European Systemic Risk Board

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See also Council of Regulators, Financial Stability Oversight Council, systemic regulator and trading book risk.


European Systemic Risk Board established

The legislation establishing the European Systemic Risk Board (ESRB) came into force today. The seat of the ESRB is in Frankfurt am Main and its Secretariat is ensured by the European Central Bank (ECB).

The ESRB is an independent EU body responsible for the macro-prudential oversight of the financial system within the Union. It shall contribute to the prevention or mitigation of systemic risks to financial stability in the Union that arise from developments within the financial system. The ESRB shall also contribute to the smooth functioning of the internal market and thereby ensure a sustainable contribution of the financial sector to economic growth.

As foreseen in the legislation, the Chair of the ESRB is the President of the European Central Bank, Mr Jean-Claude Trichet. Mr Mervyn King, Governor of the Bank of England, was elected today as first Vice-Chair of the ESRB by the members of the General Council of the ECB.

The General Board of the ESRB will have its inaugural meeting on 20 January 2011.

Discussion of establishment of the ESRB

The European Systemic Risk Board (ESRB) will be established in January 2011 as the body responsible for the macro-prudential oversight of the EU financial system. It is mandated to actively monitor the various sources of risk to financial stability in the EU – across Member States and financial sectors – with due consideration of also global developments. It should identify the risks and assess how they could impact the financial system so as to prioritise them. In this context, systemic risk is defined in legislation on the ESRB as “a risk of disruption in the financial system with the potential to have negative consequences for the internal market and the real economy.” The ESRB should issue warnings on significant systemic risks and issue recommendations for policy action to address such risks.

The creation of the ESRB is a response to one of the key lessons of the financial crisis regarding the need for an enhanced macro-prudential oversight of the financial system as a new policy function. The value added of a macro-prudential function to safeguard financial stability is its focus on detecting, assessing and addressing vulnerabilities that arise from the interconnections between financial institutions and markets, as well as from macroeconomic and structural developments, including financial innovation. It will thus take a system-wide perspective, which will complement micro-prudential supervision, whose purpose is to assess the soundness of individual financial institutions.

The design of a framework for the conduct of macro-prudential oversight as new policy function involves significant challenges, but also represents a unique opportunity for reinforcing the arrangements to safeguard financial stability. In particular, the following three main components should underpin a macro-prudential framework:

  • first, the necessary conditions for an enhanced monitoring of the financial system as a whole, in order to identify potential threats to financial stability;
  • second, the instruments for translating financial stability assessments into concrete policy action aimed at enhancing the resilience of the financial system; and
  • third, appropriate governance structures, including mechanisms for ensuring an effective interplay between, and coordination of, macro and micro-prudential responsibilities.

As regards the first, one of the basic prerequisites for an effective macro-prudential function is the availability of a comprehensive set of information on the financial system that can be used for the detection and assessment of systemic risk. This implies the attribution of specific tasks to the macro-prudential authority with respect to accessing and collecting such information, which may include macro-economic and macro-financial data and indicators, as well as market intelligence. In this regard, the European Supervisory Authorities (ESAs), the European System of Central Banks, the Commission, the national supervisors and the national statistical authorities have the obligation to cooperate closely with the ESRB and to provide all the information necessary for the fulfilment of its tasks. In addition, the ESRB may request the ESAs to supply information also on individual institutions on the basis of a reasoned request.

The ESRB will therefore have access to ample sources of information on risks. The development of the appropriate infrastructure for pooling such information on an EU-wide basis will be a major step forward in the assessment of financial stability in the single market, but this will require substantial analytical and data-related expertise, as well as market knowledge. Work is already under way to set up efficient procedures for regular information-sharing between the ESRB and the ESAs. The second component relates to the instruments available to the ESRB, which should be geared to mitigating systemic risk on the basis of the outcome of the monitoring of the financial system. As mentioned earlier, they include the issuance of risk warnings and policy recommendations, as well as the monitoring of the follow-up by the respective addressees on the basis of an “act or explain” mechanism.

One of the challenges in this respect is ensuring the effectiveness of the ESRB’s instruments. From the very outset, this will require the development of analytical tools and models that underpin the macro-prudential policy process, including reliable systemic risk indicators that support the issuance of warnings or recommendations on the calibration of prudential measures. Such measures may include specific capital and liquidity requirements to take account of financial cycles, or of the systemic relevance of financial institutions. Furthermore, the effectiveness will also depend on close cooperation between the members the ESRB and, in particular, the ESAs, which are expected to play an important role in the implementation of the ESRB’s recommendations.

Macro-prudential governance, as a third component, is decisive for the functioning of the overall financial stability architecture. Central banks should play a major role, given their interest in, and responsibility for, the stability of the financial system, as well as their analytical expertise and the information they have on the real economy, financial markets and market infrastructures.

The participation of the governors of all EU central banks in the General Board of the ESRB, as well as the attribution of the Chair to the ECB’s President, shows that the importance of this role has been recognised. The ECB has also been requested to provide the Secretariat and the necessary analytical, statistical, logistical and administrative support. For this purpose, the ECB will optimise its existing capabilities and infrastructure in the areas of financial stability monitoring, macro-economic analysis and the collection of statistical information, to the benefit of the ESRB.

Supervisory authorities should be involved in, and contribute to, the macro-prudential function with information, analysis and regulatory advice. The conduct of macro-prudential policies will to a large extent also depend on supervisory measures. Accordingly, the macro-prudential framework should provide for coordination mechanisms between macro and micro-prudential responsibilities, which should also avoid any potential overlaps or conflicts of interest.

