advisory Technical Committee of the ESRB; EBA = European Banking Authority; ECB = European Central Bank; EFC = Economic and Financial Committee; EIOPA = European Insurance and Occupational Pensions Authority; ESA = European Supervisory Authority; ESMA = European Securities and Markets Authority; ESRB = European Systemic Risk Board; NSA = National Supervisory Authority.

Approach of the ESRB to Monitoring and Assessing Systemic Risk

Short-term risks. In addition to the risk dashboard (described below), various inputs are used for systemic risk analysis, including documents such as ECB risk surveillance notes, risk analysis reports, the ECB white book, market intelligence reports by the ECB and the Bank of England, European Commission staff reports on systemic risks, the ESA’s dashboards, the Joint Committee of the European Supervisory Authorities’ report on risks, and notes by the ESRB Secretariat with bottom-up questionnaires for identifying risks.

Medium-term risks and activities. Once identified, medium-term and long-term risks result in the setting up of working groups involving staff from the ECB, the European Commission, ESAs, national authorities, and academics. The working groups provide analytical papers to prepare policy recommendations on medium-term risks. In 2011 and 2012, attention was focused on risks arising from bank funding and asset encumbrance, U.S. dollar–denominated bank funding, lending in foreign currencies, loan forbearance, regulatory treatment of sovereign exposures, interconnectedness of credit swap and interbank markets, stress testing, securities financing transactions, money market funds, high-frequency trading, and the treatment of long-term guarantees in insurance.

Data exchange with national and EU institutions. Data exchange between the ESRB and other national and EU supervisory authorities is guided by the EU regulation, which allows the ESRB to receive aggregate and disaggregated data from the ESAs, the European System of Central Banks (ESCB), the European Commission, and NSAs, and for them to receive necessary information on relevant risks from the ESRB. Unlike the ESAs, ESRB’s access to data on an individual systemic institution is limited and usually requires justification. This restriction may hamper systemic risk analysis, which often needs to be based on real-time supervisory data.

Main Outputs of the ESRB

When significant risks to the EU financial system are identified, the policy instruments available to the ESRB to avert or mitigate them are warnings or recommendations (which could be confidential or made public) issued to the EU, EU member states, the European Commission, the ESAs, or the NSAs. The implementation of these warnings and recommendations is essential for the credibility and the policy relevance of the ESRB.

Risk Warnings

The ESRB delivered confidential messages to governments during 2011, in response to the deterioration of market conditions. The ESRB Chair, Jean-Claude Trichet, made public reference to concerns addressed in his communication to governments, without revealing their format, frequency, and contents. Press releases published after the General Board meetings, however, regularly hinted at the substance of the ESRB assessment and contained substantial warning elements. The launch of Long-Term Refinancing Operations in late 2011 and early 2012, the announcement of steps to establish an SSM at the ECB in June 2012, and an Outright Monetary Transactions program in September of the same year contributed to reducing tail risks of exit from the euro area and associated redenomination risks. The ESRB did not issue statements referring to risks in relation to the banking union, but positions were taken publicly by the Advisory Scientific Committee of the ESRB (ASC) in reports (July 2012 report on “forbearance, resolution and deposit insurance” and September 2012 report on the EC proposal for a banking union).

Recommendations by the Board of the ESRB

The ESRB has publicly issued six recommendations:

  • Recommendation on lending in foreign currencies (issued September 2011; published November 2011; deadlines June and December 2012 and December 2013). The recommendation focused on improving the resilience of national financial systems to currency risks, reducing asymmetric information between borrowers and lenders, and taking policy actions to contain foreign currency lending in a countercyclical manner and improve incentives and risk pricing, including through supervisory actions.

  • Recommendation on U.S. dollar denominated funding of credit institutions (issued December 2011; published January 2012; deadline June 2012). Noting that a number of EU credit institutions have significant U.S. dollar funding needs and maturity mismatches, creating strains in the financial system, the ESRB recommended that steps be taken to mitigate risks of tensions in U.S. dollar funding, and improve monitoring and data collection.2

  • Recommendation on the macroprudential mandate of national authorities (issued December 2011; published January 2012; deadline June 2013). The ESRB noted that the effectiveness of EU macroprudential oversight also necessitates national macroprudential frameworks to be in place to ensure effective follow-up on ESRB warnings and recommendations. The text provided guiding principles for core elements, including requiring clear objectives, tasks, and powers to overcome bias toward inaction, and recommended giving a leading role to central banks.3

  • Recommendation on funding of credit institutions (issued December 2012; published February 2013; specific timeline between December 2013 and December 2016). This recommendation addresses the issue of asset encumbrance with a comprehensive approach, based on enhancement of institutions’ risk management and supervisory monitoring. The ESRB is still deliberating on a proposal for market transparency of asset encumbrance.

