Setting Counter-cyclical Capital Buffers in Converging Economies

1. Macroprudential policy and instruments: Setting counter-cyclical capital buffers in converging economies Jan Frait Executive Director Financial Stability Department Ministry of Finance Seminar Smilovice, 6 December 2011

2. Outline Macroprudential policy Countercyclical capital buffers in Basel III and the standpoint of the Czech National Bank in the EU discussions in this area The CNB analysis focusing on the problems(concerns) when using the suggested credit-to-GDP gap guide for converging economies Possible alternatives for converging economies based on economic fundamentals: the CNB work in progress 2

3. Macroprudential Policy Framework

4. What is a macroprudential policy framework? • Following the global financial crisis, on the EU level as well as on the national levels the ways how to establish the additional pillar for financial stability – macroprudential policy framework – is being discussed. • Until the crisis, the concept of macroprudential policy was discussed primarily within the central banking community under the leadership of the Bank for International Settlements (BIS henceforth). • After the crisis, the term “macroprudential” has become a buzzword (Clement, 2010) and the establishment of effective macroprudential policy framework has become one of the prime objectives of the G20, EU, IMF and other structures. • In the EU, such a desire has already been reflected in the decision to create the European Systemic Risk Board as the EU-wide authority of macroprudential supervision and by number of iniciatives focusing on defining the EU-wide framework for macroprudential regulation.

5. What is a macroprudential policy framework? • The term “macroprudential” is now too embracive and it is often used outside of the scope of its original meaning. • The CNB looks at the concept of macroprudential policies from relatively narrow perspective of the original BIS approach (e.g. Borio, 2003, Borio and White, 2004). • The objective of a macroprudential approach in the BIS tradition falls within the macroeconomic concept and implicitly involves monetary and fiscal policies (Borio and Shim, 2007, and White, 2009). • In the BIS tradition, the phenomenon of financial market procyclicality (mainly the procyclical behaviour of credit provision) stands centrally (Borio and Lowe, 2001, or Borio, Furnine and Lowe, 2001).

6. What is a macroprudential policy framework? • The other stream is modelling of systemic risk associated with individual institutions. By comparison with canonical models of systemic risk like Diamond and Dybvig (1983) emphasining interlinkages and common exposures among institutions, in the BIS logic, systemic risk arises primarily through common exposures to macroeconomic risk factors across institutions. • The cross-section dimension of systemic risk (common exposures among institutions, network risks, infrastructure risks, contagion ...) has been intensively studied by the IMF (see special chapters on systemic risks in the last few Global Financial Stability Reports).

7. The CNB’s historical interpretation of financial stability The CNB’s approach to financial stability has historically been strongly macroprudential and close to the relatively narrow BIS interpretation focusing primarily on risks associated with the financial cycle. Its objective is to ensure that the financial system does not become so vulnerable that unexpected shocks ultimately cause financial instability in the form of a crisis. Sound financial system Yes: resilience No: vulnerability Financial stability Financial vulnerability Shocks No Financial volatility Financial instability (crisis) Yes 7

8. Financial stability vs. macroprudential policy – the CNB view The CNB considers macroprudential policy to be an element of financial stability policy (Frait and Komárková, 2011). The main distinguishing feature of macroprudential policy is that unlike traditional microprudential regulation and supervision (focused on the resilience of individual financial institutions to mostly exogenous events): it focuses on the stability of the system as a whole; it primarily monitors endogenous processes in which financial institutions that may seem individually sound can get into a situation of systemic instability through common behaviour and mutual interaction, the objective of financial stability analysts is therefore avoid the risk of the fallacy of composition – wrong assumption that the state of the whole is the sum of the state of seemingly independent parts. 8

9. Macroprudential policy and systemic risk - objectives The macroprudential policy objective is to prevent systemic risk from forming and spreading in the financial system. Systemic risk has two different dimensions: The time dimension reflects the build-up of systemic risk over time due to the pro-cyclical behaviour of financial institutions contributing to the formation of unbalanced financial trends. The second dimension is cross-sectional and reflects the existence of common exposures and interconnectedness in the financial system. The two dimensions of systemic risk cannot be strictly separated, as they largely evolve jointly over the financial cycle. The experience commands that the time dimension of systemic risk has to be regarded as more important. Cross-sector dimension cannot be ignored especially due to the risk of contagion from domestic as well as foreign environment. 9