The legislation contains a number of provisions that provide the basis for a close institutional collaboration between the ESRB and the ESAs. The provisions range from the mutual participation in the boards of the ESRB and the ESAs – including the chair of the Joint Committee of the ESAs as second Vice-Chair of the ESRB – to cooperative duties in the monitoring and assessment of systemic risk, the conduct of stress-tests and the sharing of information, as mentioned earlier. National supervisors will also participate in the ESRB’s General Board and will, as is important, be members of the Advisory Technical Committee. This committee will be one of the main support structures of the ESRB, together with the Advisory Scientific Committee of independent experts.

In conclusion, the establishment of the ESRB will introduce a new policy function at the EU level, which has a great potential for enhancing the ability of European and national authorities to safeguard the stability of the EU’s financial system as a whole. The challenges of designing and implementing this new EU-wide macro-prudential policy function are considerable. However, with appropriate preparations, which are already ongoing in close cooperation with all the parties involved, a smooth start of the ESRB may be envisaged in 2011.

The building blocks of financial systems

  • Source: Systemic Risk Clare Distinguished Lecture in Economics and Public Policy by Jean-Claude Trichet, President of the ECB organised by the Clare College, University of Cambridge, Cambridge, 10 December 2009

"...Perhaps the most well known Nobel Laureate from Clare College is James Watson, who, together with Francis Crick, derived the structure of DNA. DNA incorporates the building blocks of life. As the recent instability illustrates, we economists still need to achieve as clear an understanding of the building blocks of financial systems – not simply the institutions small and large that populate them, but also the fundamentals of the rules and incentives that drive their behaviour; and, particularly, how they combine and interact with each other in the presence of amplification mechanisms stemming from leverage and other forces.

Let me mention two more recent Nobel laureates in economics whose work relates to my topic today. In 1996, James Mirrlees of Trinity College won the Nobel Prize for his contributions to the economic theory of incentives under incomplete information. In 2001 Joseph Stiglitz, who spent time in Cambridge in the 1960s, won the Prize for his analysis of the functioning of markets when information is asymmetrically distributed. [1] I shall argue in my lecture that such information problems and the incentives that they provide for economic behaviour are one important element in the phenomenon of systemic risk, and therefore in the wide transmission of financial instability.

The nature of systemic risk

So what is systemic risk? In the context of our natural environment, it is the threat that the actions of millions of individuals, all acting in pursuit of their own interests, can cause a breakdown of the world’s ecosystem, a global catastrophe which will ultimately damage everyone. This, of course, is the topic of the international climate change negotiations this week and next in Copenhagen.

Similarly, in the context of our economic environment, it is the threat that developments in the financial system can cause a seizing-up or breakdown of this system and trigger massive damages to the real economy. Such developments can stem from the failure of large and interconnected institutions, from endogenous imbalances that add up over time, or from a sizable unexpected event. A seizing-up of the financial system – or large parts of it – is what we experienced last autumn. The consequence was an economic freefall, a surge in unemployment and a massive increase in public debt.

What makes financial systems prone to systemic risk?

The financial system is composed of intermediaries, markets and the infrastructure of payment, settlement and trading mechanisms that support them. Intermediaries are connected with each other through direct transactions, as in interbank markets, and through similar investment and financing decisions with third parties such as other intermediaries or end investors.

Financial markets, in turn, are connected with each other through the trading activities of financial intermediaries and through end investors active in more than one market. Systemic risk within the financial system relates to the risk that these inter-connections and similarities render emerging financial instability widespread in the system. Even if the original problem seems more contained, important amplification mechanisms can be at work.

This complex network of financial connections is extended through the savings and financing needs of all economic sectors, notably non-financial firms, households and the government. By reallocating savings from individuals and sectors with a surplus of funds to individuals and sectors in need of funds, the financial system plays a central role in the economy. So, systemic risk, in a broader sense, relates to the risk that widespread instabilities in the financial system translate into adverse effects on growth and welfare in the economy at large.

How is it that financial instability can be triggered by initially self-contained events, which are then transmitted so widely that the fallout ultimately reaches systemic dimensions?

ECB research by Philipp Hartmann and others, which has investigated systemic risk for at least a decade, suggests that there are three particularly important ways in which this can happen. [2]

The first is contagion. The failure of one financial intermediary can lead to failures of other financial intermediaries, even when the latter have not invested in the same risks and are not subject to the same original shock as the former. [3]

Second, widespread financial imbalances can build up over time and then unwind abruptly. Hyman Minsky described how in good times consumption and investment increase, generating income, which fuels the financing of more consumption and investment but also the neglect of increasing risks. Even small events can then lead to a re-pricing of risk and an endogenous unravelling of the credit boom, which then adversely affects many intermediaries and markets at the same time. [4]

Third, negative aggregate shocks can adversely affect intermediaries and markets simultaneously. Historical research has shown that many banking crises were related to economic downturns. [5] Note that the three mechanisms can happen independently or they can reinforce each other.

There are a number of features of financial systems that make them particularly prone to these forms of systemic risk. Let me just highlight three key ones.

The first pervasive feature of financial systems is what we call externalities. They particularly relate to the complex and dynamic network of exposures among major intermediaries. What in tranquil times is an efficient mechanism to share risk, can, in times of stress, become a dangerous channel for transmitting instability. Two contracting parties do not have an incentive to take account of the effects of their risk-taking on third parties. As a consequence, the risk at the level of the system may be higher than the sum of individual risks.

The second key feature of financial systems is asymmetric information. Financial systems allocate funds from agents who have them but possess no specific knowledge about promising investment opportunities, to agents who have knowledge about the opportunities but not the funds to engage in them. This creates an agency problem between the two parties, which may be handled more or less well through the underlying financial contracts. If contracts are incomplete and negative news arrive on some of the investment projects, but information asymmetries do not allow lenders to judge whether this also affects other investment projects, funding may evaporate for all projects alike.