    The recommendation also touches upon funding risks and feasibility, on an aggregated basis, of funding plans in the near future, and on the identification of best practices for covered bonds.

  • Recommendation on money market funds (issued December 2012; published February 2013; deadline June 2014). In light of the upcoming European Commission review of the Undertakings for Collective Investment in Transferable Securities framework, the ESRB recommends that money market funds move from the constant to the variable net asset value model. Moreover, explicit liquidity requirements, as well as enhanced public disclosure and reporting by money market funds, should be introduced. Finally, better information sharing between authorities on money market funds is recommended.

  • Recommendation on intermediate objectives and instruments of macroprudential policy (issued April 2013; published June 2013; deadlines December 2014 and December 2015). The ESRB specified the intermediate policy objectives, proposed an indicative list of macroprudential instruments to achieve these objectives, and made recommendations on policy strategy for national macroprudential authorities, and periodic evaluations of intermediate objectives and instruments. The ESRB recommended that countries set up appropriate legal frameworks that permit macroprudential authorities to hold direct control or recommendation powers over the macroprudential instruments.4 It also recommended that macroprudential authorities be involved in the resolution of financial institutions, more specifically, in the design and national implementation of (1) recovery and resolution regimes for banking and nonbanking financial institutions and (2) deposit guarantee schemes. Last, it recommended that the European Commission ensure, in its legislation, efficient interaction among member states and sufficient flexibility for the activation of macroprudential instruments.

Other Activities of the ESRB

ESRB risk dashboard (first publication, September 2012).

  • As requested by the regulation establishing the ESRB, a risk dashboard has been produced and a set of quantitative and qualitative indicators published on the ESRB website. The set of indicators is one of the inputs for the Board’s discussions on risks and vulnerabilities. The dashboard will be updated and revised on a quarterly basis.

ASC reports and other publications and advice on regulatory reforms.

  • Various reports have been published on the ESRB website, including ASC reports on the European Commission proposal for a banking union (September 2012); and on forbearance, resolution, and deposit insurance (July 2012). Other publications include an occasional paper on money market funds in Europe and financial stability (June 2012); commentaries on the ESRB institutional setup (February 2012); on the macroprudential mandate of national authorities (March 2012); on systemic risk resulting from “retailization” (July 2012); and on lending in foreign currencies (December 2012); a letter from the Chair to EU legislators on macroprudential tools in the CRR/CRD IV (April 2012); and two advisory notes to the European Securities and Markets Authority in the context of the European Market Infrastructure Regulation on eligible collateral for central counterparties and the use of over-the-counter derivatives by nonfinancial corporations.5

Were the Various Instruments of the ESRB Effective and the Framework Credible?

Criteria. Assessing the effectiveness of the ESRB framework and instruments is a complex task, given that no established international best practices are available for assessing macroprudential authorities. Moreover, it is important to keep in mind that the supranational dimension of the ESRB is, by its nature, a political constraint that national macroprudential bodies would not have to deal with. Against this background, several indicators can provide a useful gauge of the effectiveness of the ESRB instrument and framework:

  • Prioritization and quality of risk warnings and recommendations;

  • Policy relevance, including through the publication of risk warnings;

  • Publication and implementation of recommendations by addressees; and

  • Capacity to communicate its analysis of systemic risks.

Risk warnings and recommendations of the ESRB were relevant and adequately prioritized. The ESRB’s risk warnings appeared to be timely given that they were issued when the crisis became systemic for the EU financial system. They correctly identified the emerging systemic risks and called for policy implementation, readiness to take action, and the need for coordinated supervisory actions, including recourse to backstop facilities. Policy recommendations also correctly identified medium-term risks to the EU financial system and called for adequate policies to mitigate these risks. In retrospect, the recommendation on U.S. dollar funding of EU financial institutions also appeared to pinpoint a key vulnerability that contributed to the seizure of wholesale funding markets at the end of 2011.

The ESRB managed to partly communicate its warnings publicly, although it is not clear how influential or timely they were. The press release of the September 21, 2011, ESRB Board meeting explicitly referenced this warning, for example, the systemic nature of the crisis, the need for coordinated supervisory action, and suggested recourse to “the possibility for the European Financial Stability Facility to lend to governments in order to recapitalize banks, including in non-program countries.” It is, however, difficult to assess the extent to which these public statements (let alone the private warnings) were influential. At the time that the European Banking Authority recapitalization exercise was being debated and concerns about disorderly deleveraging were being raised, the ESRB took a public position, but only at a late stage, through the introductory statement of Sir Mervyn King at the press conference of the General Board meeting of December 22, 2011. At that time, the parameters of the recapitalization exercise had been decided on and it was already clear that there would not be any common guarantee schemes and backstops established at the EU level, and the deleveraging of EU banks was already proceeding in an uncoordinated fashion.

