Current Developments in Monetary and Financial Law, Volume 6

Chapter 6: Some Thoughts on Macroprudential Supervision

International Monetary Fund. Legal Dept.
Published Date:
February 2013
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The global financial crisis that began in summer 2007 has forced the world’s financial regulators to think about overhauling their regulatory and supervisory frameworks. The argument goes that the traditional “microprudential” supervision, which focuses on maintaining the soundness of individual financial firms, failed to identify the risks that had been accumulated in the global financial system as a whole; to address this problem, a “macroprudential” approach is needed, which aims for ensuring the soundness of the entire financial system with a view to preventing systemic shocks from disrupting macroeconomic output. “Macroprudential” has thus become the keyword of the day among financial regulators.

Yet the fact that the case for a macroprudential approach has been put forward for many years is less well known. Therefore, I will first refer to past discussions on the issue of macroprudential supervision. I will discuss why the idea of macroprudential supervision was proposed in the farther past, and why it lost traction among policymakers thereafter before gaining renewed importance recently. I will then talk about what was, and is, needed to make this approach operational.

Lastly, I will introduce the work related to macroprudential approaches to supervision that has been done by Japan’s Financial Services Agency (FSA). Since Japan experienced a serious systemic crisis more than ten years ago, the FSA has taken various measures to ensure overall financial stability with due consideration to its system-wide effects and macroeconomic impact.

Past Discussions on Macroprudential Supervision

The Case for Macroprudential Supervision

“…a fundamental lesson from the current crisis is that effective supervision at the individual firm level, while necessary, is not sufficient to safeguard the soundness of the financial system as a whole…. This points to the need for regulators, supervisors, and central bankers to supplement strong microprudential regulation with a macroprudential overlay to more effectively monitor and address the build-up of risks arising from excess liquidity, leverage, risk-taking and systemic concentrations that have the potential to cause financial instability.”

“Since the risk of distress to the financial system as a whole is not simply the sum of the risk to its individual components, the impact of the collective behaviour of economic agents on aggregate risk needs to be taken into account explicitly. To illustrate, take the example of a bank’s leverage during an economic expansion. It may be individually appropriate for banks to take more risk during benign economic times, for example by increasing lending. However, when this behaviour is widespread, the overall leverage of the banking sector may create the potential for financial instability.”

The above quotation is an excerpt from the report of a Group of Twenty (G-20) working group issued just before the London Summit in April.1 While various explanations have been made as to what a “macroprudential approach” actually means, I think this report summarizes the discussions quite well. The points are:

  • First, the need to address the build-up of risks in the financial system as a whole; and

  • Second, the need to take into account the impact of the collective behavior of firms and investors.

The reason why the macroprudential approach has recently attracted increased attention is because this approach is intended to address the following three challenges, which have tended to be overlooked under the traditional supervisory framework. These challenges are:

  • Identifying the concentration of risk latent in the financial system (which is difficult to spot by supervision of individual firms only);

  • Addressing the structure of spillover effects, which cause systemic risk; and

  • Taking the feedback loop between the financial system and the real economy into consideration.

Déjá Vu?

However, if we look back at past discussions, we can find that the arguments for macroprudential supervision are not new. In fact, they have been put forward by policymakers and international institutions for many years.

“There are three aspects to this [comprehensive approach]: firstly, overcoming the separate treatment of micro-prudential and macroprudential issues; secondly, bringing together the major international institutions and key national authorities involved in financial sector stability; and thirdly, integrating emerging markets more closely in this process.”

“The various regulatory groupings deal predominantly with microprudential issues pertaining to the stability of the individual institutions within their purview. However, the greater importance of financial markets… implies a greater need to consider microprudential policies in a wider setting, including the ways in which such policies could be blunted or sharpened by market practices and disciplines, or have unintended aggregation effects.”

The above quotation is not from a recent statement. This is an excerpt from what is called the “Tietmeyer Report” to the Group of Seven (G-7) Finance Ministers and Central Bank Governors in 1999,2 which led to the establishment of the Financial Stability Forum (FSF). The FSF has recently been reorganized as the Financial Stability Board (FSB). According to Jaime Caruana, former Director of the Monetary and Capital Markets Department of the International Monetary Fund (IMF) and now General Manager of the Bank for International Settlements (BIS), the term “macroprudential” was coined at the BIS as early as in the 1970s (Caruana (2009)). We also remember the famous speech in 2000 made by Sir Andrew Crockett, the then manager of the BIS, on this issue (Crockett (2000)).