The special nature of financial systems is not simply characterised by the presence of these two imperfections. Externalities and information problems are also present in other economic sectors. The additional problem in the financial system is that they can result in the third feature: powerful feedback and amplification mechanisms, which render their implications more severe and widespread. Illiquid assets, maturity mismatches between assets and liabilities and leverage amplify the force with which problems of one intermediary are pushed through the complex network of exposures. Sizable amounts of debt relative to capital and short-term funding have more dramatic effects in situations of stress.

For example, intermediaries’ losses can trigger “fire sales” of already largely illiquid assets, which reduce their values and cause losses to other intermediaries, as for example described in research on contagion by Hyun Shin and his co-authors. [6] Moreover, funding and market illiquidity can reinforce each other, leading to vicious liquidity spirals multiplying the initial shocks. [7]

These effects are further amplified due to asymmetric information. In the aggregate, they lead to the nonlinear adjustments that are so characteristic of financial instability. The fact that such adjustments are nonlinear is particularly important for research and makes modelling extremely difficult. [8] Such adjustments may cause violent regime changes, pushing the system from a state of tranquillity to a state of turmoil.

One key element in phases of turmoil and crisis is speed. The rapidity of unfolding developments is often not modelled explicitly, but it is one of the greatest challenges for policy makers. Financial crises are by no means new phenomena, but the speed of their transmission has accelerated tremendously over the past few decades. While the unfolding of the sovereign debt crises in the 1980’s occurred over the course of years, the Asian Financial crisis developed, at its peak, over months rather than years. The last intensification of the present crisis, starting in mid-September last year, has spread around the globe in the course of half-days. Many factors have contributed to this acceleration, including the process of global financial integration, the increasing leverage in institutions, the technological advancements that allow for an instantaneous transmission of information world-wide and the accumulation over a long period of time of unsustainable global imbalances.

In the eco-systems of our natural environment, feedback mechanisms are often prevalent, too. As soon as one part of the system is adversely affected, this can take the form of an adverse feedback look destabilising the system as a whole.

Amplification effects are not only important in the transmission of instability, but also in the build-up of imbalances that sow the seeds of systemic risk. A very important phenomenon in this regard is herd behaviour in investment. For example, investment managers and loan officers may sometimes ignore valuable private information in order to mimic others when their own evaluation, their own remuneration or their own external reputation depends on their performance relative to the rest of the market. [9]

This behaviour is individually rational but socially wasteful. Here at the University of Cambridge, the famous analogy that John Maynard Keynes made between newspaper beauty contests and financial market behaviour comes to mind. [10] I am also convinced that one of the main reasons behind herd behaviour in financial markets in general, particularly in times of crisis, is a lack of transparency. The fostering of transparency as concerns financial institutions, financial markets and financial products is therefore one essential policy lesson from the present crisis.

Our latest experience with systemic risk

Let me now apply the relevant elements of this framework on how to think about systemic risk to the present crisis. A particularly relevant source of systemic risk was the build-up of widespread financial imbalances – the second form of systemic risk I described – in the period of 2003 to 2007. The years prior to 2007 were characterised by low financial market volatility and risk premia, rapid financial innovation in credit markets, low interest rates across the maturity spectrum and ample liquidity conditions.

In particular, rapid financial innovation led to securitisation techniques with thus far unknown complexities and to long and uncontrollable chains of intermediaries between originators and final investors. Ratings agencies gained global power as the pricing of securitisation tranches was largely based on their assessment, while leverage mounted ever higher and a shadow banking system developed up largely unregulated.

At the same time, mark-to-market accounting rules became increasingly widespread, while unsustainable external deficits and surpluses in some major economies paved the way for macroeconomic imbalances at the global level. Information began to flow instantaneously around the globe and raised competitive pressure on all financial market participants.

In this environment, banks and other investors engaged in a “search for yield” with the help of the new credit products and investment vehicles, circumventing existing regulations. The pace of this herd behaviour into ever more complicated forms of securitisation far exceeded the market’s capacity to solve a number of open issues of valuation, risk management and incentives.

The result were widespread financial potential instabilities in the form of a highly complex, opaque and – as it turned out later – illiquid system of credit risk distribution. Many investors were either ignorant or imprudent with regard to the risks that they had acquired. Contrary to conventional wisdom, this distribution led to much less diversification than thought and to some surprising concentrations of risks in a number of large and complex financial institutions. While mortgage market exposures, including those in US sub-prime mortgages, were part of the problem, it later turned out that the problem of bad assets was much more widespread.

The underlying risks started to materialise when house prices declined, delinquencies in US sub-prime mortgage markets rose, and the so-called ‘special purpose vehicles’ that held highly concentrated exposures to these markets came under pressure. In June and July 2007, credit default swap premia started to increase sharply, rating agencies downgraded a large number of asset-backed securities and collateralised debt obligations. Even AAA-rated CDO index tranches declined below par value.

The eventual instability became systemic for the first time when money markets became impaired in early August 2007. The re-pricing of risks made the major intermediaries active in interbank markets aware that they might experience further losses in the future and that the same might apply to their counterparties. Given the lack of transparency of the credit risk distribution system, asymmetric information was omnipresent. It became difficult for intermediaries to distinguish good assets and counterparties from bad ones.

This led banks to hoard liquidity as a protection against the risk of their own assets and counterparties becoming illiquid, rather than lending available funds in money markets. [11] Such malfunctioning of the interbank markets makes the problem immediately systemic, as all major banks depend on those markets. For central banks, there was no alternative to making sizable liquidity interventions aimed at keeping the system afloat.

