Procyclicality and Macroprudential Policy

Procyclicality and Macroprudential Policy Jan Frait

I.Procyclicality and Provisioning

Procyclicality • Financial system procyclicality means the ability of the financial system to amplify fluctuations of economic activity over the business cycle via procyclicality in financial institutions’ lending and other activities. • The procyclical behaviour of financial markets transmits to the real economy in amplified form through easy funding of expenditures and investments in good times and financial restrictions leading to declining demand in bad times. • Procyclicality have increased over the last few yearsdue to (i) the greater use of leverage in the financial and real sectors, (ii) closer ties between market and funding liquidity e.g. through increased use of collateral in secured financing, (iii) increased contagion effects in integrated markets as well as (iv) the (unintended) effects of some regulations, including accounting standards. (EFC WG Report 2009)

To provision or not to provision • Debate about the instruments that might reduce the potential procyclicality of regulation is not a new one. • Borio and Lowe (2001) – To provision or not provision • paper written just prior to the setting and implementation of current regulations, • describes a conflict between the interests of supervisors and accountants, • financial supervisors have tended to emphasise the role that provisions can play in ensuring that banks maintain adequate buffers against future deteriorations in credit quality, • accounting authorities have stressed the importance of provisions in generating fair and objective loan valuations. • The accountants won the battle … but after a few years we seem to be at the start back again.

To provision or not to provision, to buffer or not to buffer • After the crisis - to provision or not to provision, to build capital buffers or not to build capital buffers • bank supervisors have always beenmore supportive of liberal general provisioning regimes and reserves than have accountingand securities authorities • this time the supervisors may use the opportunity, but it is not so easy to win a war … • Procyclicality may be caused by broad spectrum of factors going much beyond accounting and capital regulation framework of financial institutions‘ regulation.

Procyclicality as a hot issue • ECOFIN roadmap on financial supervision, stability and regulation takes the issue of procyclicality rather seriously: • Valuation and accounting standards: Refinement of the accounting rules in respect of dynamic provisioning • Pro-cyclicality: • Follow-up to the report of the EFC-WG on Pro-cyclicality and the July Ecofin Conclusions Possible measures to address pro-cyclicality of capital requirements in the short term • Identify policy tools to mitigate pro-cyclicality in the financial system and financial regulation, including of capital requirements through counter-cyclical capital buffers in the CRD - dynamic provisioning, proc-cyclicality of CRD. • Similar agenda set also by Financial Stability Board. • Projects set by BCBS and IASB to propose what is required and expected.

To provision or not to provision • In general principle, banks should set aside provisions to cover their expected losses while their capital should primarily be used to cover unexpected losses. • There generally exist several provisioning systems differing in either when the provisions are created and entered in the accounts or what event triggers provisioning. • Currently prevailing practice is “specific” provisioning. • specific provisions are fixed against losses on predominantly individually assessed loans and start at the moment an evident event occurs; • specific provisioning is backward looking (i.e. it identifies risk ex post). • General provisions • are set against losses from portfolios of loans and can be forward looking (i.e. they identify credit risk ex ante)

To provision or not to provision • The key argument for forward-looking provisioning is the inherent tendency of banks to relax excessively lending standards during economic upturns and tighten them excessively during downturns • the risks are underestimated during upturns leading to credit booms with loans extended with prices set too low, • subsequent downturn leads to re-pricing under the impact of higher default rate, potentially ending in credit crunch. • Forward-looking provisioning should therefore help to ensure correct pricing of expected credit risk emerging at time when the credit is extended.

To provision or not to provision • The international accounting standards currently in force (IAS 39) allow banks to provision only for loans for which there is clear evidence of impairment (i.e. backward-looking provisioning). • specific provisions are created and entered in the accounts only after credit risk comes to light (which usually occurs in times of recession), • In the general/dynamic provisioning system provisions are also created when credit risk comes into being (i.e. to a large degree in times of boom) • banks provision against existing loans in each accounting period in accordance with the assumption for expected losses: • at times when actual losses are smaller than assumed a buffer is created which can then be used at times when losses exceed the estimated level… • This looks straighforward, but in practice it is not so.