The IMF is no stranger to this debate, either. Following the G-7’s recommendations, the Fund initiated the Financial Sector Assessment Program (FSAP) in 1999, first as a pilot exercise. The FSAP was later incorporated in the Fund’s regular activities and assumed an increasingly important role in the Fund’s work. The following is an excerpt from the Fund’s handbook for the FSAP exercise3:

“Surveillance of the soundness of the financial sector as a whole—which is macroprudential surveillance—complements the surveillance of individual financial institutions by supervisors—which is microprudential surveillance. Macroprudential surveillance derives from the need to identify risks to the stability of the system as a whole, resulting from the collective effect of the activities of many institutions.”

“Macroprudential surveillance uses a combination of qualitative and quantitative methods. … The quantitative methods include a combination of statistical indicators and techniques designed to summarize the soundness and resilience of the financial system. The two key quantitative tools of macroprudential surveillance are the analysis of FSIs [financial soundness indicators] and stress testing. … FSIs help to assess the vulnerability of the financial sector to shocks. Stress testing assesses the vulnerability of a financial system to exceptional but plausible events by providing an estimate of how the value of each financial institution’s portfolio will change when there are large changes to some of its risk factors (such as asset prices).”

“Analysis of macrofinancial linkages attempts to understand the exposures that can cause shocks to be transmitted through the financial system to the macroeconomy. … Surveillance of macroeconomic conditions then monitors the effect of the financial system on macroeconomic conditions in general and on debt sustainability in particular.”

This states explicitly that the Fund conducts macroprudential surveillance and analysis of the linkages between the financial sector and the real sector.

Both the establishment of the FSF and the initiation of the FSAP at the IMF were in response to the turmoil in the international capital markets in the late 1990s, in which the world witnessed all of the three problems the proposed macroprudential approach is supposed to address (i.e., risk concentration, spillover, and macrofinancial feedback loop). In the Asian crisis, the risks associated with the mismatch of currency and maturity had been concentrated in the banking sectors and balance of payments of East Asian countries. Then, materialization of these risks in one country spread quickly to others that had common risk factors. And, in the debacle of LTCM (Long-Term Capital Management, a hedge fund), the United States authorities encouraged Wall Street banks to bail out the firm for fear of severe global market turmoil, because LTCM had borrowed heavily from large financial firms around the world to increase leverage related to their arbitrage transactions of bonds.

Macroprudential Supervision in Today’s Setting

As we have just seen, the case for a macroprudential approach in financial supervision has been put forward by at least part of the international community for years. Then, it has regained renewed attention again recently. Why?

One of the reasons is that financial transactions have become more complex than before, with financial firms more interconnected via the markets and across borders. Accordingly, serious risks latent in the markets have increasingly become common risk factors for many financial firms, which would materialize themselves once an individual firm runs into trouble. Because of a high level of interconnectedness, the effect could spread to the global financial system through increased counterparty risk and behavioral changes at financial firms, with market liquidity dried up and the pricing function of the markets severely impaired. This, in turn, would threaten the soundness of other financial firms around the globe. It is therefore increasingly important that regulators strive to identify such common risk factors and make use of this analysis in supervision.

Yet we also need to look at the risk factors that have been common to various crises in history. Most of past financial crises followed overly optimistic expectations about the economy and, in particular, about asset prices stemming from long periods of economic expansion. Investors, households, and financial firms tended to under-price the risks associated with their activities in such circumstances, leading to excessive risk-taking and rapid credit growth. This increased the leverage in the financial system and in non-financial sector to an excessive level, which became unsustainable once market participants became suddenly risk-averse following a shock event. The current crisis is no exception.

Thus the point here is the fact that, even though the world’s regulators had been aware for years that a macroprudential approach to supervision is necessary and the efforts had been made to this end by the FSF and the IMF, they were not able to prevent another financial crisis that began in summer 2007.

