Macroprudential Supervision and the Transmission Mechanism
What is the Central Bank thinking?
Below is a review of recent central bank literature in the area of macro prudential supervision, this review is intended to elucidate why it is that a banking crisis crosses the line between free market private individual economics and public sector control, in a sense why the banking system is “different” in that executive officers of a financial institution have a higher order responsibility (ironically) to the general welfare of the population which flows form their interrelationships with government. The below may seem like an “as dry as dust” exposition of some complex theories of monetary economics but this detail was omitted as background generally to the process of implementation of Basel II during the early to mid 2000s, it was “taken as read”; what the process and events of the CC [CREDIT CRISIS] make clear is that the logic presented was generally unread.
A leading Central Banker recently presented an eloquent and succinct definition of Financial Stability, here it is;
“ Financial stability exists when the various parts of the financial system such as payments and settlements systems, financial markets and financial intermediaries such as banks can operate smoothly and without interruption and with each part resilient to shocks. A stable financial system is able to absorb adverse shocks. The maintenance of a stable financial system is fundamentally important to the operation of the economy. For example, it facilitates the provision of credit, the security of depositors’ funds and the smooth operation of payments systems. Serious financial instability can manifest itself in terms of banking crises and recession and can be very costly for any economy in terms of disruption and reduced output and employment.”
Macroprudential Supervision and the Transmission Mechanism
Macroprudential Supervision is the role of Central Banks and Supervisors as quasi executives of government in oversight and maintenance of the stability of the financial system. David Blanchflower, noted academic and an x-member of the Bank of England’s Monetary Policy Committee (MPC), [the committee which sets UK interest rates in the context of the UK Government’s Economic Policy], described the role of the Bank of England in a speech in Edinburgh;
“The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment. Price stability is defined by the Government’s inflation target.”
In his conclusions to the speech Blanchflower describes the manner in which the CC has obfuscated the ability of the Bank of England and the UK Government to manage economic policy;
“There have been difficulties recently with the very high rate of the 3-month LIBOR, which is one measure of the rate at which banks lend unsecured funds to each other on the London wholesale money market. LIBOR at term maturities beyond a month normally stays reasonably close to actual or expected policy rate. However, it has exceeded Bank Rate, by a considerable margin in recent months. The spread of three month LIBOR over overnight index swaps, (an approximation of the expected policy rate; have risen since around August 2007, at times reaching 100bp, a spread not seen since sterling left the ERM in 1992. At the time of writing the LIBOR rate was 5.89% compared with Bank Rate of 5.0%. The spread between LIBOR and Bank Rate is a measure of liquidity and is often used as an indicator of credit risk. The spread tends to be much wider during times of financial stress, because at such times banks and other financial institutions are reluctant to lend to each other, as they perceive that there is a higher risk that they will not be repaid. As a consequence, when we cut rates by 25bps on April 10th was not reflected in lower retail rates. The credit markets need to be unlocked. The Special Liquidity Scheme, that I welcome, is designed to address the impasse in credit markets by putting further liquidity into the system, allowing banks to swap temporarily their high quality mortgage-backed and other securities for UK Treasury Bills. The hope now is that the LIBOR rates will fall and the normal transmission mechanism of monetary policy is restored.”
Macroprudential oversight is focused upon what is called the Transmission Mechanism (of Monetary Policy, to give it its full title!), the manner in a post Friedman world in which Government policy objectives and fine tuning are effected upon the real economy and the behavior of citizens (or subjects)! If banking crises disrupt the Monetary Transmission Mechanism then the Government and its agency representatives have no choice but to constrain the ability of the banking industry to do it again, otherwise in effect we are all ruled by risk mad bankers! That is the point of this post CC politicization of banking analysis! Let us look as briefly as possible at a simple depiction of what the monetary transmission mechanism is before proceeding to analyze how banking crises work through their disruptive effects thus concluding with where Banking supervision has to proceed in a Basel III world.
The Transmission Mechanism of Monetary Policy
The glossary on the European Central Bank website simply describes the Transmission Mechanism as;
“The process through which monetary policy decisions, e.g. the interest rate decisions taken by the Governing Council in the case of the euro area, affect the economy in general and the price level in particular.”
Stability is therefore inherently intertwined with the Transmission Mechanism. A 1999 paper from the Bank of England describes the Transmission Mechanism.