Implementation of ESRB recommendations has been satisfying so far. All six recommendations were published within two months of their issuance, demonstrating broad consensus among member states on the importance and relevance of these policy recommendations. So far, implementation of the first five recommendations has been satisfactory:

  • On foreign exchange lending, all EU member states, Norway, and Iceland have responded on the self-assessment part, but some member states with fixed exchange rate regimes pointed out that measures should be applied only with respect to lending in foreign currencies other than their reserve currency.

  • On U.S. dollar funding, implementation has also been very good, while further follow-up may be needed in some specific areas.6 The recommendation has also helped raise important issues requiring further consideration. Implementation of the nonpublic part has been linked to adoption of the CRR/CRD IV legislative proposals.

  • The recommendation on national macroprudential mandates received extremely high responsiveness (all EU countries, plus Norway), highlighting the positive reception of the ESRB recommendations. The high level of compliance in the first follow-up phase is a positive signal for the role of the ESRB in coordinating future uses of macroprudential tools at the EU level.

The ESRB should further develop its capacity to communicate its systemic risk analysis. Publication of the risk dashboard is an initial step in setting up a regular analytical tool to analyze systemic risks. This tool is complemented by surveillance notes produced by the ECB. However, as noted in the ESRB regulation, publication of the risk dashboard should be associated with publication of an analysis of systemic risks. This coordinated publication would help enhance the capacity of the ESRB to communicate its systemic risk analysis and warnings.

The effectiveness of the ESRB framework may need to be strengthened. Future effectiveness of the ESRB hinges on its “will to act,” the enforceability of its recommendations, and the policy impact of its warnings. Its capacity to act will depend on a decision-making process that will need to be flexible enough to facilitate timely decisions on the communication of emerging risks and policy recommendations. To promote a “bottom-up” approach to risk identification, the ESRB staff could propose the work program and systemic risk analysis to the Steering Committee, while the Advisory Technical Committee could play a more technical role. The ESRB was designed to operate without legally binding powers; the key is to assess whether this constraint could impede its future effectiveness. With respect to recommendations, the “act or explain” mechanism seems to have operated relatively well so far, but follow-up on risk warnings has been less evident. Another area that may require attention is the frequency of the General Board meetings. As experienced in 2011, quarterly may not be adequate to ensure timely communication of risk warnings in the midst of a financial crisis. It could be useful to consider a simplified, more focused, decision-making structure in an emergency situation.

Should the ESRB Play a Role in Crisis Management?

Although it was established during a systemic crisis, the ESRB has produced outputs broadly balanced between medium-term and short-term risks. Although recommendations were more focused on medium-term risks, two timely risk warnings were issued, and various publications and communications were highly relevant in the context of the ongoing financial crisis. The ESRB Board did not take explicit positions or issue risk warnings in relation to the proposal for a banking union, partly limited by its mandate.7 The ESRB is supportive of the banking union, as clarified, for instance, in the ASC report on the European Commission proposal, but discussions seem to have demonstrated a diversity of opinions among member institutions. This example demonstrates that the constraints of the ESRB framework may become binding on policy issues that are highly political and on which Board members hold diverse views.

The ESRB has a clear mandate to issue risk warnings during systemic crises, but it is excluded from playing a role in crisis management. Although the ESRB should play a role in the use of macroprudential tools across EU countries (more on this below), the application of macroprudential tools is likely to remain asymmetric, and tools for systemic crisis management (including exceptional liquidity provision) will remain in the hands of central banks and other institutions. However, the ESRB should bring a macroprudential perspective to stress tests, in collaboration with the ECB and the European Banking Authority, including when they are used for crisis management purposes.

Macroprudential Toolkit for EU Countries

The macroprudential toolkit should include a carefully selected set of instruments that would be sufficient to address the most foreseeable sources of systemic risks. Macroprudential risks are multidimensional and arise through various institutions, markets, and sectors. One instrument may address more than one dimension of systemic risk, but there are uncertainties about the effectiveness of instruments. An effective toolkit should be able to mitigate amplification channels for systemic risks. It should have built-in flexibility to address the changing nature of systemic risks. Some instruments would have a broad range of action whereas others may be more focused on specific markets or sectors. Some instruments may be more effective at constraining the buildup of systemic risks or at mitigating the impact of shocks, whereas others may be more efficient and create fewer distortions. It is also important to select instruments that provide the ability to determine the appropriate timing for their activation or deactivation. Some instruments may have a broad scope, affecting both the time dimension and cross-sectional dimension of systemic risk, while other instruments (perhaps of a more structural nature) would be more appropriate for addressing the only cross-sectional dimension or only the time dimension. Given the size, interconnectedness, and complexity of European global systemically important banks, ensuring a specific focus on structural elements of the toolkit has merit. Last, instruments should duly consider the diversity of countries and circumstances within the EU. For example, the experience of emerging European countries may have been more similar to that of other emerging markets than to the experience of advanced EU countries (Box 20.1).

