Macroprudential supervision in banking union

Dirk Schoenmaker 09 December 2012

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There is a strong tendency to focus on the stability and soundness of individual banks. Supervisors may thus be bogged down by the details of these banks, while losing sight of emerging imbalances in the wider financial system. In the heated debate about the Single Supervisory Mechanism, policymakers are preoccupied with issues such as the range of supervision – all 6000 Eurozone banks, or only the large cross-border banks? – and the division of labour between the ECB and the national supervisors.

Another issue is the appropriate separation within the ECB between the monetary function performed by the Governing Council and the supervisory function to be executed by the newly envisaged Supervisory Board. With this preoccupation with micro-issues, we risk missing the broader macro trends in the European financial system.

Integrated policy framework

Europe needs an integrated approach to the EU financial architecture: monetary stability, financial stability (macroprudential), and financial supervision (microprudential). The Eurozone was built on the German approach to central banking, the ECB should only care about monetary stability. Both the 2007-2009 financial crisis and the ongoing euro banking and sovereign crisis show that the interface between the policy objectives of monetary and financial stability is important.

One policy objective, one policy instrument

Tinbergen (1952) argues that you need at least one independent policy instrument for each policy objective. Figure 1 illustrates the overall policy framework for the monetary and financial system. The analysis of the synergies and conflicts of interests between policy objectives is helpful to assigning policy areas to different institutions. When the synergies between objectives dominate, these objectives may be assigned to one institution. By contrast, when the conflicts of interests dominate, objectives may be better assigned to different bodies.

The first trade-off is the interaction between monetary and financial stability. New theories suggest that monetary policy and financial stability policies are closely linked. Adrian and Shin (2008) document that balance sheets of financial intermediaries provide a window on the transmission of monetary policy through capital market conditions. Goodhart (2010) indicates that central banks have resumed their traditional financial stability role after the financial crisis. The main synergy between monetary and financial stability is to steer the financial system.

Diverging trends in monetary and financial stability

A major conflict of interests is diverging trends in monetary and financial stability. While monetary stability focuses on retail consumption prices, financial stability looks at the development of asset prices, such as real estate prices and equity prices, and aims to counter the procyclicality of the financial system (as well as the procyclical working of microprudential supervision). After setting the interest rate for monetary policy purposes, the central bank considers which macroprudential tools are needed to stabilise the financial cycle (leaning against credit bubbles). The chosen interest rate is thus taken as given for financial stability purposes. Macroprudential tools include inter alia countercyclical capital buffers to constrain undue credit growth, loan-to-value ratios to constrain rising real estate prices, margin or collateral requirements to constrain rising equity prices, and the macro-perspective of stress tests.

The second trade-off is between macroprudential and microprudential policies. Until recently, the prevalent approach to financial stability has implicitly assumed that making individual financial institutions safe will make the system as a whole safe. But this is wrong. It represents the fallacy of composition (Brunnermeier et al. 2009). This fallacy concerns the idea, fundamentally at the basis of original Basel banking supervision, that to safeguard the system it suffices to safeguard the components. But in trying to make themselves safer, financial institutions can behave in a way that collectively undermines the system. Selling an asset (such as equity), when the price of risk increases, may be a prudent response from the perspective of an individual bank or insurer. However if many banks and insurers act in this way, the asset price will collapse, forcing financial institutions to take yet further steps to rectify the situation. The responses of the financial institutions themselves to such pressures lead to generalised declines in asset prices, and enhanced correlations and volatility in asset markets. So the micro policies can be destructive at the macro level.

Figure 1. Hierarchy of objectives

A hierarchy of objectives

It is more appropriate to think in terms of a hierarchy of objectives (Figure 1). The first two objectives, price and financial stability, are equally important. The latter objective, sound financial institutions, aims to protect individual depositors and policyholders (against insolvency risk of the financial institution). The first two objectives aimed at the ‘economy’ are more important than the latter objective aimed at ‘individual firms’. In a market-driven economy, financial firms should be allowed to fail to contain moral hazard, unless there is a systemic threat. When there is a conflict of objectives, the macroprudential concerns should override the microprudential concerns (Kremers and Schoenmaker 2010).