While this first phase of what we described at the time as “market turmoil” was indeed very challenging, the dramatic transition to a full-blown systemic crisis happened in September 2008. The failure of a very large US investment bank, in conjunction with other news and a series of events that increased uncertainty, led to a widespread loss of confidence in the financial system.

As a consequence, the economic outlook worsened dramatically. The economic models in use were not able to predict the sharp downward revisions of growth figures that followed over the subsequent seven months.

The events of September 2008 clearly showed that in economic policy, we have no good understanding of the very rapid transition to an eventual systemic crisis. In this sense, we were left alone. Policy-makers had to rely on informal information, real-time data releases and their own wisdom and judgements on how the situation was evolving.

What have we learned from this experience in terms of identifying those structural trends in financial systems that are important for systemic risk?

First, we need much more analysis of the implications of the business models of major intermediaries for the system as a whole. Some of the crucial factors, whose relative importance has shifted over time, include originate-to-distribute models, rising maturity mismatches and the combination of proprietary trading and investment advice.

Second, in line with previous experiences we have been reminded that the very fast growth of innovative financial instruments and new financial intermediaries, in particular off-balance sheet vehicles, can imply significant risks.

Third, financial integration needs to be accompanied by reform of supervisory and regulatory approaches and institutions. Major reforms in this area are currently being discussed in the European Council and European Parliament, including the establishment of a European Systemic Risk Board. [12]

Fourth, advancing financial consolidation raises the question of how to regulate and, in the event, wind down large and complex financial intermediaries whose disorderly failure could pose systemic risks.

Fifth and finally, as financial sectors develop, households may take greater risks, for example in mortgage markets and, more broadly, in their pension investments. While this also raises issues of consumer protection, from a systemic perspective, it becomes increasingly important to know how resilient the household sector and consumption can be in such a situation. [13]

Macro-prudential supervision: a policy response to systemic risk

I have discussed the nature of systemic risk and our latest experience of it in the present crisis. Let me now turn to the question of how policy-makers can respond to systemic risk. Today, I want to focus particularly on the challenges for policy-makers of detecting risks of systemic instability materialising in the future, and of then containing these risks.

Detecting systemic risks early is the task of macro-prudential supervision. I would like to focus on the analytical issues underlying this policy and stress three approaches, linking them to the three forms of systemic risk I discussed at the start of my lecture.

First, there are large and complex financial intermediaries, or like-minded clusters of financial institutions, that play prominent roles in the financial system. We can describe them as particularly important “nodes” in the financial network, which stand out through their risk, size and interconnectedness. [14] The full understanding of their individual on- and off-balance sheet exposures and their lending and borrowing to each other is a crucial element in assessing and containing risks of contagion.

Second, the extent and diversity of investment practices across all segments of the financial system requires particular attention. For example, fast-growing credit to similar sectors or regions could be a sign of vulnerabilities building up. The imbalances might become unsustainable later and unravel in a disorderly fashion. This risk requires looking at early-warning signals in current market data. For example, aggregate credit might grow at a pace that is disproportionate to the credit required to finance sustainable investment and consumption. The complete set of important intermediaries, markets and instruments also needs to be checked for early-warning signals, since similar risks could be hidden in different parts of the financial system.

Third, current market data may not give the full picture of all relevant future scenarios. Detecting systemic risks early also requires stress-testing the system against extreme events and shocks that would surprise markets. Such macro-stress tests help to make an assessment of the resilience of financial systems against shocks that have a low probability but a highly destabilising power. [15]

Compared to the vision of systemic risk that I have outlined so far, two weaknesses of the supervisory and regulatory approach that we had before the crisis stand out.

For one thing, the old approach focused too much on individual risks and too little on interconnections across intermediaries and markets.

For another thing, it generated a lot of information about some types of intermediaries but much less on others (including the shadow banking system). This made it difficult to understand fully the pro-cyclical behaviour of the system in the aggregate.

Even if we understand the nature of systemic risk and know the basic approaches for detecting its different forms, there are very important challenges for macro-prudential supervisors.

One challenge is to be able to collect all the information that is necessary to identify systemic risks early. It requires combining some micro-level data with and aggregate data from components of the financial system. This means covering major types of intermediaries, in particular large and complex ones, key markets and wholesale market infrastructures. To contain systemic risk, macro-prudential supervisors need to have a good understanding of all parts of the financial system that are relevant for the risks of contagion, the endogenous build-up and unravelling of widespread imbalances and macro shocks.

Some of these data are more difficult to compile and bring together than others. There are some financial sectors about which considerably less is known than about others. Compare, for example, banks or insurance companies with non-listed highly leveraged institutions. Although nowadays individual hedge funds do not seem to be a source of significant systemic risk, it is very important that the relevance of this industry for the overall cyclicality of the financial system is assessed. A particularly complicated topic is measuring the interconnectedness among the systemically most important intermediaries.

The implication is that an effective exchange of information between the functions of macro-prudential supervision and micro-prudential supervision is an essential element of identifying and containing systemic risk. There will be strong demands on micro and macro-prudential supervisors to ensure smooth exchange of information under the post-crisis regulatory and supervisory regime we are striving to establish.

Another challenge is more of an analytical nature. The economic models we have at our disposal at present do not capture necessarily all relevant dimensions of systemic risk. For example, despite progress in developing macro-stress testing frameworks, there are still limitations in how economic analysis captures the two-sided interaction between financial instability and the performance of the broader economy. Standard macroeconomic models often do not have a well developed financial sector and are linear in nature. As I have noted, systemic instability involves major nonlinearities and, in any case, cannot be analysed without proper representation of the financial sector. [16]

There are many good finance approaches to the topic of financial instability, but they are often not aggregate enough to capture realistic features of the macroeconomy, including for example the conduct of monetary policy. Speaking here in the intellectual “powerhouse” of the University of Cambridge, I therefore call on the academic research community to make major efforts towards a better integration of financial and macroeconomic analyses to address these limitations. [17]

A final challenge is given by the policy instruments available to contain systemic risks beyond monitoring and warning about them. Macro-prudential regulation is a relatively new policy area. We have much experience of how micro-prudential regulation affects the stability of financial intermediaries and markets. A much more complex matter is using regulatory tools to stabilise the financial system as a whole.