Half of NPLs is not overdue ... Creation of LLP follows cycle, but not fully LLPR in CZ 10

Provisioning in Spain • Spain used „traditional“ provisioning up to 2000: • general provisions (GP) reflected estimate of average expected loss from total loans: • GP = g*ΔL , where L stands for total loans and g for the parameter (between 0.5% and 1%), • while specific provisions (SP) were set in a standard way: • SP= e*ΔM, where M stands for impaired loans and e for the parameter (between 10% and 100%). • total provisions: TP = g*ΔL + e*ΔM. • In 2000, additional compotent was added – statistical provisions: • Total provision (TP) = Specific (SP) + General (GP) + Statistical (StP)

Provisioning in Spain • Banks sorted loans to six homogenous categories with different risk coefficient s (defined by supervisor as average specific provision rate over the whole cycle). • StP = Lr – SP, where Lr is a latent risk s*L, where s stands for the coefficient of a historical average specific provisions (between 0% and 1.5% in the standard approach), • SP < Lr (low impairedloans) StP>0 (building up of the statistical fund), • SP > Lr(high impaired loans) StP<0 (depletion of the statistical fund), • balance of the statistical fund: StF = StPt+StFt-1, with a limit: 0≤StF≤3*Lr

Provisioning in Spain • System had to be modified with effect from 2005 due to the IRFS – statistical provisions were hidden in newly defined general provisons: Total provision (TP) = Specific (SP) + General (GP) SP: unchanged, GP: • banks must make provisions against the credit growth according to parameter  which is the average ratio of estimated credit losses (“collective assessment for impairment” in a year neutral from a cyclical perspective) and  parameter which is the historical ratio of average specific provision (coefficient s in previous version), • 1st component reflects losses in the past, 2nd reflects specific provisions in the past relative to current ones (dynamic component), • limits for fund set as 0,1% ≤ GF ≤ 1,5% of total loans.

Provisioning in Spain • Developments in provisioning funds in Spain after 2000 – developments of provisions‘ components Source: Saurina, J. (2009): The Spanish experience of counter-cyclical regulation. Prague, October 23, 2009.

Provisioning in Spain • Spanish authorities considered a new system IFRS compatible (IFSB not). • Fund was set in good times, buffer was created prior to current crisis • NPLs 200% covered at the beginning of 2008 (EU average 60%), • Nevertheless, at the end of 2008 only 100% covered, later on not covered … • never sure whether the fund will suffice ... still better that nothing. • Spanish system viewed as accounting tool – though BdE considers it as part of toolbox for macroprudential supervision. • BdE does not think it distorts accounting statements: • Banks are required to disclose the amount of the dynamic provision, apart from the specific provision. • Thus, users of accounting statements can “undo” the impact of the dynamic provision on the P&L.

Provisioning in Spain • Spanish system was rather simple – a kind of pre-dynamic provisioning: • not optimal, just one of potential solutions, • doubts whether it really restricts excessive lending, • can hardly be adopted in current recessionary conditions, • unilateral attempts to do so might do more harm than gain – see Brunnermeier, M. et al. (2009), • proposal by Commissionto use it via CRD supported neither by industry nor by supervisors (including the CNB).

Do the Czech banks provision procyclically? • There is a negative relationship between GDP growth and the ratio of loan loss provisions to total loans in the Czech Republic for the period 1998–2008. • Does it reflect procyclical behaviour? • If yes, how strong are the non-procyclical features of banks‘ behaviour? • For results see Frait and Komárková (2009)

Do the Czech banks provision procyclically? • There is a negative relationship between GDP growth and the ratio of loan loss provisions to total loans in the Czech Republic for the period 2001–2011. • Does it reflect procyclical behaviour? • If yes, how strong are the non-procyclical features of banks‘ behaviour?

Do the Czech banks provision procyclically? • Variables: • macroeconomic: the growth rate of real GDP (ΔlnGDP), • the unemployment gap (UNEMPL_gap); • bank-specific: the ratio of loan loss provisions to average total assets (LLP/TA), loan growth (ΔlnLOANS), the ratio of total loans to TA (LOANS/TA), pre-tax earnings (EARN), the ratio of equity capital to TA; • other: „t“ denotes time and „i“ the individual banks, TA stands for the average total assets for the two periods (0.5(TAt+TAt-1)).

Do the Czech banks provision procyclically? • If banks behave procyclically, the rate of economic growth will be negatively correlated with provisioning, unemployment rate gap positively, loans growth and the ratio of total loans to total assets positively if banks behave prudentially, pre-tax profitpositively, capital ratio more likely negatively.