Box 20.1Lessons from Macroprudential Policies in Emerging Europe

During the past decade, many countries in central and eastern Europe relied on a rich set of macroprudential instruments to respond to capital inflows and credit booms (Ötker-Robe and others, 2007). Credit and housing booms across the region were commonly fueled by foreign-exchange-denominated or indexed loans. Instruments included reserve or liquidity requirements, capital requirements, loan classification and provisioning rules, as well as specific measures to limit foreign currency lending or restrict credit eligibility. When policymakers took action, they did so through different instruments, at different times, and with different levels of intensity. Many of the governments joining the EU in 2004 preferred to strengthen supervisory and monitoring measures and limited their use of administrative and prudential measures. In some cases, policies were tightened at a late stage, while in others, policies were relaxed during the expansion. There are cases in which prudential requirements were set very high; for example, reserve requirements on shortterm and foreign currency deposits reached, at their peak, 30 percent in Romania and 45 percent in Serbia.

Studies typically found modest impacts of macroprudential measures on overall credit growth and temporary effects on capital flows (Kraft and Galac, 2011; Vandenbussche, Vogel, and Detragiache, 2012; Bakker and Klingen, 2012). A reason for the limited effectiveness in limiting credit booms is that some of the prudential measures were circumvented through cross-border lending or lending by nonbanks. In a number of cases, subsidiaries in emerging Europe simply booked some loans with the parent institution or a nonbank subsidiary (leasing company) instead of with the local banking affiliate to avoid restrictions on lending imposed by host country authorities. Some studies found that domestic credit growth was significantly affected by macroprudential measures; others also find a dampening effect on house price appreciation. Measures taken during the upturn, however, helped build buffers that became valuable during the downturn.

The Basel III countercyclical capital buffer (CCB; the only macroprudential instrument adopted by the Basel Committee on Banking Supervision) is a necessary but not sufficient element of the toolbox; it should be complemented by more targeted instruments to address the cross-sectional and time dimensions of systemic risks (Box 20.2).

  • Although broad in scope, the CCB has limitations. There will be long lags (up to a year) between the announcement of capital add-ons by supervisors and implementation by banks, although under the draft capital requirement directive (CRD), a shorter lag may be possible under extraordinary circumstances. During downturns, the decision to release the buffer by the macro-prudential supervisor may be inconsistent with the microprudential principle under which banks should not deplete capital when nonperforming assets are building up. The CCB may be a blunt tool: the buildup of imbalances concentrated in particular sectors could lead to a crisis well before the buffer is triggered by aggregate developments.8

  • Limits on loan-to-value ratios (LTV) and debt-to-income ratios (DTI) are examples of the possible instruments that could usefully complement the CCB. Contingent upper bounds on LTV, potentially complemented by an upper limit on the DTI to ensure ability to repay, would be useful instruments to complement the CCB, and can be adapted to specific real estate developments. Implementation could be challenging because of the risks of regulatory arbitrage and political economy considerations, but evidence from emerging markets suggests these ratios may be effective instruments for mitigating house price appreciation, at least temporarily. Empirical evidence from euro area countries’ lending standards tends to confirm the same view. The benefits of ratios may differ across countries, according to the characteristics of their mortgage markets (including, for example, whether mortgages are full recourse). Relaxing the LTV limit in a downturn may also create conflicts between the macroprudential and the microprudential perspectives.9

A set of principles should be adopted to ensure the willingness to act and trigger the use of macroprudential instruments during upswings. The ability to identify and measure systemic risks and vulnerabilities is a key factor for successful implementation of macroprudential tools, and there must be clear criteria for activation (BIS, 2012). The decision to trigger activation is likely to be complex because there is no easy measurement of systemic risk as a result of its multidimensional nature. Assessing success is also difficult because the counter-factual may not be known. Costs of mistimed activation could be asymmetric—delayed action may be more costly than too-early intervention. Delayed activation might suggest that the instruments are not as effective as believed because there may not be enough time for the instruments to have an impact, but too early activation may lead to unnecessary side effects. Having rules in place is important to reduce uncertainty and to anchor expectations, but, given the limited experience with macroprudential policies, a large element of discretion and judgment is likely to be necessary to determine the timing and extent of tightening (Borio, 2009).

Box 20.2Effectiveness of Macroprudential Instruments in Advanced EU Countries and Lessons from Euro Area Bank Lending Standards

Most advanced economies have no or little experience with macroprudential policies; as a result, there is little empirical evidence of the effectiveness of macroprudential instruments in mitigating systemic risk in these economies. Model simulations of the impact of Basel III instruments, such as the countercyclical capital buffer, imply, however, that the impact on credit growth or house prices would most likely be modest. For example, according to results reported in the Macroeconomic Assessment Group’s interim report of August 2010, the long-term impact on credit of a 2.5 percent increase in capital requirements phased in over two years is estimated to be between 2 and 9 percent (Table 20.2.1). Although non-negligible, these effects remain modest in comparison to the amplitude of recent housing booms in the euro area (Table 20.2.2).1

Table 20.2.1Impact of a 2.5 Percent Increase in Capital Requirement on Credit(in percent) Phased in Over Two Years
Horizon4.5 Years8 Years
Source: MAG Interim Report August 2010; based on “satellite model.”
Source: MAG Interim Report August 2010; based on “satellite model.”
Table 20.2.2Euro Area Housing Booms(in percent, Cumulative 2000–07)
House price appreciation140104
Household mortgage credit growth158145
Source: Authors’ calculations.

