Jon Frost and Julia Giese.
A seismic shift is occurring in the European financial system. Since 2008, the aggregate size of bank balance sheets in the EU is essentially flat, while market-based financing has nearly doubled. This shift presents challenges for macroprudential policy, which has a mandate for the stability of the financial system as a whole, but is still focused mostly on banks. As such, macroprudential policymakers are focusing increasing attention on potential systemic risks beyond the banking sector. Drawing from a European Systemic Risk Board (ESRB) strategy paper which we helped write along with five others, we take a step back and set out a policy strategy to address risks to financial stability wherever they arise in the financial system.
In the paper, which benefited from input from a broad range of European policymakers, we start from the notion that risks to financial stability (“systemic risks”) can originate both in the banking sector and in other parts of the financial system. This is not a theoretical argument. In the decades prior to the global financial crisis, markets were rattled by the near-failure of the hedge fund Long-Term Capital Management (LTCM) in 1998, and of unregulated “fringe” institutions during the UK secondary banking crisis in the early 1970’s. During the crisis, the “breaking of the buck” by money market funds, the near-failure of AIG and the freezing of securitization markets helped transmit shocks across the financial system.
On a conceptual level, we argue that various types of market failures can lead to financial crises. These market failures include: (i) excessive credit growth and leverage, leading to credit booms and busts; (ii) excessive maturity and liquidity mismatch and market illiquidity, leading to fire sales of assets; (iii) direct and indirect exposure concentrations, leading to contagion amongst interconnected financial institutions; and (iv) misaligned incentives, reflecting perceptions that some institutions are “too big to fail.” Each of these risks transcends sectoral boundaries. For example, while excessive leverage has been associated with banks, it can also be created outside the banking sector through collateralised lending, such as securities financing transactions (SFTs), or through collateralised mortgage financing. Banks and non-banks can also create excessive leverage synthetically through the use of derivatives.
As a further example, excessive maturity and liquidity mismatch can arise in a number of intermediaries, particularly in asset management. Investment funds help savers to diversify risk and reduce transaction costs, but they can also introduce principal-agent problems, as fund managers are trusted to act on behalf of investors. Their interactions in a sell-off may be subject to coordination failures. We find, based on public sources compiled by Bank staff, that the share of redeemable (open-end) funds in asset management is growing (see figure). In some open-end funds that invest in illiquid assets, there may be potential for “runs.” This refers to the risk that many investors want to redeem their shares but underlying assets cannot be sold fast enough, or only at a steep discount. As one example, many UK property funds experienced large investor redemptions in July 2016. These risks can be mitigated by liquidity management tools, including swing pricing, redemption fees and gates, or the possibility to temporarily suspend redemptions (several UK property funds used these tools). This is in line with recent FSB recommendations. Yet there are currently insufficient data on the actual use of these instruments at an aggregate (industry-wide) level.
Figure: Global asset management industry by redemption profile
If authorities aim to consistently address these types of risks, then policy reform is needed. Specifically, authorities need macroprudential instruments that cover the financial system as a whole. Instruments should apply to both lenders and borrowers, targeting entities and activities. Current macroprudential requirements mainly apply to bank credit, which is only one component of total credit. But we argue that all forms of credit can contribute to credit booms and busts. Hence, all forms of credit need to be within scope, i.e. bank loans, non-bank loans and debt securities, whether domestic or cross-border. In addition to non-bank lenders, macroprudential policy can directly target total credit of borrowers. In this context, while mortgage lending can come from non-bank sources, such as pension funds, insurers and investment funds, loan-to-value (LTV) limits in several EU countries currently only apply to lending by domestic banks. Such LTV limits should apply instead to all forms of lending, as they do e.g. in the Netherlands.
Going forward and as we discuss in the ESRB strategy paper, the development of several of the following tools might be prioritized. The following are the focus of intensive work in international fora, including the ESRB:
- Leverage and liquidity tools for investment funds: to prevent runs on investment funds, authorities should use existing legal tools to limit both direct and synthetic leverage. For example, the EU’s Alternative Investment Fund Manager Directive (AIFMD) gives authorities the legal basis to restrict funds’ use of debt and derivatives. Moreover, authorities should ensure that funds have access to liquidity management tools like redemption fees, gates and swing pricing.
- Macroprudential margin and haircut requirements: These instruments restrict the amount of financing that can be obtained from a given amount of collateral through the cycle. By requiring conservative margin and haircuts during financial upturns, they can combat procyclicality during downturns, and thus soften systemic shocks in the repo and derivative markets.
- Activity-based measures for commercial real estate: Like LTV measures for residential mortgages, LTV limits for commercial real estate loans could combat excessive credit. Ideally they should apply equally regardless of whether credit is provided by banks, insurers, investment funds or others.
- Recovery and resolution plans for non-banks: Credible recovery and resolution plans can ensure that institutions can fail without pulling down the entire system. This is relevant for the insurance sector, but also central counterparties (CCPs), which are highly interconnected with the rest of the financial system. New EU rules focus on precisely this area.
In developing this new policy area, a few challenges will need to be tackled. These include:
- What level of stability do societies want? While most policymakers and the public agree that crises are costly and that the avoidance of crises contributes to long-term growth, there could be short-term trade-offs between growth and stability. When these arise, how should society balance the two objectives?
- How much should policymakers worry about the links between banks and non-banks? For example, if the banking sector is made more resilient, can it be better insulated from shocks in asset management or in financial markets? Or will contagion channels remain in place through asset and liability-side connections?
- Should policy take a stance on the right balance between banks and markets? While some research suggests that a market-based financial structure may be more conducive to long-run growth and stability than a bank-dominated financial system, this question has deep implications and hence warrants further investigation.
Answers to these questions are the subject of discussion, and readers are more than welcome to weigh in. Feel free to use the comment section below.
In the meantime, there is an ambitious work program for European macroprudential, microprudential and business conduct authorities. While the specific mandates of these authorities differ, they all share a commitment to promoting financial stability and sustainable welfare in Europe. By working together, these authorities can continue to contribute to a safe, stable and diversified European financial system.
Jon Frost is a senior economist in the Financial Stability Division at De Nederlandsche Bank. Julia Giese works in the Bank’s Macro Financial Analysis Division.
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