10. Conseptual approach of the CNB‘s macroprudential policy • The key concept describing the time dimension of systemic risk over financial cycle is leverage (the indebtedness of economic agents, stocks of loans, the ease of obtaining of external financing, the size of interest rate margins and credit spreads, etc..). • The leverage can be approximated by credit-to-GDP ratio: • increases until the financial cycle turns over, sometimes the turn is disorderly and presents itself as the eruption of financial crisis. • then starts to decline, although in the early phase of the crisis remains high (given falling nominal GDP it can even rise in the initial post-crisis years). • The deleveraging phase can therefore last several years, and in the event of a deep crisis the leverage ratio can, after a time, fall below its long-term normal value. • Consequently, the leverage ratio adjusts to economic conditions after a considerable lag, so stock measures have only a limited information value as a guide for the macroprudential policy response during the financial cycle. • For this reason, forward-looking variables are needed that can be used to identify situations where the tolerable limit for systemic risk has been exceeded.

11. Leverage over credit cycle – a slow motion process Conduct of macroprudential policy changes throughout financial cycle. leverage turning point (start of crisis) Good times (systemic risk accumulation): leverage phase with excess optimism Bad times (systemic risk materialization): deleveraging phase with excess pessimism time Normal level of leverage Discontinuity in marginal risk of financial instability: e.g.financial markets indicators (credit spreads, CDS spreads) or market liquidity indicators Signal for termination of supportive policies: contemporaneous indicators (default rates, provision rates, NPL rates, lending conditions) and financial markets indicators Signal for macroprudential tools activation: forward-looking or leading indicators (credit-to-GDP gap, real estate prices gap …) 11

12. Credit cycle and systemic risk – two phases In a credit cycle, systemic risk evolves differently in two phases:accumulation (build-up) and materialization (manifestation). Note the financial stability paradox: a system is most vulnerable when it looks most robust. Build-up of systemic risk Materialisation of systemic risk period of financial exuberance period of financial distress period of low current risk period of high current risk time time normal conditions degree to which risks materialise as defaults, NPLs and credit losses marginal risk of financial instability 12

13. Macroprudential policy and systemic risk - definition • Macroprudential policy can be defined as the application of a set of instruments that have the potential to • increase preventively the resilience of the system, in the accumulation phase, against the risks of emergence of financial instability in the futureby • creating capital and liquidity buffers, • limiting procyclicality in the behaviour of the financial system • containing risks that individual financial institutions may create for the system as a whole. • mitigate the impacts, in the materialization phase, of previously accumulated risks if prevention fails.

14. Macroprudential policy and systemic risk - tools • True (genuine) macroprudential tools are those which can be applied in the form of rules and can therefore take the form of built-in stabilisers. • They should automatically limit the procyclicality of the financial system or the risky behaviour of individual institutions. • They should be explicitly focusing on the financial system as a whole and endogenous processes within it. • In addition to true macroprudential tools, various microprudential regulatory and supervisory tools can be used for macroprudential purposes. • If these tools are applied not to individual institutions, but across the board to all institutions in the system, they can be regarded as macroprudential instruments. • Measures of this type, along with monetary policy tools, fiscal policy tools and tax measures, have been applied in many countries in the past in an effort to slow excess credit growth.

15. II. Countercyclical capital buffers – concept

16. Countercyclical capital buffer in Basel III (1) • countercyclical capital buffer (CCB henceforth) is genuine macroprudential tool • „optimists“ believe that the CCB could be used for taming a credit boom • help the authorities to lean against the build-up phase of the cycle by raising the cost of credit, and therefore slowing down its provision, when they conclude that the stock of credit has grown to excessive levels relative to the benchmarks of the past experience • this potential moderating effect on the build-up phase of the credit cycle should be viewed as a positive side benefit, rather than the primary aim of the CCB regime

17. Countercyclical capital buffer in Basel III (2) • „pessimists“ presume that the quantitative impact of the CCB during the credit boom will be rather weak • it should primarily protect the banking sector and general economy from the after-effectsof excess aggregate credit growththat have often been associated with the build up of system-wide risk • What kind of after-effects? …to maintain the flow of credit in the economy when the broader financial system experiences distress after a credit boom (smooth landing)

18. The role of a macroprudential authority regarding CCB to monitor credit and its dynamics (and potentially other indicators) and make assessments of whether system-wide risks are being built up based on this assessment, to decide whether the CCB requirement should be imposed (set above the zero value) to apply judgment to determine whether the CCB should increase or decrease over time (within the range of zero to 2.5% of risk weighted assets, in very strong credit booms even above 2.5%) to be prepared to remove the requirement on a timely basis if the system-wide risk crystallizes 18