Having said that, I nevertheless see very encouraging discussions and progress on this front. For example, the 2009 Geneva Report on the World Economy on “The fundamental principles of financial regulation” points the way to how regulators can determine higher capital requirements for financial intermediaries that exhibit features enhancing systemic risk. [18] Additional capital for interconnectedness, leverage, maturity mismatch and asset growth will limit the scope for the externalities I was discussing before.

New initiatives are also under way to enhance the transparency of financial activities. These will help to limit the adverse effects of imperfect and asymmetric information on systemic stability. Overall, a great deal of work is going on at the Financial Stability Board, the Basel Committee on Banking Supervision and at other competent bodies to strengthen the macro-prudential dimension of financial regulation.

As with climate change, an effective policy response demands international coordination. Global warming has been called the biggest market failure ever; the present crisis has been perhaps the biggest financial market failure ever. We know from basic theory and practice that addressing market failure requires a major and coordinated policy response, both immediate and in the longer term.

Systemic risk and macroeconomic stabilisation policies

I have identified the endogenous build-up and subsequent unravelling of financial imbalances, as driven for example by herd behaviour in investment, leverage to finance investment exposures and complex and opaque financial contracts, as a particularly relevant form of systemic risk. While macro-prudential supervision is at the forefront of preventing severe asset bubbles from emerging, this may not be sufficient, given the macroeconomic components of cycles. Therefore, macroeconomic stabilisation policies need to make their contribution to reducing pro-cyclicality. [19]

Macroeconomic authorities have faced the challenge posed by financial booms and busts in two ways.

First and foremost through solid institutions: the pre-emptive arm against system instability. Stability-oriented macroeconomic frameworks have ensured price stability and economic prosperity in all developed countries for the last quarter of a century. Demand and real incomes have grown steeply, but steadily. Their steady course has instilled a wide sense of security in investors and savers. [20] The European stability culture can be seen as vindicated by the crisis.

However, macroeconomic stability has not been a sufficient condition for financial stability. It cannot eliminated systemic risk altogether. Macroeconomic authorities have therefore been frequently called on to provide remedial action, once booms have turned into busts. The aim of their action has been precisely to avoid the transformation of individual financial risks into systemic risk.

Ex post remedial action has often been activated as soon as the financial firestorm has threatened the stability of the economic system. But such action risks raising expectations that macroeconomic policy will always insure against tail risks, no matter how large. Expectations of this sort can contribute to an under-pricing of financial risk in subsequent phases of the financial cycles. They can encourage concentration of market positions in the financial scene.

At the same time, the instruments of counter-cyclical policy have been used so intensely – and more so from one financial cycle to the next – that authorities might have tested the extremes of their control procedures. I am borrowing here from dynamic control theory. Repeated attempts to fine tune a mechanical or electronic system after a shock sometimes leads to “instrument instability” that makes the system spiral out of manageable bounds. [21] Economic and financial systems, I suspect could have some structural similarities with physical systems, leading to the same kind of “instrument instability”.

Moral hazard and policy instrument instability pose questions to which we are not in a position to a firm answer at this point in time. I would like to see these questions studied and debated in eminent academic institutions like this.

Turning to actual developments, as I mentioned already, we saw perhaps the most appalling manifestation of such a threat in the autumn of 2008. In the early phase of the present financial crisis, precautionary hoarding of liquidity brought to a complete seizure of many segments of the market for credit. At the same time, panic sales of assets made market liquidity disappear. Market liquidity is high when traders can easily find a price, and that price is very close to what every other trader pays for the same asset at the same time. In early October 2008 the market could simply not find a value for many of those securities that had been so highly priced only few weeks before.

To avoid a cascade of counterparty defaults, governments offered generous financial guarantees and injected fresh capital into the system. Central banks increased their lending to replace the withdrawal of private lending – in interbank transactions and, sometimes, in the broader market for capital. This concerted intervention very much attenuated the downward part of the cycle and blocked channels of financial contagion. In short, it provided catastrophe insurance.

There is no doubt that macroeconomic policy-makers’ interventions have had a stabilising effect. Market compensation for risk has gradually returned to more normal levels. The free-fall of the economy has been halted and turned around. The financial crisis has not precipitated the extreme spiral of falling prices, rising debt burdens and chain bankruptcies that some economists had feared.

For what concerns monetary policy, conditions are now stable enough that we can start to withdraw some of the excess support that is now not needed to the same extent as it was in the past. [22]

Concluding remarks

Let me draw to a close. An English proverb, echoed in many other languages, warns that sometimes, ‘you can’t see the wood for the trees’. Systemic risk is about seeing the wood, and not only the trees. Macro-prudential supervision, supposed to detect systemic risk and propose remedial action, has been devised because in a highly integrated and complex financial system, micro-prudential supervision alone can no longer guarantee financial stability. The main challenge in systemic risk analysis is therefore to integrate all relevant perspectives, including those of economists, supervisors, regulators, accountants, securitisation experts, rating experts, risk managers and many others to take a holistic view on the system, its dynamics and its interlinkages.

As we have seen, small things can make a big difference and seemingly self-contained initial events can lead to a system collapse. We therefore need a detailed understanding of each part of the financial system. At the same time, their complex interactions mean that we need to keep the big picture in sight, too. We must not allow the understandably narrow focus of detailed knowledge to hamper insight into the system as a whole. Like researchers on the climate and the natural environment, we need to combine the micro and macro perspectives.

