The Management of Systemic Risks: Current Priorities - Governor Philip R. Lane

Address to ESRB 2018 Annual Conference

Introduction

I am delighted to have the opportunity to contribute to the annual conference of the European Systemic Risk Board (ESRB). As the current chair of the Advisory Technical Committee (ATC) and the former chair of the Advisory Scientific Committee (ASC) of the ESRB, I have developed deep respect for the high-quality and wide-ranging research and policy work that has been undertaken by the ESRB, with much of it comprising joint work undertaken through collaborations between the ESRB secretariat, ECB staff, European Commission staff and the staff of the national competent authorities and the European Supervisory Authorities (ESAs). In addition, it is important to acknowledge the invaluable contributions of the members of the ASC, both through ASC-initiated reports and their contributions to the various working groups.

Let me divide my remarks into two parts. First, I wish to discuss the role of macroprudential policies in building resilience during the current phase of economic expansion across Europe.  Second, I will turn to the non-bank sector and emphasise the importance of deepening our understanding of the stability properties of the entire financial system, which calls for a special focus on the interconnections across markets and across different types of intermediaries.

Macroprudential Policies and Building Resilience During Good Times

A basic motivation for the post-crisis emphasis on developing macroprudential policy frameworks is the lesson that excessive leverage served to amplify pre-crisis imbalances, increased vulnerability to adverse shocks and raised the costs of post-crisis adjustment.   This holds true not only in relation to the 2008 global financial crisis but is also evident from comprehensive empirical studies of previous financial crises (Reinhart and Rogoff 2009, Schularick and Taylor 2012, Laeven and Valencia 2013). 

For the euro area, Martin and Philippon (2017) provide counterfactual simulations that show how leverage limits would have limited the boom-bust cycle across members of the monetary union. For the US, Aikman et al (2018) show how interventions to limit leverage in the financial system and among households could have done much to avoid or mitigate the 2008 crisis. 

In relation to macroprudential tools that are especially relevant in managing cyclical risks, ten ESRB member countries have now activated the counter-cyclical capital buffer (CCyB), while twenty have introduced borrower-based measures (BBMs).  

The economic logic of the CCyB is straightforward: by requiring an additional capital buffer during cyclical upswings, the banking system should be better prepared for future downturns. In particular, in the event of an adverse shock, this capital buffer can be released, thereby mitigating the damaging pro-cyclical withdrawal of credit supply under adverse conditions.

In order to be effective in building resilience, it is essential that the CCyB is activated sufficiently early during upswings in the financial cycle (Lozej and O’Brien 2018, O’Brien et al 2018). Otherwise, there is a risk that the CCyB is activated too late, especially taking into account the one-year lead time in its implementation.

In calibrating the CCyB, it is necessary to assess the likely capital depletion in the banking system in the event of a cyclical downturn.  A range of analytical tools (including taking lessons from stress tests) can be helpful in making this determination. 

I wish to highlight two relevant factors.  First, a banking system with a high stock of non-performing loans (NPLs) is inescapably more exposed to cyclical risk. Just as the recent improvement in macroeconomic conditions has been an important contributor to the marked decline in NPLs in the last couple of years, a cyclical reversal could undo some of this progress by making it more difficult for a debtor to maintain adherence to the terms of a loan contract or comply with the terms of a restructured loan.  Especially if it is assessed that a banking system has not set aside sufficient provisions for NPLs, there will be a direct connection between the stock of NPLs and the optimal value of the CCyB.  

Second, at a practical level, it is wise to recognise that there is not always a clean division between cyclical risk and certain types of systemic risk.  For instance, one reason why a country may impose a systemic risk buffer is that its banking system is over-exposed to the real estate sector.  While real estate crashes may occur independently of a downturn in the macroeconomic or aggregate credit cycle, it is difficult to envisage a cyclical reversal that is not associated with credit losses on property loans.  Accordingly, to the extent that a systemic risk buffer provides some degree of de facto cyclical protection, this should be taken into account in calibrating the CCyB.  A more extensive discussion of the interplay between the CCyB and various types of structural buffers is provided by ESRB (2017).

In relation to new mortgage lending, borrower-based measures that restrict loan-to-income (LTI), debt-service-to-income (DSTI) and loan-to-value (LTV) ratios have built-in features that limit pro-cyclical dynamics. In the absence of such ceilings, cyclically-strong economic conditions might otherwise drive mortgage market dynamics towards more aggressive LTI, DSTI and LTV ratios due to upward revisions (by lenders and borrowers) in projections of future levels of house prices and incomes. In addition, by limiting the risks of over-borrowing by households and over-lending by banks, household and bank balance sheets should be more robust in the event of a future downturn. Boosting the resilience of both banks and households serves dual purposes:  in addition to its contribution to financial stability, consumer protection mandates are more easily fulfilled if sharp fluctuations in credit conditions are avoided and the risks of financial distress are contained.

Finally, it is helpful to recognise the complementarities between macroprudential measures and counter-cyclical fiscal policies in mitigating macro-financial risks.  At a basic level, a fiscal strategy of running surpluses during upswings in order to facilitate the smooth operation of automatic stabilisers (and, possibly, activist fiscal measures) during reversals contributes to a lower amplitude of the macro-financial cycle.  In turn, a milder boom-bust cycle reduces the magnitude of the optimal CCyB.