19. The view of the Czech National Bank when Basel III was discussed, CNB in general supported the CCB as a useful macroprudential tool as well as harmonized methodology for setting it across countries which would – however – allow sufficient flexibility for national policymakers (reflecting different level of financial intermediation in converging economies and other specificities of individual countries) supported the Basel III approach to determine the bank-specific capital buffer (linked to the credit dynamics in the country where the loans were granted) * EC: Consultation Document–Countercyclical Capital Buffer. 25 October 2010. 19

20. Implementation of the buffer in CRD IV/CRR • within consultations of the European commission* (October – November 2010) – especially in the area of application of capital buffer for cross-border banks - the CNB • supported the Basel III-compatible approach to determine the bank-specific capital buffer (i.e. linked to the credit dynamics in the country where the loan was granted), • rejected the alternatives approaches suggested by the Commission (determining the buffer according to the jurisdiction of the parent bank or according to the jurisdiction from which the credit is ultimately granted). * EC: Consultation Document - Countercyclical Capital Buffer. 25 October 2010.

21. June 2011 discussion within the ESRB: countercyclical buffer in CRD IV/CRR • CNB supported the June 2011 letter by ESRB to European Commission suggesting that in the area of buffers the CRD IV text should • allow national policymakers to set buffers in excess of 2.5% without reference to exceptional circumstances • permit the setting of buffers in excess of 2.5% for third country exposures • allow for national policymakers to voluntary reciprocate when buffers are set in excess of 2.5% • strengthen the role of ESRB in monitoring and peer-reviewing the buffer setting • July 2011 publication of the CRD IV/CRR draft to a large extent reflected these suggestions

22. September 2011 discussion within the ESRB: the countercyclical buffer in CRD IV (1) • however, the July 2011 CRD IV/CRR text does not grant full flexibility to national policymakers • A „dual“ regime has been suggested • standard countercyclical capital buffer regime (decision on the buffer rate made quarterly, the indicators used to determine the rate approved by the ESRB, full reciprocity with voluntary reciprocity if buffer rate above 2.5%) • an additional (structural) buffer regime (reviewed only annually, any indicator/variable could be used by national authorities – not only those approved by ESRB, variables may include also non-cyclical/structural variables, no international reciprocity)

23. September 2011 discussion within the ESRB: the countercyclical buffer in CRD IV (2) • CNB supports the CRD IV amendment proposals approved byGeneral Board of ESRB in September 2011 to remove the dual regime of the buffer, as • cyclical instrument is not appropriate to tackle structural (non-cyclical) systemic risk • characterized by important rigidities (prohibition of reciprocation, only annual review) • there would be problems with communication of the two types of buffers • reflected in amendment of Art 126 CRD - modify 126 (3) and to repeal 126 (4)

24. September 2011 discussion within the ESRB: maximum versus minimum harmonization • in general, the CNB supports the possibility of national policymakers to tighten capital requirements in Pillar 1 (i.e. the CNB supports harmonization of minimum standards and not maximum harmonization) due to macroprudential reasons • in the September 2011 GB ESRB meeting, the CNB supported • strengthening of the delegated authority of the Commission (no time limit for tightening periods; broader scope of measures) and underlining the role of ESRB… reflected in proposal for a re-cast of Article 443 CRR and the related Recital • and – more importantly - providing Member States with the same authority to address systemic risks… reflected in proposal for a new Article 443-bis CRR

25. III. CCB – calibration

26. The common reference guide: credit-to-GDP gap the common reference guide* for setting the CCB is based on the aggregate private sector credit-to-GDP gap a gap between currently observed value and the calculated long-term trend of private sector credit to GDP • for calculation of the long-term trend, the Basel committee suggests using the Hodrick-Prescott filter with a high smoothing parameter • buffer set as a function of the credit-to-GDP gap * BCBS: Guidance for national authorities operating the countercyclical capital buffer. BIS, December 2010, pp. 4 and 8. 26