The academic research community can make a significant contribution in supporting policy-makers to meet these challenges. It can help to improve analytical frameworks for the early identification and assessment of systemic risks. And it can contribute to discussions on the further identification and optimal use of macro-prudential regulatory instruments.

Macro-prudential supervision is an important tool to contain systemic risks and thereby contribute to sustainable growth and prosperity. The proposed establishment of a European Systemic Risk Board next year is a very important initiative in this regard. Ensuring systemic stability will also alleviate undue pressures on monetary and fiscal policies to extend financial safety nets. The standard macroeconomic stabilisation policies can then focus more clearly on their primary objectives and thereby make their own best contribution to growth and well-being.

Thank you very much for your kind attention.

Macro-prudential policy instruments I

  • Source: The Way Forward with Monetary, Fiscal and Macroprudential Policies Speech by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECB at the Conference “Europe after the Crisis: Resuming the Long-Term Perspective” organised by the Confederation of Swedish Enterprise and the Centre for Global Studies, Stockholm, 11 December 2009

"...A formidable challenge for the central banking community in the period ahead is to respond in the best possible way to calls to enhance macro-prudential oversight. In the EU, a decision has been taken to establish a European Systemic Risk Board. This body will be responsible for carrying systemic risk surveillance and assessment at an EU-wide level and, where considered necessary, to translate these assessments into risk warnings and possibly policy recommendations.

The financial crisis has illustrated that a very large gap exists between, on the one hand, the risk surveillance and assessment tasks and, on the other, the advice on risk mitigation and possible policy follow-ups. The establishment of the ESRB along with its sister body, the European System of Financial Supervision, which will work in close co-operation, should represent a significant step in this direction.

In the new setting, macro-prudential policy instruments should aim at influencing variables such as maturity mismatches, excessive credit growth, leverage, or the risk appetite of market participants.

The types of policy tools that might be activated to address systemic risks may include counter cyclical capital buffers, enhanced liquidity requirements, forward-looking loan-loss provisioning, leverage ratios, haircut and collateral requirements in secured lending, or setting maximum loan-to-value ratios on mortgages. In this sense, the use of these policy tools should take account of both macro-financial and contagion aspects, and most likely will require a continuous interaction between the ESRB and the relevant supervisory and regulatory authorities.

Progress has been made in laying out a framework for systemic risk surveillance and assessment. The ESRB – or, for that matter, any other body responsible macro-prudential oversight – will aim at reducing systemic risk. The establishment of the ESRB but also the new EU supervisory architecture mean that vulnerabilities and potential sources of risk for the financial system will be detected in a timelier manner. This will foster better awareness of these risks and their potential implications.

Regulation will make the system more resilient. In fact, to the extent that we can narrow the policy gap between systemic risk assessments and their translation into risk mitigating policy actions, this will ultimately enhance the financial system’s resilience to adverse disturbances. In this sense the political support for these reforms is absolutely essential...."

Macro-prudential policy instruments II

"...The element that had been more unexpected in the current crisis is the rigour with which systemic risk has been triggered by the collective behaviour of financial institutions and the ways in which they interact in financial markets. The crisis has highlighted the importance of improving our understanding of interconnectedness in the financial system, both via the direct links between financial institutions and the indirect ones created in financial markets.

The crisis has taught us that major risks can emerge from within the financial system itself. It was not the real economy that threw the financial system into disarray, but the reverse.

Endogenous risks – risks that emerge from within the financial sector – can have many causes. They may arise, for example, because large parts of the system rely on the same sources of funding, or because they have similar exposures – to rising financial imbalances, to currency mismatches and to widespread mis-pricing of risk.

We have also seen that turbulence can arise from relatively modest initial shocks. The system is so interconnected that what looks stable can turn out to be ‘meta-stable’, which means potentially highly instable. Snow on mountain slopes can be meta-stable, looking pristine and tranquil yet turning into an avalanche after only a minor disturbance.

The meta-stability of a system is a complex concept, which calls for analysis of the interplay between diverse phenomena. In financial systems, these phenomena include herd behaviour, complex networks of relationships between counterparties, and contagion from common or correlated exposures to particular asset classes. They also include the undesirable pro-cyclical effects of prudential rules, of accounting rules, of credit rating agencies, and of compensation systems that put undue emphasis on short-term earnings...

...Macro-prudential recommendations will not be addressed to individual institutions. This remains the sole prerogative of micro-prudential supervisors. Instead, they will be addressed to regulators, supervisors or other authorities so as to foster regulatory and supervisory policies. These authorities have instruments which can steer variables such as maturity mismatches, excessive credit growth, leverage, or the risk appetite of market participants. While it might not be desirable or feasible to target these variables directly, prudential policy instruments – individually or in combination – can affect them indirectly.

Macro-prudential supervision will not and should not be a substitute for micro-prudential supervision. Rather, it should complement micro-prudential supervision; it has been conceived because the deep integration of the financial system has made it too difficult to ensure systemic stability while focusing on financial institutions one at a time.

In providing specific warnings and recommendations, based on a comprehensive analysis of systemic risk, an effective framework of macro-prudential supervision can close the gap between the analysis of financial stability and micro-prudential supervision.

Setting up a formal framework for macro-prudential supervision will also help to coordinate macro-prudential policies more effectively at the international level. This will be particularly important for the EU, given the depth of its financial integration with the rest of the world...

...4. Implications for the financial sector

Let me turn to the last part of my lecture and reflect on the possible implications for the financial sector.

The financial sector has an important stake in a well-functioning macro-prudential supervision framework and will ultimately benefit from it. The industry should be closely involved in such a framework, as information and insights from market participants will be essential inputs.