Do the Czech banks provision procyclically? • Conclusions: • The negative GDP growth and positive unemployment rate gap suggest that provisioning is significantly procyclical and lacks to a large extent forward-looking assessment of cycle-related risk; • …however • The procyclicality is being partly reduced: • (i) positive and relative high coefficient of the pre-tax profit = the income smoothing or tax optimization, • (ii) positive coefficient of loans to total assets = prudential behaviour confirmed; • … but banks set aside fewer provisions to cover their expected losses when their capital buffer is larger (negative capital/TA coeff.).

II.Proposals for taming procyclicality

Existing proposals for taming procyclicality • Through-the-cycle expected loss provisioning (TELP) – EU Commission consultation to further changes in CRD from July 2009: • Based on through-the-cycle expected loss – forward looking estimation of losses that should be covered by TELP. • TELP designed in line with Spanish approach – baseline method uses both α and β parameters, more simple method considers parameter β only. • Prudential measure of a „corrective kind“ which nevertheless has impact on the accounting. • Proposal does not address the issue of consistency between IFRS and CRD. • TELP potentially in conflict with regulatory concept of expected loss in Basel II. • IRB institutions (only) apply models to set expected losses and their coverage by provisions is tested (if provisions not sufficient, difference deducted from regulatory capital).

Existing proposals for taming procyclicality • Expected loss approach (IASB, June 2009) • The expected cash flow approach - considered as a part of IASB project on replacing IAS 39 Financial Instruments Measurement and Recognition. • A major deviation from incurred loss approach - no trigger for an impairment test required • it should reflect better the economic reality of banks’ lending activities than the incurred loss approach in that it requires an earlier recognition of expected credit losses, • it should help to avoid ‘incurred but not reported losses’. • The present value of the expected future cash flows is measured using an initial internal rate of return calculated on the basis of cash flows actually expected at inception (taking into account expected credit losses), and not on the basis of contractually agreed cash flows.

Existing proposals for taming procyclicality • Expected loss approach (IASB, June 2009) cont. • Initial internal rate of return will thus be lower than the contractual rate, with the difference representing the risk premium charged to the borrower in order to cover the statistically foreseeable risk of non-recovery. • Difference between cash flows received that represent contractual interest and interest recognised as revenues on the basis of the (lower) internal rate of return would be recognised in the balance sheet as a credit expected loss provision. • Subsequent or additional impairment loss is recognised through continuous re-estimation of credit loss expectations. Reversal of impairment loss is recognised in profit or loss when there is a favourable change in credit loss expectations. • Would bring subjectivity, number of complex issues, transparency issues. • Spanish approach and economic cycle reserve can serve as complementary tools to it.

Existing proposals for taming procyclicality • Economic cycle reserve (ECR) – UK Turner review • An additional non-distributable reserve which would set aside profit in good years to anticipate losses likely to arise in future. • A formula driven method would simple and non-discretionary similarly to Spanish system: • a buffer of the order of magnitude of 2 – 3 % of RWAs at the peak of the cycle, • reserve could vary according to some predetermined metric such as the growth of the balance sheet or estimates of average through-the-cycle loan losses. • A discretionary method would be entity-specific, tailored to the peculiarities of each bank’s portfolios.

Existing proposals for taming procyclicality • Economic cycle reserve (ECR) – UK Turner review cont. • The approach has a macro-prudential defensive focus and is meant to be accounting neutral • it is to be shown only as a movement on the balance sheet, rather than on the P&L (is intended to be built and drawn by appropriation of retained earnings), • but there are very strong arguments that it should also appear somewhere on the P&L, • allowing bottom line profit and earnings per share (EPS) to be calculated both before and afterits effect, and thus providing two measures of profitability, the ‘traditional’ accounting figureand a second figure struck after economic cycle reserving. • Capital buffers under Basel III and CRD4 (conservation, countercyclical, systemic risk, SIFI) – now at the most advanced stage due to its attractiveness to the regulators and supervisors.

III.Capital buffers

Capital buffers:nothing new • Borio and Lowe (2001)revisited • One possibility … is a clearer treatment of the relationship between provisions and regulatory capital … • to exclude general provisions from capital and to set provisions so that they cover an estimate of the net embedded loss in a bank’s loan portfolio, • capital could then be calibrated with respect to the variability in those losses (their “unexpected” component). (p. 46) • Another approach … supervisors could supplement capital requirements with a prudential provisioning requirement … • instead of having the annual statistical provisioning charge deducted from a bank’s profit and loss statement, have it added to the bank’s regulatory capital requirement for unexpected losses. (p. 48)

Capital buffers:nothing new • Procyclicality of Basel II was widely debated prior its implementation. • There was a clear understanding that risk-sensitive regulatory capital requirements tend to rise more in recessions and grow less during expansions, laying the ground for potentially pro-cyclical effects. • The authors of the framework therefore pretended that they included some mitigating factors to dampen the potential pro-cyclical effect of Basel II's increased risk-sensitivity. • Although improved risk management was one of the arguments for the introduction of Basel II, it now appears that neither regulatory capital nor economic capital has been set adequately to capture actual risk, particularly the risk contained in the trading book.