27. CNB work on countercyclical capital buffers the CNB is focusing on the issue of how to calibrate the CCB in converging economies Financial Stability Report 2010/2011* responds to question “how the CCB would have been set if the regime had been existing before crisis?“ through the analysis of ten CEE countries in the period of strong credit growth 2003-2007 conclusion: basic methodology recommended by Basel Committee for setting the CCB rate (credit-to-GDP gap calculated according to the purely statistical method of Hodrick-Prescott filter) is not appropriate for converging economies like the Czech Republic it is surely not appropriate for advanced countries previously experiencing lasting credit boom either! * Geršl, Adam – Seidler, Jakub: Excessive credit growth as an indicator of financial (in)stability and its use in macroprudential policy. Thematic article, FSR 2010/2011, CNB. 27

28. CEE converging countries and calculation of credit-to-GDP gap • short time-series (Basel recommends 20 years of quarterly data) • fast credit growth is incorporated in the trend (convergence in credit to GDP - initial low level of financial intermediation and catching up process)

29. CEE countries and buffer calculation – what makes things complex • banking sector restructuring (bad assets in the 1990s – especially CZ and SK, bank privatizations) • changes in the composition of credit to the private sector (increasing share of loans to households) • end-point bias of HP filter as an obstacle to practical conduct of macroprudential policy

30. Deleveraging and buffer calculation

31. Application of the guide to the Czech Republic • using HP filter with recommended lambda would indicate excess credit growth (even since 2003 if estimated „continuously“) • holds even if other reasonable denominators are used (assets)

32. Application of the guide to the Czech Republic • when estimated in credit growth phase only (2004-2008), HP filter captures only short-term deviations

33. Historical comparison does not reveal excessive credit in the Czech Republic (1) Czech Republic has lower level of credit to GDP than selected core EU countries when at similar level of economic development (in the 1980s) other features of credit growth in the Czech Republic also do not indicate the build up of system-wide risk (no FX loans to households; no external funding; high deposit-to-loan ratio; low LTV ratios) contrasts with e.g. Latvia that had comparatively much higher stock of credit in 2008, several „dangerous“ features of credit boom and lower level of GDP per capita 33

34. Historical comparison does not reveal excessive credit in the Czech Republic (2) .... 34

35. IV. CCB – the way forward

36. The discretion of policymakers is anchored in Basel III • credit-to-GDP ratio should serve only as a guide* • rather than relying mechanistically on the credit/GDP guide, authorities are expected to apply judgment in the setting of the buffer in their jurisdiction after using the best information available to gauge the build-up of system-wide risk • in addition, the calculated long-term trend of the credit/GDP ratio is a purely statistical measure that does not capture turning points well* • therefore, authorities should form their own judgments about the sustainable level of credit in the economy; they should use the calculated long-term trend simply as a starting point in their analysis * BCBS: Guidance for national authorities operating the countercyclical capital buffer. BIS, December 2010, pp. 4 and 8.

37. The alternative to HP filter: fundamental „out-of-sample“ method leads to different credit-to-GDP gaps and different potential buffers • a way how to form judgment about the sustainable level of credit in the economy: • regressing the credit to GDP on a range of economic fundamentals (GDP per capita; households consumption; inflation,FX loans to households; external funding; deposit-to-loan ratio; LTV ratios etc.), using data for developed countries • applying the estimated elasticities „out of sample“, i.e. on CEE countries to calculate „equilibrium credit“ • in contrast to HP filter, the fundamental out-of-sample method takes into account the economic fundamentals influencing the level of credit in the economy • the HP filter would not define some countries as in a situation of excess credit growth while fundamental method would (figures below in the table are calculated for 3Q 2008, i.e. just before the CEE countries were hit by the global financial crisis)

38. Results of the „out-of-sample“ method in comparison to HP filter

39. Results of the „out-of-sample“ method in comparison to HP filter

40. Results: comparison of HP and out-of-sample methods

41. Countries above equilibrium credit • it seems that for CEE countries, the out-of-sample method better predicts the problem countries • empirical evidence shows that the four countries identified as being above equilibrium credit (LV, BG, EE, SI) and the two close to the border (HU and LT) did not show particularly high Tier 1 capital ratios before crisis in 2008 (except Bulgaria) and some of them experienced relatively high drop in RoE of banks

42. Further developments • to be fair, the out-of-sample method also has a number of drawbacks • fundamental variables selection (housing prices seem to be a relevant variable, but can themselves suffer from bubbles) • selection of advanced (sample) countries • different fundamentals in advanced (sample) countries versus CEE countries at the current stage of development • estimation method suffers by losing country-specific constant • the methodology is being developed further and made more robust to be more appropriate for practical implementation • other methods and indicators are being tested as to their signaling properties for a built-up of systemic risk in converging economies • the indicators for deciding on policy reversals are needed too