End 2006.

Source: Authors’ calculations.

End 2006.

Although macroprudential instruments have rarely been used in the Economic and Monetary Union, banks in the euro area typically rely on nonprice measures to contain credit supply or to screen borrowers. The ECB Bank Lending Survey provides very useful information on price and nonprice measures used to tighten credit supply and on the contribution of various factors affecting the supply of credit. Among the former, the Bank Lending Survey reports the net proportion of banks that reported a net tightening of the loan-to-value ratio (LTV). Among the latter, the survey also provides the net proportion of banks reporting that the cost of capital contributed to the tightening (or loosening) of lending standards. Such indicators provide, indirectly, very useful information that would help gauge the potential impact that macroprudential measures could have on credit growth and house price appreciation in the euro area.

An econometric analysis using panel data suggests that limits on LTVs would have an economically significant impact on credit growth and house prices in Economic and Monetary Union countries (Tressel and Zhang, forthcoming). A panel data analysis was performed to assess the impact of net changes in LTVs on credit growth and house price appreciation. An instrumental variables approach was designed and appropriate control variables were included to correct for the endogeneity of lending standards. The analysis suggests that the impact of net changes in LTVs on credit growth or house prices would be very large, and significantly larger than the impact of price margins. As an illustration, a figure reports that the estimated net tightening of lending standards would reduce mortgage credit growth or house price appreciation by 10 percentage points. The analysis implies that the required net tightening of LTV to reduce mortgage credit growth and house price appreciation would be 8 percent and 25 percent, respectively. As a benchmark, the net tightening of lending standards in the euro area in the year following the collapse of Lehman Brothers was a net 117 percent.

While quantitative conclusions from survey responses should be arrived at cautiously, the comparison with the post-Lehman period does suggest that changes in limits on LTVs may have relatively strong effects on mortgage credit and house prices (Figure 20.2.1).

Figure 20.2.1Implied Net Tightening of Lending Standards

(In percent)

Source: Tressel and Zhang (forthcoming).

Note: LTV = loan-to-value ratio.

1 Spain relied on dynamic provisioning as a measure to build capital buffers, but the measures were weakened after 2004.

Finding a set of early warning indicators to trigger the use and release of instruments is key to the successful implementation of macroprudential policies. The indictors could include (1) the credit-to-GDP ratio or its deviation from a trend level (the gap measures), at an aggregated or a sectoral level; (2) indicators of market volatility (e.g., credit default swap spreads) or other price-based measures of default or distress; and (3) indicators measuring bank vulnerability and potential funding stress, such as noncore bank liabilities. Sectoral measures (such as measures of household or corporate indebtedness) would more easily identify the buildup of sectoral vulnerabilities that may not be well captured by the private-credit-to-GDP ratio. The rules-based triggers should be transparent, thus preventing surprises to markets. They would help constrain the incentives for risk taking, and prevent forbearance. The triggers based on market prices need to be carefully designed to minimize the risk of touching off a downward spiral, which could undermine financial stability.10

The set of EU principles for macroprudential policies should provide guidance on their interaction with monetary policy. On one hand, conventional monetary policy instruments are not well suited to mitigating systemic risks, and on the other hand, maintaining price stability may not always coincide with the financial stability objective. The experience of the recent crisis has demonstrated that relaxed monetary policy can, however, help fuel the upturn of the credit and asset price cycle, including by affecting risk-taking behaviors. It also plays a role in financial downturns by supplying liquidity to financial intermediaries and markets. In the EU, several key considerations should be taken into account to ensure that monetary policy tools and macroprudential instruments enhance rather than reduce the effectiveness of each policy.11

  • Interactions between monetary and macroprudential policies. The two policies share several transmission channels, including bank lending channels, and therefore will interact—and perhaps conflict—with each other even if they have, in theory, different objectives. Monetary policy may have to respond to the buildup of systemic risks, especially when macroprudential instruments are constrained. In a downturn, monetary policy decisions (including unconventional ones) may have to internalize financial stability considerations. Uncertainty about the effectiveness and side effects of specific macroprudential instruments adds a motivation to consider possible complementarities and synergies between these instruments and instruments of monetary policy.