Financial Stability and Market-Based Finance

Each year, the ESRB publishes the EU Shadow Banking Monitor, which tracks the size and functioning of market-based finance: the latest edition was recently published on the 10th of September.  The entities covered by this publication held €42 trillion at the end of 2017, which corresponds to 40 percent of total EU financial assets.  Since these entities account for an outsized share of cross-border financial intermediation, the ESRB plays a unique role in enabling the coordination of national efforts to track developments in market-based finance in a consistent manner. Under the aegis of the ESRB, each member institution can contribute to a common understanding, drawing upon the diverse expertise of central banks, national competent authorities and the European institutions in shining light on the wide range of financial intermediation activities that are categorised under the broad label of market-based finance.  

In terms of financial stability, market-based finance matters for two broad reasons.  First, the systemic dependence of the economy on market-based finance means that instability in this sector may be sufficient to trigger the macro-financial doom loops that define a financial crisis.  Second, the deep interconnections between market-based financial entities and banks mean that an adverse shock to market-based finance may additionally trigger a banking crisis. As noted in the latest EU Shadow Banking Monitor, about 8 percent of bank assets are invested in the universe of entities covered by this report, while banks rely on this sector for €2.2 trillion in funding. 

Accordingly, it is essential for policymakers to monitor the dependence of the real economy and the banking sector on market-based finance.  For instance, the increasing importance of non-banks as credit providers to non-financial corporates and households and as investors in real estate markets means that understanding the interplay between financial conditions and macroeconomic developments requires a broader assessment that looks beyond banking data and takes into account (inter alia) the credit supply schedule and risk appetite of non-bank intermediaries.  Equally, in terms of financial stability risks, shifts in the leverage, liquidity and maturity profiles of the balance sheet entities warrant similar attention to the focus put on these indicators in relation to bank balance sheets.

The complexity and diversity of the market-based finance universe puts a premium on the granular-level data and high-quality analysis that can identify the primary risk factors and the interconnections that could act as triggers and amplifiers for adverse shocks.  At the EU-wide level, it is especially important to understand the operation of euro-denominated spot and derivatives securities markets and take into account the intrinsic cross-border nature of these markets.  At the country level, national authorities can do much to collect and analyse data in relation to the market-based financial activities hosted in individual jurisdictions.

In relation to the EU-wide perspective, the derivatives data collected under EMIR has the potential to enable substantial progress in our understanding of the risk transfers that are embodied in derivatives contracts (ESRB 2016, ESMA 2017).  Given the large scale nature of the EMIR data, it is essential that researchers ask focused questions if useful insights are to be obtained.  Among the interesting contributions that have been delivered so far, we have seen work on:   the uses of credit default swaps and interest rate swaps by banks; the pricing of foreign-exchange options; network analysis of interest rate derivatives markets; and event studies such as the de-pegging of the Swiss Franc (Aldasoro and Barth 2017, Hau et al 2017, Bellia et al 2018, Fiedor et al 2018, Hoffmann et al 2018)

At the national level, the Central Bank of Ireland is collecting information and publishing a range of studies in relation to the large numbers of investment funds, money market funds, financial vehicle corporations and special purpose entities that are hosted by Ireland: an overview is provided by Lane and Moloney (2018). Although the end investors and ultimate destinations for these assets are predominantly elsewhere and do not directly affect the stability of the domestic financial system, it is important for the analysis of international financial stability that international financial centres disclose as much as possible about the nature of the cross-border transactions that are intermediated through these locations.

As examples, the Central Bank of Ireland made two substantial contributions to the 2018 edition of the EU Shadow Banking Monitor. The first contribution focuses on the international linkages of Irish-domiciled non-securitisation special purpose entities (SPEs), while the second, in conjunction with staff from a number of other ESRB member institutions, analyses the use of credit default swaps (CDS) by UCIT (undertakings for collective investment in transferable securities) funds. 

While acknowledging the progress to date, much remains to be done in terms of improving our understanding of market-based finance and its interconnections with the banking sector.  At a global level, closing data gaps and fostering information sharing is necessary if the progress at EU level is to be replicated more widely.  In terms of the analytical frontier, the new ECB-ESRB Bridge Programme for Data Science provides scope for greater collaboration between the policymaking and research communities.

Conclusions

Let me conclude.  Ten years since the crisis, the policy importance of the work of the ESRB has never been stronger.  With macroeconomic and financial recovery in Europe, the potential for macroprudential policy to build resilience and curb excesses during good times may prove to be essential in limiting the costs of future downturns:  it follows that the current generation of policymakers have an important duty to be pro-active in the implementation of appropriate macroprudential measures. 

Importantly, policymakers need to take a wide angle:  the stability of the financial system rests not just on the banking sector but also on the market-based financial sector.  The more information we gather and the better the analysis of market-based finance (at national, EU-wide and global levels), the better prepared we will be for future crises.

Acknowledgements:  I thank Benedetta Bianchi, Neil Killeen and Kitty Moloney for assistance in preparing this speech.

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