Capital buffers:nothing new • High (perceived) costs of scraping Basel II down was reflected in the desire of regulators/supervisors to continue relying on Basel II framework in dealing with procyclicality. • First, they hoped, after the current crisis, micropolicies might become easier for implementation including „theoretical“ tools within current Basel II-Pillar 2: • Internal Capital Adequacy Assessment Process, Supervisory Review and Evaluation Process • Stress testing with scenarios and methodology from supervisors • Backward testing of PDs and LGDs, downturn LGDs, conservative margins, tests of adequacy of provisions ... • Second, they struggled to add some procyclicality-mitigating factors into the concept.

CEBS proposal • CEBS (CEBS, 2009) proposed practical tools for supervisors to assess under Pillar 2 the capital buffers that banks have to maintain under the Basel II/CRD framework (focusing on procyclicality of banking book of IRB banks). • CEBS was considering the use of mechanisms that adjust probabilities of default (PDs) estimated by banks, in order to incorporate recessionary conditions. • Current PD: the long-term average of the default rates (either at the grade or portfolio level). • Downturn PD: the highest PD over a predetermined time-span. • The scaling factor is: SF = PD_downturn / PD_current (close to 1 in a recession and higher than 1 in expansionary phases). • The size of the buffer decreases in recession and increases in an upswing. • CEBS says proposal might easily be adapted in a Pillar 1 context, but ...

Countercyclical capital buffers • BCBS‘s Countercyclical Capital Buffer proposal (2nd stage, issued for comments in September 2010) • The CCB proposal is designed to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. • The primary aim is to use a buffer of capital to achieve the macroprudential goal of protecting the banking sector from periods of excess credit growth that have often been associated with the build up of system-wide risk. • Protecting the banking sector in this context is not simply ensuring that individual banks remain solvent through a period of stress. Rather, the aim is to ensure that the banks in aggregate has the capital on hand to maintain the flow of credit in the economy without its solvency being questioned, when the financial system experiences stress after a period of excess credit growth. • This focus on excess aggregate credit growth means that jurisdictions are likely to only need to deploy the buffer on an infrequent basis, perhaps as infrequently as once every 10 to 20 years.

Countercyclical capital buffers • The starting point is Basel III new regulatory capitalization minimums: • New common equity ratio (Core Tier1, CT1) of 7%, split between a 4.5% minimum requirement and a conservation buffer of 2.5%. • A countercyclical buffer of up to 2.5% of common equity, implemented according to national circumstance. • A supplementary, non-risk-based leverage ratio, to be tested at 3%. • Systemically important banks to carry loss-absorbing capacity “beyond the standards announced”. • The CCB is thus presented as an add-on to the capital conservation buffer, effectively stretching the size of the rangein which restrictions on distributions of profits are applied.

Countercyclical capital buffers • The starting point is Basel III new regulatory capitalization minimums (cont.): • Goldman Sachs view of Basel III (GS Global Investment Research): • CT1 ratio of 7% as the new regulatory minimum for banks of non-systemic importance - for banks deemed to be of systemic importance, the CT1 minimum is subject to an additional surcharge and is therefore to be set at a level above the 7% CT1 minimum. • A regulatory minimum is just that: a minimum. In practice, banks will aim to exceed the minimum to be on the safe-side; and exceeded it further, before capital return to shareholders is considered. 7% is not the “magic” number; rather, it is a floor. • From an equity investor’s perspective, the relevant level of capital is not the regulatory minimum but rather one above which all key parties—bank managements, regulators, debt holders, “the market”—would not object to capital being returned to shareholders. This level—the GS target capitalization—will also differ among banks.