“Monetary policy works largely via its influence on aggregate demand in the economy. There are several links in the chain of causation running from monetary policy changes to their ultimate effects on the economy; this is termed the Transmission Mechanism of Monetary Policy. A central bank derives the power to determine a specific interest rate in the wholesale money markets from the fact that it is the monopoly supplier of ‘high-powered’ money, which is also known as ‘base money’. The key point is that the Bank chooses the price at which it will lend high-powered money to private sector institutions. In the United Kingdom, the Bank lends predominantly through gilt sale and repurchase agreements (repo) at the two-week maturity. This repo rate is the ‘official rate’. A change in the official rate is immediately transmitted to other short-term sterling wholesale money-market rates, both to money-market instruments of different maturity (such as rates on repo contracts of maturities other than two weeks) and to other short-term rates, such as interbank deposits. This quickly affects the interest rates that banks charge their customers for variable-rate loans, including overdrafts.”
If other things are equal (especially inflation expectations), higher interest rates also lower other securities prices, such as equities. This is because expected future returns are discounted by a larger factor, so the present value of any given future income stream falls.
Individuals are affected by a monetary policy change in several ways. First, they face new rates of interest on their savings and debts. So the disposable incomes of savers and borrowers alter, as does the incentive to save rather than consume. Second, the value of individuals’ financial wealth changes as a result of changes in asset prices. Firms are affected by the changes in market interest rates, asset prices and the exchange rate that may follow a monetary policy change. Changes in firms’ financial position in turn may lead to changes in their investment and employment plans. All of the changes in individuals’ and firms’ behaviour, when added up across the whole economy, generate changes in aggregate spending.
“From time to time, there may be effects running from the banking sector to spending behavior not directly caused by changes in interest rates, for example a fall in bank lending, caused by losses of capital on bad loans or by a tightening of the regulatory environment. Negative shocks of this kind are sometimes referred to as a ‘credit crunch’!”
The relationship of Short Term Interest Rates and Risk Appetite.
In a special feature of its Financial Stability Review (FSR) of December 2007 the European Central Bank reviews the impact that short term interest rates have upon the banking system’s appetite for Credit Risk.
Before we explore the ECB view of this crucial relationship (published at the zenith of the CC we note), let us remind ourselves of the interrelationship of the “three estates” concerned in this financial stability merry-go-round. In general a Central Bank manages Money Supply through the Banking System, affecting the behavior of ordinary people and corporates directly through short term interest rates. The Central Bank does that as an agent of the Central Government of a democracy. The Banking system can then disrupt that “transmission mechanism” interrelationship either through structural innovation or by failure to hold sufficient capital as a result of a lack of recognition of interconnectedness in the politico-economic process. This is a rough exposition, for sure, but a useful summary before we proceed.
The authors of this ECB special supplement argue that banks are at the core of the financial system and credit risk is the main risk that they face. Therefore, it is crucial for financial stability that bankers and other specialists engaged in supporting the banking industry understand the effects of monetary policy on bank risk-taking and credit risk.
The ECB paper states that the interrelationship of credit risk appetite and short term interest rates have not been studied to any great extent. By contrast, the effects of monetary policy on the volume of bank credit in the economy have been widely studied. These studies have concluded that an expansionary monetary policy increases the volume of bank loans in the economy.
Following a brief overview study of the relationship between credit risk and short term interest rates the ECB paper concludes;
“when interest rates are low at loan origination, not only do banks grant loans with higher credit risk, but they also relax their lending standards and lend more to borrowers with bad credit histories and sub-prime credit ratings. All of these results suggest that bank risk-taking increases when interest rates are low at loan origination and that in this way monetary policy affects the composition of bank credit in the economy” The paper continues, “Empirical evidence indicates that low short-term interest rates encourage bank risk-taking. Banks relax their lending standards and grant loans with higher credit risk but reduce loan spreads. Despite this increased risk-taking, low short-term interest rates reduce credit risk in the very short run since they reduce refinancing costs, thereby lowering the credit risk of outstanding bank loans. As the volume of outstanding bank loans is larger than that of new loans, low interest rates may make banks safer in the very short run. In the medium run, however, interest rates that are too low encourage bank risk-taking and increase credit risk in banks, thereby threatening financial stability, especially if they then return to or rise above normal levels”.
Finally the ECB special paper concluded with a salutary recommendation for Bank supervisors and indeed Bank executives also; “It is also found that banks which are less well monitored – and therefore more subject to moral hazard – take on excessive risk when interest rates are low, thus suggesting that better banking regulation and corporate governance reduce the impact of low short-term interest rates on risk-taking.”
Claudio Borio, an important member of the staff of the Bank for International Settlements who has written extensively on issues in Risk Management and who made a crucial contribution to the Basel II implementation process agrees with the ECB authors in his paper reviewing the CC as Borio sees it;
“underwriting standards become looser during particularly benign conditions in the more mature stages of credit booms, with the loans granted during those stages having the worst ex post default performance.”