Following the crisis, active discussions are underway in the United States and Europe on how to reform the organization of financial regulators and supervisors to make macroprudential supervision operational. Perhaps it is a natural habit of bureaucrats and lawmakers to get obsessed with organizational change in times of reform. This aspect of debate is certainly important. But what is more important is not reorganization per se but how macroprudential supervision can be made more effective.

To this end, I think we need to reflect on why the previous efforts did not work effectively.

What Is (Was) Needed to Make Macroprudential Supervision Operational?

“Before the current crisis, central banks issued warnings regarding the build-up of risks through financial system reports. However, issuing warnings are not so difficult. …”

“If we seriously wish to reduce such risks, remedial action is required. But in order to go beyond analysis and take remedial actions, a proper assessment, a strong will, together with a robust legal framework which enables effective action, are all necessary.”

The quote above is a comment by Governor Shirakawa of the Bank of Japan in a speech he made in June this year (Shirakawa (2009)). Indeed, a number of analyses had been made by central banks, supervisors, and international institutions since about 2005 on the substantial risks associated with the securitization business. The problem was that such warnings were treated lightly and did not lead to concrete action. Also, these warnings were not strong enough in retrospect. This may have been a reflection of the fact that, although they were aware of the possible emergence of a bubble, the authorities were not sufficiently convinced that this was a bubble that justified bold action.

Robustness of Analytical Framework

It seems to me that there are a number of hurdles standing in the way of effective macroprudential supervision. One of them is the need for the robustness of analytical frameworks. The lack of a robust theoretical framework or established practice in macroprudential supervision probably led to the reduced attention to these aspects by national authorities and at international discussions in the 2000s as the last crisis faded out, and to the failure to identify accumulation of risks in the run-up to the current global financial crisis.

Moreover, the regulators would need to intellectually challenge conventional wisdom and resist plausible counterarguments that try to justify the asset price movements which could later turn out to be bubbles. This requires that these bodies have in place sufficient analytical capability. In fact, these counterarguments are always put forward at boom times. For example, there was the “new economy” theory prior to the burst of the “dotcom” bubble; plausible theories were also proposed in Japan in the 1980s that tried to explain that stock price developments were rational. In the run-up to the current crisis, arguments were also made praising financial innovation, such as securitization, for strengthening the resilience of the financial system by dispersing risks to a wider range of investors.

In addition, the regulators need to be prepared for challenges against their assessment of tail risks. The assessments based on the results of stress testing or scenario analyses are particularly prone to these challenges because the assumptions could well be seen as arbitrary.

“Will to Act” and Resisting Political Economy Considerations

Another hurdle is how to translate assessments into action and how to resist substantial pressure from political economy considerations. It would take strong determination to take bold measures to prevent excessive leverage and contain market overheating. This is because tightening prudential policies at boom times is often disliked by market participants and politically unpopular. In addition, once that action is followed by the reversal of market situations, the regulators could easily be blamed for triggering the downturn. It is therefore challenging to obtain public and political support to such policies. Meanwhile, the regulators would be under pressure to loosen prudential standards at bad times to the extent that would put the soundness of the entire financial system at risk.

These challenges look substantial, which may not be solved just by reforming the organizational structure of financial regulation. The organizational measures necessary will probably differ among countries according to political, economic, and financial circumstances as well as historical experience. Moreover, further efforts will be necessary on many fronts, including in establishing analytical frameworks and building consensus on the need for forward-looking prudential policies to address boom-bust cycles.

Japan FSA’s Action Related to Macroprudential Supervision

I would now like to introduce to you some of the work related to macroprudential approaches done by Japan’s FSA. Since the time of Japan’s banking crisis in the late 1990s, the FSA has made efforts to take supervisory measures with due consideration to the soundness of the financial system as a whole and to their impact on the real economy (Figure 1).