  • Principles guiding the use of macroprudential instruments in a monetary union. Where monetary policy is constrained, such as in the euro area, macroprudential instruments become relatively more important policy instruments, particularly if financial cycles are not synchronized across countries and if price stability is more likely to conflict with financial stability. Although macroprudential policies should not substitute for macroeconomic policies, they should be well placed, in the absence of alternative policy instruments, to play a prominent role in helping mitigate the buildup of systemic risks when monetary policy cannot be relied upon to “lean against the wind” and when fiscal policies are constrained and cannot be relied upon to react in real time to asset price developments. In the euro area, macroprudential instruments could play an even more important role given the lack of a fiscal union that could provide transfers to help cushion the impact of a crisis and smooth the necessary rebalancing at the national level.

The macroprudential toolkit should also be complemented by guidance on macroprudential actions that would be needed to mitigate adverse effects during an economic downturn. Many instruments are conceptually more suited for the upturn than for the downturn. In a downturn, a fundamental tension arises between microprudential and macroprudential objectives, and market pressures may prevent policymakers from being able to release capital buffers or relax limits on other macroprudential tools (Figure 20.2).12 While liquidity provision by the central bank and unconventional measures may be essential tools for stabilizing markets during systemic crises, there may also be merit in considering the potential role of structural or cyclical macroprudential instruments in correcting fire sale externalities and dampening other contagion effects.

Figure 20.2Capital Adequacy Through the Cycle in Sweden

(In percent of risk-weighted assets)

Source: Ingves, 2011.

Proposal for the Minimum Set of Macroprudential Instruments

The minimum set of instruments, in addition to the CCB and limits on LTV and DTI that all EU countries should have in place, could be enriched by an additional set of indicative instruments that would play a complementary role. Among others, such instruments could include the following:

  • Time-varying exposures to specific sectors. Time and sectoral contingent risk weights would usefully complement the CCB for two reasons. First, they would target more specifically the sectors in which systemic risk is developing, thus allowing a cross-sectoral differentiation of risks. Second, because of their targeted nature, they could more effectively tame financial imbalances without adversely affecting the supply of credit to other segments of the economy. Examples of such measures include contingent risk weights on interbank lending and lending to sovereigns, corporates, or households.13

  • Funding of financial intermediaries. Balance sheet expansions during the boom leading up to the global financial crisis were financed by relying on wholesale funding, often of a short-term nature. A possible instrument complementing the two quantitative liquidity constraints of Basel III would aim at limiting the use of noncore funding instruments and could help address both the time dimension and the cross-sectional dimension of systemic risk.

  • Collateralized lending markets. A possible instrument would be contingent margins or valuation haircuts on existing securities used as collateral in the securitized lending markets (such as for repos). This instrument would be used to regulate the supply of secured funding, which would help reduce the risk of fire sales. It would also counteract the shadow banking system’s contribution to procyclicality by affecting the system’s funding conditions in wholesale markets. Ideally, strong margining should be extended to OTC markets to provide an incentive for the move to central clearing of derivatives.

Effective Macroprudential Oversight for the EU

Because EU financial systems are integrated, a supranational approach to macro-prudential oversight is necessary. Decisions to act on macroprudential risks must have an EU dimension to overcome cross-country externalities, leakages, and ring-fencing tendencies and minimize the risks of regulatory capture at the national level. Strong coordination of policy actions at the EU level is needed to avoid regulatory arbitrage by financial institutions that are located outside of the country setting macroprudential policies. The establishment of the SSM, which gives the ECB macroprudential powers, will require designing systems for coordination between the ECB and the ESRB.

Role of the ESRB

The ESRB has a role to play in ensuring effective macroprudential oversight for the EU financial system as a whole, in close cooperation with the ECB. The ESRB should continue providing guidance on the macroprudential policy framework (including mandate, institutional arrangement, and instruments) to ensure that macroprudential policy is operational in all member states. Notwithstanding resource constraints, the ESRB may also play a role in the calibration of individual macroprudential instruments across all EU countries, while collaborating closely with the ECB for SSM countries. The calibration should ensure the identified risk is adequately addressed, and allow for flexibility at the national level while also ensuring convergence of practices across countries. In particular, the instrument should be calibrated in a way that mitigates risks effectively—without imposing undue costs on the financial sector—and all national macroprudential authorities should be encouraged to adopt similar quantitative responses to systemic risks.