Any well-functioning macro-supervisory framework needs the support of market participants, because a rigorous monitoring of systemic risks will require continuous market intelligence. Contact with market participants will be essential for detecting important trends, such as growing financial imbalances, convergence of business models, similarities in investment strategies and innovations in financial instruments – to name just a few.

It will be of immense value to establish a structured dialogue with the financial industry to this end. Anecdotal evidence will be of little relevance if there is no possibility to drill down to the sources of risk on the basis of well-founded information and a regular dialogue with market participants.

I understand that there may be concerns that this will impose an additional reporting burden on the industry. In my view, this should not happen. To the extent that macro-prudential oversight requires micro-prudential data, the latter should be available from supervisors, and full confidentiality will be ensured. Any additional reporting would be exceptional.

Macro-prudential supervision should also avoid leading to an excessive burden of regulation. The legal principle non bis in idem applies to regulation: the financial sector cannot be regulated twice. The aim of macro-prudential supervision is to provide better regulation – and if possible much better, not in quantity but in quality.

Indeed, I foresee several benefits for the financial industry from well-functioning macro-prudential oversight.

The first and main benefit is of course a more stable financial system, which is as much to the advantage of all players in the industry as it is to everyone in the wider economy.

The second benefit is, as I have just mentioned, better regulation, rather than more regulation. Better regulation combines micro-prudential and macro-prudential perspectives. Macro-prudential policy advice should allow market participants to internalise the potential effects of systemic risk in conducting their business. This should enable financial institutions to improve their forward-looking capacity in decision-making, taking corrective measures with sufficient lead time, and being more resilient to market tensions if and when they arise.

The third set of benefits lies at the technical level. The analytical progress that will go hand in hand with a strengthening of macro-prudential oversight should benefit financial institutions’ in-house risk analysis.

This applies in particular to the large, complex and interconnected institutions, on which a substantial part of the macro-prudential analysis is likely to be centred, as these institutions tend to contribute significantly to the level of risk of the overall system. For example, there are likely to be benefits for the further enhancement of financial institutions’ internal models, including stress testing, notably by taking account of system-wide factors and macro-financial variables.

A better understanding of the concept and measurement of systemic risk will lead to more accurate indicators of aggregate leverage, correlation and concentration of exposures to specific asset classes and of a firm’s interconnectedness.

With a view to enabling better measurement of key elements in systemic risk analysis, it is the responsibility of financial institutions to continue to enhance the transparency and granularity of their individual reporting. This could improve, for example, individual firms’ assessment of counterparty risks. Better measurement will also allow for better management. Risk management decisions will be better informed. And financial institutions’ preparedness for specific risks will be enhanced..."

Proposal for a European Systemic Risk Board

1. Why do we need a European Systemic Risk Board (ESRB)?

We need a European Union-wide system to be able to assess and prevent potential risks to financial stability in the EU properly and swiftly. The rapid propagation of the financial crisis from the US to Europe in 2007/2008 highlighted the present weaknesses in monitoring and assessing potential threats and risks arising from the interaction between macro-economic developments and the financial system in the EU but also worldwide. This is why the Commission proposes the creation of the ESRB and its close cooperation with the Financial Stability Board and the International Monetary Fund whose powers in terms of international financial stability and economic surveillance are also being reinforced.

2. What kind of risks will the ESRB monitor?

The notion of systemic risk is wide. The ESRB will have to monitor the soundness of the whole financial system. This can cover very different areas, from the financial situation of the banks to the potential existence of asset bubbles or the good functioning of the market infrastructures. The ESRB will have to identify all the potential risks and, as the intention is not to end up with an endless list, it will also have to prioritise them and issue warnings when it thinks that the risks are significant.

3. How will the ESRB deal with the risks it will identify?

If the ESRB identifies risks to stability it shall issue recommendations to the country or group of countries concerned. If the addressee agrees with the recommendation, it must communicate the actions undertaken to deal with the potential problem. If it does not agree and chooses not to act, the reasons for that must also be properly explained. If the ESRB feels that the explanations are not convincing, it shall inform the Council of ministers.

In general, the ESRB recommendations will also be sent to the Council. In some cases, the Council itself will be the addressee. It is notably the case of the warnings or recommendations addressed to the Community as a whole. But in most cases, the warnings and recommendations will be transmitted to the relevant addressee and to the Council. This transmission of warnings and recommendations is not intended as a filter or as a way to water down their content, but aims on the contrary at increasing the moral pressure on the recipient to act or explain.

The quality of the ESRB work will provide a significant moral incentive to follow up on its recommendations or give convincing reasons for not to.

Specific follow-up procedures are also foreseen. For instance, when a national supervisory authority intends to deviate from an ESRB recommendation, it must first discuss and justify it with the competent European authority and will have to take into account its views before answering the ESRB. And if the ESRB feels that the explanations are not convincing, it shall inform the Council.

4. Why is it proposed to give central banks, including the European Central Bank, a prominent role within the ESRB?

Central banks have always played a key role in macro-prudential supervision and in many countries they are responsible fully or in part for the supervision of individual institutions. .The European System of Central Banks (ESCB) includes all 27 national Central Banks of the European Union and the 27 Governors sit in the General Council of the ECB. Being at the heart of the EU monetary system and having wide ranging expertise in the macro-prudential field, the ESCB holds a unique and privileged position for analysing and assessing the linkages between developments in the financial sector and the macroeconomic performance of EU economies. It is therefore appropriate for the ESCB to have a prominent role in the European Systemic Risk Board.

5. The Secretariat of the ESRB will be entrusted to the ECB. Does this mean that non euro area Central Banks will be excluded from the preparation of the ESRB work?