Figure 1.Japan FSA’s action related to macroprudential supervision

At the time of the banking crisis in the 1990s, the FSA gave priority to preventing spillovers and to avoiding triggering a global financial crisis. In the absence of an effective framework for bank resolution and in view of heightened uncertainty, a blanket guarantee of bank deposits had been announced, and maximum care was taken to resolving problem banks with a view to containing its systemic impact to the extent possible. The FSA also took measures to ensure that credit to the corporate sector, particularly to small- and medium-sized enterprises (SMEs), would not be tightened excessively. While Japan has been criticized for having been slow to resolve its banking sector problems, we think that it was somewhat unavoidable given the circumstances at that time. Meanwhile, an effort was made in parallel to put in place a robust bank resolution framework aimed at enabling the FSA to act effectively to address systemic risk. Following the implementation of this framework, the FSA took actions to increase the transparency of bank balance sheets and encourage the banks to dispose of their non-performing loans, resisting pressure for regulatory forbearance.

A second example is that of a forward-looking response to a possible asset price bubble. In late 2006, the FSA issued warnings to the financial services industry with regard to their activities in the commercial property market. This was a response to a sharp rise in commercial property prices in Japan’s selected metropolitan areas. Observing that this stemmed from structural changes in the pricing mechanism of properties and banks’ lending techniques, and significant capital inflows to the market from abroad, the FSA revised its annual supervisory policies to make it clear that it would closely examine banks’ risk management practices for their activities in this market. It also took supervisory action against some REITs (real estate investment funds) for inadequate risk management and compliance (Sato (2008)). In hindsight, this action seems to have helped alleviate the impact of the global financial crisis on Japan’s financial system and economy, since global investment banks had been very active in this market prior to the crisis. At that time, however, the FSA was faced by severe criticism that it was destroying the nascent market.

In response to the current crisis, the FSA has conducted cross-sectoral analyses, making use of its position as the integrated regulator covering not only banks but also the insurance sector and financial markets. It has also tried to maintain confidence in the stability of Japan’s financial system by enhancing transparency about the situation of the system. Specifically, the FSA has disclosed the aggregate of the exposure of Japanese financial firms to securitized products on a quarterly basis from end-September 2007 data. Furthermore, the FSA took measures to sustain banks’ financial intermediary function, particularly to SMEs, including through intensive off-site and on-site monitoring of banks’ lending activities. These are the measures aimed at addressing possible “fallacy of composition” in banks’ behavior, with a view to preventing their individual judgment to tighten lending standards from causing credit crunch, which would rather deteriorate their financial soundness. Also, FSA officials have been making active contribution to discussions on how to mitigate procyclicality of the capital adequacy requirements, both at international fora and in public (for example, Himino (2009)).

Finally, I will turn to explaining the institutional set-up for financial regulation and supervision in Japan. As mentioned earlier, the FSA is Japan’s integrated financial regulator, covering both the banking and non-bank sectors and market regulations. Having also the function of drafting legislation, the FSA’s coverage of financial regulation and supervision is probably the most comprehensive among the regulators of the world’s major jurisdictions (Figure 2).

Figure 2.International comparison of institutional frameworks for financial regulation

*The creation of France’s prudential regulatory authority (Autorité de Controle Prudentiel) was announced on July 27, 2009

At the same time, the Bank of Japan (BOJ), the central bank, also has the objective of ensuring financial stability, in the sense that it is held responsible for ensuring the smooth functioning of the interbank payment system. Based on this responsibility, the BOJ has bank examination functions (on a contractual basis), and complements the FSA’s on-site and off-site supervision. Having experienced a system-wide crisis in the 1990s, cooperation between the FSA and the BOJ has been strengthened and they stand ready for closer consultation whenever intensive monitoring is required.

This setup many not be a perfect one. Perhaps the FSA may need a strengthened analytical capability to become more responsive to macroprudential issues. However, I can say that the Japanese authorities have not encountered any serious problems in dealing with the ongoing market turbulence from the standpoint of ensuring the soundness and functioning of the financial system as a whole. Experience of the last banking crisis has made close cooperation between the FSA and the BOJ a natural response to shocks to the financial system, even without a formal mechanism such as a systemic risk board. It is my view that historical and other country-specific circumstances should be taken into account to assess the need to establish such a mechanism, or to contemplate an organizational framework for macroprudential supervision.


Group of Twenty (2009). Underlines have been added by the author of this paper.

Tietmeyer (1999). Emphasis has been added by the author of this paper.

International Monetary Fund (2005). Emphasis has been added by the author of this paper.

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