The ESRB should play a forceful role in cross-border coordination, particularly in ensuring reciprocity across EU countries and in harmonization of national macroprudential frameworks. National authorities may not have jurisdiction over all lending within their territories, including by foreign bank branches. To avoid regulatory arbitrage and negative spillover effects, and to ensure the effectiveness of macroprudential action across the highly interconnected EU financial systems, a mechanism is needed whereby home country authorities reciprocate the macro-prudential measures put in place by host countries, based on the exposures of the consolidated national financial institutions to the asset class of the host country under consideration.14 Ensuring policy effectiveness is particularly relevant for emerging economies with high degrees of cross-border banking activities and direct cross-border lending. Thus, the use of macroprudential instruments over a particular activity could be referred by national authorities to the ESRB for approval so that all EU banks, regardless of origin, are covered. Even though reciprocity is not required by the legislation, the ESRB should, if it is satisfied that the macroprudential action taken by the host authority is justified, issue a recommendation to other macroprudential authorities to reciprocate the measures taken by the host authority, when home and host countries are not part of the SSM (see below). The ESRB has already announced its intention to establish coordination procedures when appropriate.

The ESRB could validate the decisions of member states to set or modify macroprudential instruments when these decisions interact with EU standards. For example, under CRR/CRD IV,15 member states will have the flexibility to vary risk weights and sectoral buffers at the national level for macroprudential purposes. A potential solution to prevent arbitrage, leakages, and negative externalities may be for the use of risk weights to be based on asset classes that could apply to all financial institutions irrespective of their location.

Interaction with Other EU Bodies and the SSM

The ESRB will need to continue to work closely with the ESAs. Continued interaction between the ESRB and the ESAs will be important to ensure a proper meshing of macroprudential and microprudential instruments and risk assessments. Strong cooperation is needed also in the exchange of data and information. As noted in the European Financial Stability Framework Exercise report, the current regulations stipulate that requests for detailed data from the ESAs will have to be ad hoc and motivated, and the ESRB (or the European Banking Authority) has no direct access to data. This constraint may continue to hamper the effectiveness of the ESRB.

The ESRB depends on the ECB for analytical, statistical, logistical, and administrative support. Close collaboration between the two institutions may remain important in the future. Because the ESRB is an EU institution covering non—euro area countries and nonbanks, there may be a future need to strengthen its analytical resources, independently of the analytical contribution of the ECB. The creation of the SSM may further require that the ESRB develop its own resources and acquire some measure of independent analytical capacity.

The ESRB will need to continue work closely with the European Commission. In particular, the ESRB needs to issue a warning when the commission’s legislative action unduly constrains macroprudential policy action. In addition, the ESRB should recommend that the commission take positive legislative action to ensure that common macroprudential toolkits are available to policymakers across the EU, potentially beyond the instruments included in the CRR/CRD IV.

The creation of a banking union covering at least the euro area countries will likely have a profound impact on the ESRB:

  • The ECB will appropriately have macroprudential power over banks under the SSM. The Draft Council Regulation (2012/0242) concerning the establishment of the SSM assigns to the ECB macroprudential powers over banks under the SSM. However, the ECB will not have macroprudential powers over other financial institutions. The ECB’s macroprudential powers will facilitate early identification and action on systemic risks, and enhance information sharing, home-host coordination, and internalization of cross-border externalities within the SSM. The ECB is appropriately given binding powers to be able to use macroprudential instruments that are in the CRR/CRD IV if deemed necessary, but its toolkit should include macro-prudential instruments that are not included in the CRD IV (such as limits on DTI and LTV) when a common macroprudential framework for the SSM countries is in place. The established independence and financial stability expertise of the ECB would help build a strong institutional framework among SSM countries and provide capacity to implement macroprudential instruments against national political pressure while taking into account interactions with monetary policy. However, the ECB could be subject to political pressures and disagreements with national authorities, which would add rigidities to the system, but the ECB should be able to have a final say and be able to act if needed.

  • Interaction between national authorities and the ECB within the SSM. National authorities will be allowed to retain macroprudential powers under the SSM—providing flexibility to tailor solutions to local conditions—but in close cooperation with the ECB. Either party that takes such a step needs to inform and consult with the other party ahead of time, using methods described in the European Council draft regulation for the SSM. In practice, cooperation will be critical to ensuring the flexibility to manage macro-financial developments in particular countries or asset markets, and the coherence and effectiveness of measures. Mechanisms would also need to be in place to ensure effective decision making and willingness to act. However, accountability lines between the ECB and national authorities will need to be clarified to prevent accountability gaps from arising. Mechanisms to resolve conflicts of interest between national authorities and the ECB and to overcome inaction bias must also be designed. Governance mechanisms must also protect the independence of the ECB.

  • The role of the ESRB will be complemented and enhanced by the SSM. The methods for coordination between the ECB and the ESRB in the area of macroprudential policies will need to be clearly spelled out. Although some overlap is inevitable between the tasks of the ESRB and of the ECB in the area of banking and coverage of euro area countries, this overlap should be seen as reinforcing the macroprudential oversight of the EU financial system. The ESRB will continue to coordinate macroprudential oversight between countries participating in the SSM and those remaining outside. Furthermore, the ESRB could continue to be tasked with the development of the macroprudential toolkit as outlined previously. Ensuring macroprudential oversight at the EU level will also remain important for nonbanks and markets, which will not be covered by the SSM. The ECB should coordinate closely with the ESRB, and implement warnings and recommendations issued by the ESRB in close cooperation with national authorities.