Countercyclical capital buffers • The starting point is Basel III new regulatory capitalization minimums (cont.): • Goldman Sachs view of Basel III

Countercyclical capital buffers • The essence of CCB: • Calibration of CCB should be based on credit-to-GDP ratio and its deviation from its long-term trend. • The proposal uses a broad definition of credit that will capture all sources of debt funds for the private sector (including funds raised abroad) to calculate a starting buffer guide. Ideally the definition of credit should include all credit extended to households and other non-financial private entities in an economy independent of its form and the identity of the supplier of funds. . • Conversely, the buffer would be released when, in the judgment of the authorities, the released capital would help absorb losses in the banking system that pose a risk to financial stability. This would help reduce the risk that available credit is constrained by regulatory capital requirements. • Authorities in each jurisdiction will be responsible for setting the buffer add-on applicable to credit exposures to counterparties/borrowers in its jurisdiction. • The buffer that will apply to an internationally active bank will reflect the geographic composition of the bank’s portfolio of credit exposures.

Countercyclical capital buffers • The essence of CCB (cont.): • By design, the constraints imposed on banks with capital levels at the top of the range would be minimal. • The buffer range is divided into quartiles determining the percentage of earnings to be conserved (calibration not finished yet).

Countercyclical capital buffers • The essence of CCB (cont.) - the example: • Minimum CT1 requirement for all banks is 4,5% of RWA + the capital conservation buffer is set at 2,5% of RWA. • Under this setting a bank with a CT1 ratio of 7,5% or higher would not be subject to any restrictions on distributions of capital as restrictions are only imposed in the range of 4,5% – 7%. • If this bank becomes subject to a CCB add-on of 2%, the range in which restrictions on distributions are imposed becomes 4,5% – 9%. • CT1 capital ratio of 7.5% is in the third quartile of this range and so, using the numbers in the table above, would be required to conserve 60% of earnings. • To allow banks time to adjust to a buffer level that exceeds the fixed capital conservation range, they would be given 12 months to get their capital levels above the top of the extended range, before restrictions on distributions are imposed.

Countercyclical capital buffers 41 • The CCB gives a national regulator wide discretion: • Calibration of CCB should be based on credit-to-GDP ratio and its deviation from its long-term trend, but this will be common reference point only. • The calculated long-term trend of the credit/GDP ratio is a purely statistical measure that does not capture turning points well. Authorities will form their own judgments about the sustainable level of credit in the economy. • Authorities in each jurisdiction will be free to emphasise any other variables and qualitative information that make sense to them for purposes of assessing the sustainability of credit growth and the level of system-wide risk, as well as in taking and explaining buffer decisions. • Particular consideration was given to the question of how to take account of jurisdictions with financial systems at different stages of development. Each jurisdiction will have the discretion to impose buffers above or below the guide buffer add-on level, subject to appropriate transparency and disclosure requirements.

Countercyclical capital buffers 42 • Credit-to-GDP is not enough: • Maybe a useful indicator for the risk accumulation phase. • Only gradual decline after crises.

Countercyclical capital buffers 43 • Mezní riziko vzniku krize je silně nespojité, zatímco časové řady makroveličin ne.

Countercyclical capital buffers 44 • Claudio Borio (BIS) – 2010: • Most promising real-time indicators of financial distress exploit the paradox of financial instability to their advantage • Joint positive deviations (“gaps”) of credit-to-GDP ratio and asset prices (especially real estate) from historical norms • Best signal of FD 2-4 years ahead (also out of sample) • Signal of overstretched balance sheets on the back of aggressive risk-taking (“financial imbalances”) • They also have information about output weakness and (less strong?) disinflation over similar horizons • Why? • Credit-to-GDP gap: very rough measure of economy-wide leverage • Asset price gap: very rough measure of likelihood and size of reversal • US example (Graph)

Countercyclical capital buffers 45 • Claudio Borio (BIS) – 2010:

Countercyclical capital buffers 46 • Claudio Borio (BIS) – 2010: Private credit/GDP and property price gap1Sweden

Countercyclical capital buffers 47 • BIS – 2010:

Countercyclical capital buffer: United States Vertical shaded areas indicate the starting years of system wide banking crises. The countercyclical buffer is 0 when the value of the credit/GDP gap is below 2 and 2.5 when it is above 10 per cent; for gaps between 2 and 10 percent the buffer is calculated as 2.5/8 times the value of the credit/GDP gap exceeding 2 per cent. Source: BIS calculations

Countercyclical capital buffer: Spain Works quite well – only once the stress is evident, it is necessary to release immediately and not not wait for decline in credit-to-GDP

Release indicators

Procyclicality and Macroprudential Policy