Macroprudential Policy and Banking Practice
Hervé Hannoun, Deputy General Manager of the BIS reminds us in a recent speech that a Macroprudential framework has been advocated since the early 2000s by the BIS.
“This approach starts from the observation that systemic risk and the time dimension of risk are not properly addressed by traditional Microprudential supervision. Under Microprudential regulation, each individual institution is the unit of analysis and supervision. In contrast, Macroprudential approaches focus on the system as a whole, and the linkages with the macroeconomy (“looking at the wood and not just at the trees”). Moreover, Macroprudential approaches make it possible to capture the time dimension of risk and to address the concern of excessive procyclicality in the financial system. The basic principle is to encourage the build-up of cushions in good times, when imbalances typically emerge, so that they can be run down in bad times, as the imbalances unwind.”
It could be argued that Pillar One of Basel II is the Microprudential constraint upon the banking institution whereas Pillar II is the Macroprudential aspect to the Bank’s capital requirement, that quantity of capital which provides insurance against the institutions interdependence with the system via its liquidity risk and exposure to macroeconomic policy alterations through interest rate risk. This is the function of what we refer to as “economic capital” as opposed to basic regulatory capital. Hannoun continues;
“The 2007 credit crisis has highlighted, first, the need to address risk management weaknesses. VaR-type methodologies have proven procyclical and unable to prevent excessive leverage in a context of very low volatility. Economic capital calculation based on such methodologies is a useful tool, but it should be complemented by stress testing and by basic judgment and simple indicators. Economic capital and VaR techniques amount to transforming large nominal amounts into very small values-at-risk. This reduces the perceived order of magnitude of risk exposures and gives a false sense of comfort.”
Hannoun then cites the important article by Alan Greenspan in the Financial Times of March 16th 2008 which appeared in “The Economists Forum” (the forum is in fact a blog) chaired by Martin Woolf, cited above. The Greenspan article is titled “We will never have a perfect model of risk”. Hannoun quotes Greenspan;
“The essential problem is that our models – both risk models and econometric models – as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality.”
Hannoun comments that
“Supervisors have to keep pace with complex financial innovation and models, but at the same time they have to restore simplicity, Supervisors may have overestimated the magnitude of existing capital buffers. Large global banks were not as well capitalized as was previously thought. The recent turmoil has also highlighted the need to implement Basel II. This framework should thus be promptly implemented. At the same time, all three pillars in the new Basel II Framework are currently being refined by the Basel Committee and further strengthened to reflect the lessons from the recent market turbulence and to tackle issues relating to off-balance sheet commitments and structured finance securitisation, More generally, it is key to make sure that banks hold strong capital buffers over the cycle.”
Hannoun is arguing for committed implementation of Pillar II of the Basel II accord, the economic capital quantification aspect of Basel. Greenspan is commenting upon the nature of the quantitative modeling necessary to support the quantification of economic capital. In a way both are taking regulatory capital as read. Greenspan sees “correlations among asset classes” as key to the modeling of economic capital; correlations which look negative in the business cycle upswing become clearly positive in the downswing, discrimination in the modeling of correlations is the necessity to see “risk management systems would be improved significantly”. What can be clearly seen in the views of both these important commentators on the banking system is that comprehensive and sophisticated quantification of risk capital is a fundamental necessity in banking going forward.
 John Hurley: Recent issues in financial stability, Address by Mr John Hurley, Governor of the Central Bank & Financial Services Authority of Ireland, to the Institute of Internal Auditors, Dublin, 18 April 2008.
 Speech by DAVID BLANCHFLOWER, Bruce V. Rauner Professor, Dartmouth Cllege, University of Stirling, and Member, Monetary Policy Committee, Bank of England. Inflation, Expectations and Monetary Policy, Tuesday, 29 April 2008, At the Royal Society, George Street, Edinburgh
 The transmission mechanism of monetary policy, The Monetary Policy Committee, Bank of England A Paper by the Monetary Policy Committee - April 1999
 ECB FINANCIAL STABILITY REVIEW, DECEMBER 2007, Special feature B, THE IMPACT OF SHORT-TERM INTEREST RATES ON BANK CREDIT RISK-TAKING
 BIS Working Papers, No 180; Accounting, prudential regulation and financial stability: elements of a Synthesis, by Claudio Borio and Kostas Tsatsaronis, Monetary and Economic Department September 2005.
 BIS Working Papers, No 251, The financial turmoil of 2007–?: a preliminary assessment and some policy considerations by Claudio Borio, Monetary and Economic Department, March 2008
 Policy lessons from the recent financial market turmoil, Speech by Hervé Hannoun, Deputy General Manager of the BIS, XLV Meeting of Central Bank Governors of the American Continent, Ottawa, 8–9 May 2008.