Recommendation and Conclusion

The macroprudential policy toolkit should be applicable not only to the upturns but also to the downturns of economic cycles. During the upturns, instruments need to prevent the buildup of aggregate or correlated risks over time, such as aggregate or sectoral credit imbalances; during the downturns, instruments need to mitigate the amplification and contagion effects arising from interconnectedness and the procyclicality of financial markets, most importantly, to prevent fire sales of bank assets.

Within the banking union, the ECB should have macroprudential powers, because strong monetary policy and macroprudential policy frameworks can be mutually reinforcing, and the ECB is well placed to have an integrated approach to systemic risk identification. One key challenge for macroprudential supervision is to design and calibrate macroprudential instruments and implement them against political interference. The established independence of the ECB would help build up a strong institutional framework for macroprudential policy, but accountability and governance mechanisms must be in place to limit conflicts of interest and protect the ECB’s monetary policy objective. For this reason, the ECB should be responsible for a wider range of macroprudential instruments, going beyond those included in the CRR/CRD IV, as envisaged under the European Commission proposal for SSM.

The ESRB should remain responsible for macroprudential oversight at the EU level and must have a clear mandate and legal powers to be effective. Cross-border externalities and EU-wide financial stability concerns provide the rationale for a supranational macroprudential supervisor at the EU level—these concerns cannot be effectively addressed without a coordination mechanism. The ESRB is also the EU body responsible for the macroprudential oversight of nonbanks. The establishment of the ESRB in January 2011 was a crucial step in providing greater traction for macroprudential oversight at the EU level. However, as for all EU institutions, its mandate and legal powers are limited and it has been subject to a set of institutional constraints—a complex decision-making process at the Board (with 27 member states and EU and euro area institutions being involved), no direct access to supervisory data, and no binding powers. Future consideration may be given to granting the ESRB binding powers and providing it with more resources independent of the ECB.

The coordinating role of the ESRB should be further enhanced through closer cooperation with the ESAs and the ECB as the single supervisor for the banking union. Continued interaction between the ESRB and the ESAs will be important to ensuring a proper meshing of macroprudential and microprudential instruments and risk assessments. The ESRB should interact with the ECB on macro-prudential toolkits when the ECB takes on macroprudential responsibilities. In particular, the ECB should implement warnings and recommendations issued by the ESRB, or require national authorities to “act or explain” when the ESRB issues a warning directed to them. The ECB should continue to provide support to the ESRB.

The use of macroprudential instruments at the national level would need to be consistent with the overall objective of the internal market (more specifically, the free movement of services and capital) while protecting financial stability. This approach suggests that although the available set of instruments should be comprehensive enough to address multifaceted macroprudential concerns at a national level, efficient coordination would be needed to limit possible negative externalities or unintended effects on financial stability and the sustainability of the single market.


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Regulation (EU) No. 1092/2010 of the European Parliament and of the Council of November 24, 2010.

A nonpublic recommendation on U.S. dollar funding was also issued.

The Selected Issues Paper to the IMF 2011 euro area Article IV consultation developed a similar argument on the importance of having effective macroprudential frameworks in place at the national level (Nier and Tressel, 2011).

Policy advice on the CRR/CRD IV was provided in three stages: two nonpublic letters to EU institutions in 2011 and a public letter in March 2012. Policy advice to the European Securities and Markets Authority on the European Market Infrastructure Regulation was published in August 2012.

Some member states referred to a proportionality rule as a reason not to implement the recommendation.

The ESRB’s role in influencing legislation is limited once negotiations between the legislative bodies and the EU have started.

The impact on credit supply will depend on the speed at which the buffer is built up. A fast buildup will presumably be more effective in constraining credit supply, in particular if banks have to resort to costly issuance of equity.

See also evidence reported in Lim and others (2011).

See also IMF (2011).

General considerations are discussed in IMF (2013).

During a crisis, market pressures may become the binding constraint. See, for example, the discussion at the Bank of England Financial Policy Committee at the time of the wholesale funding market pressures in September 2011:

Optimal risk weights may differ from a microprudential perspective as compared with a macro-prudential one. For example, collateralized short-term assets (such as reverse repo transactions) may appear safe from a microprudential perspective, and therefore attract low capital requirements. But they could be systemically important because a decision not to roll over the transaction may trigger fire sales of assets by the counterparty, which may amplify a financial crisis (Morris and Shin, 2008).

For example, an asset class would be defined as sovereign bonds of country A or mortgages on properties of country B.

After Parliament’s vote, the council needs to formally approve the rules. The Regulation and the Directive will then be published in the Official Journal (OJ) and enter into force. The new rules will apply beginning January 1, 2014, if published in the OJ by June 30, 2013; otherwise, they will apply beginning July 1, 2014.

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