43. Policy approach – consistency vs. discretion • The key issue is setting the long-term equilibrium trend(s) more optimistic equilibrium trajectory Credit-to-GDP clearly above more indicators and judgment required ? less optimistic equilibrium trajectory clearly below time

44. Countercyclical capital buffers – the example of policy Credit-to-GDP cannot be a sole driver of countercyclical capital buffers setting – it is a lagging slow-motion variable staying above the historical norms during the initial stages of crisis. The indicators of credit cycle dynamics and other are therefore needed to guide the shifts in setting (credit growth, lending conditions, spreads etc.) Credit-to-GDP over financial cycle Credit dynamics (e.g. y-o-y growth) period of financial distress period of financial exuberance period of financial exuberance period of financial distress CCB set to zero again time time CCB set at maximum 2,5 % long-term „normal“level of credit-to GDP CCB set to zero turning point (start of crisis): credit-to-GDP still very high, but policy has to change sharply turning point (start of crisis): credit growth falls, lending conditions tighten 44

45. Conclusions flexibility embedded in the Basel III countercyclical capital buffer regime is a desirable element should be kept to a large extent in the EU regulation (CRD IV/CRR), the ESRB should keep the coordination and ex post monitoring role CEE converging countries are exactly the ones where detrending by HP filter can not work well in calibrating the buffer macroprudential research in CEE countries has to identify set of fundamental factors that could provide solid guidance for setting this instrument and using it in efficient way 45

46. Thank you for the attention www.cnb.cz Jan Frait Head of Financial Stability Department Jan.Frait@cnb.cz Contact to the Financial Stability Department: E-mail: financial.stability@cnb.cz http://www.cnb.cz/en/financni_stability/

47. References • BANK OF ENGLAND (2009): The Role of Macroprudential Policy. Discussion Paper, November 2009. • BORIO C., FURFINE C. AND LOWE, P. (2001): Procyclicality of the financial system and financial stability: issues and policy options”, in “Marrying the macro- and microprudential dimensions of financial stability”, BIS Papers, No. 1, March, pp. 1–57 • BORIO, C – SHIM, I. (2007): “What can (macro)-prudential policy do to support monetary policy. BIS Working Papers, no 242, December. • BORIO, C. - P. LOWE, P. (2001): To provision or not to provision. BIS Quarterly Review, September 2001, pp. 36-48. • BORIO, C. - WHITE, W. (2004): Whither monetary and financial stability? The implications of evolving policy regimes. BIS Working Paper, No. 147, February 2004. • BORIO, C. (2003): Towards a macroprudential framework for financial supervision and regulation? BIS Working Paper, No. 128, February 2003. http://www.bis.org/publ/work128.pdf. • BORIO, C. (2009), Implementing the macro-prudential approach to financial regulation and supervision, Banque de France Financial Stability Review, No. 13 — The Future of Financial Regulation, September 2009. • BORIO, C.-DREHMANN, M. (2009), Towards an operational framework for financial stability: fuzzy measurement and its consequences. BIS Working Paper, No. 284, June 2009. • CLEMENT, P. (2010): The term “macroprudential”: origins and evolution. BIS Quarterly Review, March 2010, pp. 59-67 • DIAMOND, D - DYBVIG, P. (1983): Bank runs, deposit insurance and liquidity”, Journal of Political Economy, 91(3), pp 401-19. • WHITE, W. (2006): Procyclicality in the financial system: do we need a new macrofinancial stabilisation framework?, BIS Working Papers, no 193, January.

48. References • FRAIT, J., KOMÁRKOVÁ, Z. (2009): Instruments for curbing fluctuations in lending over the business cycle. Financial Stability Report 2008/2009, Czech National Bank, pp. 72-81. • Frait, J., Komárek, Komárková, Z. (2011): Monetary Policy in a Small Economy after the Tsunami: A New Consensus on the Horizon? Czech Journal of Economics and Finance 61, No. 1, pp. 5-33. • Frait, J., Komárková, Z. (2011): Financial stability, systemic risk and macroprudential policy. Financial Stability Report 2010/2011, Czech National Bank, pp. 96-111; ISBN 978-80-87225-34-9 • Frait, Jan; Gersl, Adam; Seidler, Jakub; Credit growth and financial stability in the Czech Republic. World Bank Policy Research Working Paper; no. WPS 5771 2011/08/01 August 2011