Why macroprudential policy fails?

Financial system is once more at risk under the COVID-19 threat. Since 2008, little has been done to develop a ‘’macro’’prudential approach.

Current macroprudential tools are, indeed, not macro characterized. Micro tools, such as liquidity and capital ratios, may not mitigate the systemic risk, targeting financial entities individually. The ‘’too big to fail’’ approach conflicts with a macro perspective as well.

In the interdependent and complex relations of the financial system, collapse of a minor actor might also pull the trigger of a default contagion. Lehman Brothers is an example of this.

According to the BIS, the counter party risk still exists for derivatives although the share of OTC derivative transactions has significantly fallen. Moreover, concentrating transactions on central counter parties does not entirely resolve the default problem since central counter parties (CCP) might also default.

Macroprudential goals

Both European Central Bank and International Monetary Fund argue that macroprudential approach differs from a micro perspective with respect to its focus on the system rather than individual financial institutions. The 2008 Global Financial Crisis has shown that the financial system should be analyzed as a whole in order to prevent the domino effects of the systemic risk. As the European Central Bank stated, macroprudential policy pursues three goals: 1) to prevent excessive risk taking, 2) to limit contagion effects, 3) to create right incentives for the market.

To prevent excessive risk taking, BASEL III standards require additional capital and liquidity buffers for each individual financial institution. Yet, regulating entities individually is a micro approach, which cannot entirely eliminate the systemic risk which arises from the interdependent relations in the financial system.

The second goal of limiting contagion effects brings a macro perspective. In this regard, regulatory bodies have imposed systemic risk buffers for the systemically important banks (SIBS), which are too big to fail. That is, fail of SIBs can cause a domino effect of defaults in the financial system. The ‘’too big to fail’’ approach, nonetheless, conflicts with a macro perspective as well. In the interdependent and complex relations of the financial system, collapse of a minor actor might also pull the trigger of a default contagion. Lehman Brothers is an example of this. The US authorities let Lehman Brothers fail because it was insolvent and was not ‘too big to fail’. Lehman’s bankruptcy pulled the trigger and, later on, 12 out of 13 biggest US banks needed bailout as Ben Bernanke stated in an interview (Carney 2011). During the COVID-19 crisis, non-banks are once again the weakest actors of the financial system. In the US, designation of non-banks as systemically important institution has been dependent to Financial Stability Oversight Council (FSOC)’s discretion. The FSOC lifted the designation of Prudential Financial in October 2017, AIG in September 2017, and GE Capital in June 2016 (The US Department of Treasury 2018). Again the financial system became fragile to nonbank exposures.

To reduce interconnectedness, the regulation of the over the counter (OTC) transactions have been a step further. OTC transactions were required to be conducted with a central counter party. So in case of a crisis, an institution failing to fulfill its obligations would not cause the damage to its lender. According to the BIS, counter party risk continues for derivatives although the share of OTC transactions has fallen. Besides, concentrating transactions on central counter parties does not entirely resolve the default problem since central counter parties (CCP) might also default. ‘‘In September 2018, a single trader's default wiped out roughly two thirds of the commodities default fund at Nasdaq Clearing AB, a Swedish CCP’’ (BIS 2018).

The third goal, creating right incentives for the market, is even harder to realize. Setting incentives for the market might have adverse effects as well. For instance, requiring banks to analyze and provide mortgage only to customers with sound savings capacity could lower the demand side of the mortgage loans. While the supply side of the mortgage funds is strong, a lower demand could push the housing prices up. While designing incentives, regulatory bodies have to bear all possible consequences in mind.

Additionally, measuring the systemic risk can also be a macroprudential goal. A crisis usually comes about when the decision makers are confident that the economic infrastructure is strong enough to overcome financial shocks. Therefore, a regulatory body should be authorized to periodically analyze the systemic risk, to be able to warn decision makers to take unordinary precautions in case of a crisis. After 2008, countries established monitoring missions. Nevertheless, difficulties continue in the collection of the systemic risk data. Broader authority is required especially to compile OTC transactions.

Conclusion

Financial stability regulations have so far been micro characterized. With the COVID-19 financial crisis, authorities will hopefully recognize the shortages of micro tools and they will target transaction types instead of entities.

References

Armour, John, Dan Awrey, Paul Davies, Luca En riques, Jeffrey Gordon, Colin Mayer and Jennifer Payne, 1999, Principles of Financial Regulation (Oxford: Oxford Universit. Press), pp. 416-422.

Carney, John. 2011. Bernanke’s Mystery: 12 Out of 13 Major Firms at Risk in 2008. CNBC. https://www.cnbc.com/id/41310901

Faruqui, Umar, Wenqian Huang and Előd Takáts. 2018. Clearing risks in OTC derivatives markets: the CCP-bank nexus. BIS Quarterly Review, December 2018. https://www.bis.org/author/wenqian_huang.htm

Garry J. Schinasi, 2004, ‘‘Defining Financial Stability.’’ IMF Working Paper, No. 04/187, https://www.imf.org/external/pubs/ft/wp/2004/wp04187.pdf

U.S. Department of the Treasury 2018. 2018. Financial Stability Oversight Council. Accessed November 20, 2018. https://www.treasury.gov/initiatives/fsoc/designations/Pages/default.aspx#nonbank