No, the ESRB will include the central bank governors of all 27 Member States. The ECB employs at all levels of its hierarchy citizens of all Member States, including from those who have not adopted the euro. Seconded experts from non euro area Central Banks will participate within the ECB to the work of the ESRB secretariat.

6. Will the warnings and recommendations be made public and if not why?

The issues potentially addressed in the warnings and recommendations will be extremely sensitive and we must be careful about adverse effects, such as the warnings turning into self-fulfilling prophecies by frightening financial markets. The decision whether or not to publish will, therefore, require a case-by-case decision after a careful assessment of the potential consequences.

7. What form do the legislative texts take and when do you expect them to be approved?

The creation of macro-prudential supervision at the EU level and the establishment of the ESRB are foreseen in a draft Regulation based on Article 95 of the EC Treaty, that requires co-decision by the Council and the European Parliament. The Regulation is completed by a draft Council Decision which confers on the ECB the task of ensuring the Secretariat of the ESRB.

Before making the legislative proposals, the Commission conducted extensive consultation of interested parties both after the publication of the report of the Larosière Group and of the May 2009 Communication, which outlined the new supervisory architecture. The June European Council supported the proposals contained in the Communication and welcomed the Commission's intention to adopt the legislative texts early in the autumn for a swift approval in order for the new framework to be in place in the course of 2010. The European Council has announced it would discuss the subject again in October.

8. The latest crisis has shown that systemic risks can be global in nature. Why not leave monitoring of systemic risks to the recently enhanced and renamed Financial Stability Board?

The existence of an internal market in the EU and the increasing political and financial integration of the EU require an EU-level institution to supervise and monitor risks to the financial system. The US has also announced a systemic risk monitoring body, to be created within the Federal Reserve. The ESRB will, of course, liaise closely with the new Financial Stability Board and with the other relevant international bodies, contributing to a stronger global framework for risk monitoring and more stable financial markets. This global network ought to monitor systemic risks more effectively and detect potential crises earlier to be able to defuse them or, in the very least, mitigate their impact. The ESRB will play a key role in this network and fills an important gap in financial supervision in the EU.

9. Will the ESRB lead to a greater administrative burden for financial institutions?

No. Most data needed by the ESRB will be provided to it by the European Supervisory Authorities (ESAs) using information which they already possess. Before asking for information, the ESRB will furthermore check with the ESAs that its request is proportionate.

The ESRB will also not present any extra cost for the Community budget as it will build, to the extent possible, on existing staff and resources of the European System of Central Banks, with a secretariat provided by the ECB

10. The ESRB will potentially deal with very sensitive market information. How will the confidentiality of the data be safeguarded?

There are specific articles in the Regulation and the Decision aimed at guaranteeing effective procedures for handling confidential data. Specific detailed procedures for the transmission of the information will furthermore be agreed between the ESRB and the European Supervisory Authorities. Last but not least, one should keep in mind that all the Members of the ESRB are used to dealing with highly confidential data on a daily basis.

11. Who will be the chair of the ESRB?

The chair will be elected by the members of the General Board, the main decision-making body of the ESRB, for a period of 5 years, renewable. The General Board will be composed of all the Governors of the national Central Banks in the EU, the President and the Vice-President of the ECB, a Member of the European Commission and the Chairpersons of the three European Supervisory Authorities. National supervisors and the President of the Economic and Financial Committee will also form part of the Board, but without voting rights.

12. Why will national supervisors have no voting right in the General Board?

The presence of the national supervisors inside the ESRB improves the flow of information and allows a constant exchange of views between the actors having a macro angle (the ECB, the National Central Banks, the Commission…) and those working with a micro-prudential perspective. But national supervisors are in charge of micro-supervision of individual banks, and not of the stability of the financial system as a whole. This difference in the approach, mission and analytical angle explains the difference in the voting rights.

13. The ESRB will have over 60 institutions represented in it. Is this not too cumbersome to be effective?

A broad representation of institutions within the ESRB is necessary to ensure a global macro-prudential perspective in the ESRB’s risk assessments. The ESRB must include all those who have relevant information and expertise to contribute. These include the governors of national central banks, the new European Supervisory Authorities, and national supervisors. However, a steering committee (consisting of the ESRB chairperson and vice-chairperson, five additional central bank members of the ESRB, the chairpersons of the new European Supervisory Authorities, the President of the EFC and the Commission member) will prepare and ensure efficient ESRB operations.

14. What will be the role of the Advisory Technical Committee (ATC)?

The composition of the ESRB will be very high level (Governors, Commissioner, Chairman of the European Authorities…etc). While the secretariat will be able in most cases to prepare all the discussions and provide the necessary analysis, it can happen that the ESRB needs to draw on more specific competences than the ones usually available at the ECB. The ATC will be able to bring this technical expertise on issues for which it might be needed to go beyond the support provided by the secretariat (e.g., problems linked to the supervision of the insurance sector…).

ECB wants systemic mandate

"The European Central Bank welcomed plans to give it the key role in a new European supervisory body, saying it would neither distract it from ensuring price stability nor create a threat to its independence.

In a legal opinion, the ECB welcomed plans for the European Systemic Risk Board (ESRB) — a new body to be chaired by ECB President Jean-Claude Trichet.

“The involvement of the ECB and ESCB in the ESRB will not alter the primary objective of the ESCB… which is to maintain price stability,” the opinion said.

“The ECB notes that its supporting activities for the ESRB will neither affect the ECB’s institutional, functional and financial independence,” it added.

The ESRB is part of the EU plans to make markets safer for investors by applying lessons from the credit crunch and aims to be in place next year.

It will monitor any build-up of risks in the financial system and issue warnings to relevant authorities about what should be done about risks in the financial system.


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