The policy framework for banking union

The new integrated framework is designed at the European level, as part of the newly envisaged banking union. The European System of Central Banks, comprising the ECB and the participating NCBs, has already the responsibility for monetary policy. We propose also to assign the macroprudential policy to the European System of Central Banks, as we explain below. The supervisory task in the prospective banking union is assigned to the ECB.

While much has been written on the Single Supervisory Mechanism, it is not yet clear which body can best execute the new strategy for macroprudential policy. In the aftermath of the global financial crisis, financial stability committees with a broad remit are emerging worldwide. Examples are the European Systemic Risk Board (ESRB) and the US Financial Stability Oversight Council (FSOC). Experience suggests that such broad committees, representing more or less independent institutions (central bank, treasury, supervisor) with differing objectives, are not very efficient. Members may manipulate information and vote strategically if their preferences differ. Furthermore, each institution has its own culture. The dominant culture at central banks is centred around economists, while supervisors tend to be dominated by accountants and lawyers. That will also lead to a different perspective: macro versus micro.

Our proposal is that:

  • The European System of Central Banks gets final responsibility for macroprudential policy; and
  • The European Systemic Risk Board as financial stability committee, is used to discuss financial stability developments.

The European Systemic Risk Board would be the forum to discuss macroprudential policies for the wider European Union. It will allow for aligning macroprudential policies of those without – the UK, Sweden, Denmark and most new member states – and the Eurozone. Moreover, it allows for input from the sectoral European supervisory authorities (EBA, EIOPA and ESMA). But to ensure the proactive use of macroprudential tools, the conduct of macroprudential policy would be assigned to the European System of Central Banks.

Coordination between the European and national level

There is an important issue of coordination between the European and national level. The financial cycle tends to differ between countries, also within the Eurozone. So the countercyclical capital buffer, that helps reign in excessive credit growth, is set at the country level in the Basel III framework. Furthermore, house prices, an important driver of the financial cycle, are local in Europe. The same is true for the US, where house price developments can differ significantly between states. Housing markets thus tends to be local and, in some cases, even regional, but certainly national.

Next, interfering in housing is political. While the European System of Central Banks was allowed to develop its own definition of price stability, there should be political involvement of the relevant authorities. If, for example, housing prices were rising sharply in, say, the Netherlands, but nowhere else, one would want the Dutch relevant authorities to have a proportionate much greater say in that decision than central banks and treasuries from elsewhere. This is just another aspect of the problem that macroprudential needs to be applied at a more granular level than Europe. To some extent the same problem may occur in other large geographical areas, like Canada, the US, or Australia.

Way forward

A possible way forward to ensure a proper division of functions at the ECB is to assign the monetary policy and macroprudential functions at the level of the Governing/General Council. As some ‘outs’ may join the banking union, a macroprudential committee reporting to the General Council may be the appropriate setting for macroprudential issues. The supervisory function will be performed by the newly envisaged Supervisory Board. The decision on the application of macroprudential tools will be taken in the General Council, whose members comprise the Executive Board of the ECB, the presidents of the NCBs and the chair of the Supervisory Board1.

This construction allows for both national and micro-supervisory input in the macroprudential deliberations. It also allows for the appropriate separation between the macroprudential perspective (of the General/Governing Council) and the microprudential perspective (of the Supervisory Board).

References

Adrian, T and H Shin (2008), “Financial Intermediaries, Financial Stability, and Monetary Policy”, Federal Reserve Bank of New York Staff Report, 346.

Brunnermeier, M, A Crockett, C Goodhart, A Persaud and H Shin (2009), The Fundamental Principles of Financial Regulation: 11th Geneva Report on the World Economy, CEPR, London.

Goodhart, C (2010), “The Changing Role of Central Banks”, BIS Working Papers, 326, Bank for International Settlements, Basel.

Kremers, J and D Schoenmaker (2010), “Twin Peaks: Experiences in the Netherlands”, Special Paper, 196, LSE Financial Markets Group, London.

Tinbergen, J (1952), On the Theory of Economic Policy, North Holland, Amsterdam.


1 Article 19.1 of the draft Council Regulation on prudential supervision in Banking Union specifies that the Chair of the Supervisory Board shall be elected from the Executive Board of the ECB.

 

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Topics:  EU institutions EU policies Europe's nations and regions

Tags:  Eurozone crisis, Macroprudential policy, banking union