Uncertainty is no excuse for not using macroprudential tools

Angus Foulis and Saleem Bahaj

The macroprudential toolkit available to policymakers across several central banks is new and largely untested. For example, in the UK, the Bank of England’s Financial Policy Committee (FPC) has, since the financial crisis, received powers to alter bank capital requirements and to place restrictions on the terms of household mortgages for macroprudential purposes. These policy tools have not been used systemically in the past, so their impact and the FPC’s reaction function remain unclear. Moreover, in contrast to monetary policy, where price stability can be judged against inflation, the objective of macroprudential policymakers – the stability of the financial system – is inherently unobservable. Thus macroprudential policymakers face a high degree of uncertainty over the impact and effectiveness of their tools and a target variable they cannot perfectly observe.

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Extracting insight from complexity

John Hill and Jamie Coen.

The financial system is complex and highly interconnected. Indeed, interactions between agents are key to its functioning. But these interconnections have the potential to turn small shocks into systemic crises. Understanding the complex nature of these interconnections is important, but can also be difficult. In this post we introduce new tools designed to analyse the financial network and help analysts build a better understanding of risks posed by interconnectedness.

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Regulatory arbitrage in action: evidence from cross-border lending and macroprudential policy

Dennis Reinhardt and Rhiannon Sowerbutts.

We find evidence that certain types of macroprudential regulation are avoided by borrowing from abroad. Borrowing by the non-bank sector from abroad increases after an increase in capital requirement, but not after an increase in lending standards. This is likely to be because of the way that the two regulations are applied and is supportive of strong frameworks for reciprocating capital regulation.

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The “question” or the “answer”? Market reaction to UK stress tests

Matthieu Chavaz, Jeremy Chiu and Evarist Stoja.

How might banks fare in stressful macroeconomic conditions? Are they strong enough to withstand the stress and survive or will they fall like dominoes? Stress tests offer insights into such questions.

Regulators are not only making a growing usage of such tests, they are also increasingly inclined to communicate openly about them. This is a remarkable evolution. Throughout history, regulators have typically followed some form of Hippocratic Oath and refrained from disclosing their detailed diagnostics of individual banks’ health. Regulators are now increasingly keen to release both the “answer” to stress tests (the results) and the “question” – the stress scenario regulators confront banks with. This column suggests that the disclosure of the scenario can be as important as – if not more than – the disclosure of the results.

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Rational and Behavioural Drivers of Financial Markets: the case of ‘search for yield’

Silvia Pepino.

Rational and behavioural factors can coexist in financial markets. The ‘search for yield’ (or ‘reach for yield’) observed in financial markets in recent years is a striking manifestation of the interaction of rational and behavioural factors. During an extended period of low interest rates and volatility, market participants have displayed a tendency to seek higher returns by investing in securities that carry higher credit, liquidity or duration risk. This tendency to search for yield appears to have been motivated by a mix of rational fundamental considerations, business and regulatory constraints, and behavioural biases.

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Are reserves still “special”?

Matthew Osborne and Mathew Sim.

Are central bank reserves still ‘special’?

Historically, reserves have been “special” for several reasons: they are the ultimate means of settling payments between banks; they are the main medium through which central banks make monetary policy decisions “happen”; and crucially, central banks have a monopoly supply. Some of this specialness has now reduced, at least in the traditional sense. But, as this blog post goes on to explain, new liquidity standards suggest a new and important role for central bank reserves, which will create challenges as monetary policy is normalised. Finally, control over supply of reserves could also be a useful macroprudential policy tool.

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Bringing together stress testing and capital models – a Bayesian approach

Dan Georgescu & Manuel Sales.

Capital requirements for financial institutions are typically calculated using a statistical model and a risk measure such as VaR, whereas stress tests designed by regulators and risk managers are often based on subjective scenarios with no associated probability level. The stress test cannot therefore be easily linked to the capital measure. Taking insurance as an example, we show how to establish the link using intuitive tools which (i) respect the stress test designer’s intuition about causal direction, (ii) can be calibrated to pre-determined parameters such as correlations between risks, and (iii) can be easily communicated to and challenged by non-technical audiences.

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Local housing booms and busts in England

Arzu Uluc.

A novel housing data set with information at the Local Authority level shows that changes in the proportion of high LTI mortgages was positively correlated with the size of the house price boom (1997-2007) and bust (2007-2009). Interestingly though, changes in the proportion of high LTV mortgages had the opposite relationship. This blog sets out some stylized facts on the wild swings in house prices over this period using this new data set.

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What do we know about non-bank interconnectedness?

Zijun Liu and Jamie Coen.

Non-banks are clearly important in the financial system – according to the FSB, global non-bank financial intermediation grew to $75 trillion in 2013, roughly half of banking system assets. But how are they connected to banks, and what risks does this pose? Using a new granular dataset on the exposures of banks to non-banks, we gained some important insights into what these interconnections look like in the UK. Banks’ direct credit exposures to non-banks are currently small, but there is evidence that some non-bank financial institutions have entered the core of the repo network. We found little evidence in our dataset that hedge funds are conducting risky credit intermediation, but other non-bank financial institutions seem to be leveraging up via the repo market.

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It’s a model – but is it looking good? When banks’ internal models may be more style than substance.

Tobias Neumann.

Most large banks assess the capital they need for regulatory purposes using ‘internal models’. The idea is that banks are in a better position to judge the risks on their own balance sheets. But there are two fundamental problems that can arise when it comes to modelling. The first is complexity. We live in a complex world, but does that mean a complex model is always the best way of dealing with it? Probably not. The second problem is a lack of ‘events’ (eg defaults). If we cannot observe an event, it is difficult to model it credibly, so internal models may not work well.

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