Evaluation of Macroprudential Regulation

A succinct present day description of macroprudential regulation would define it as a thick and complex web of rules employed to (a) keep financial institutions safe and a going concern, and failing that, (b) to assist their resolution and/or restructuring, and (c) to augment the resilience of financial systems to withstand shocks emanating from system-wide events as well as from bank failures and, where possible, prevent the occurrence of system-wide risks.[1] Such a description is not surprising as the financial markets, the banking system, and the regulatory landscape are indeed a thick and complex web of constituents. This essay will discuss the motivations for macroprudential policy. In particular, the obligations on financial institutions and the financial system to function within existing macroprudential policies; the challenges of the presence of current and future statutory framework versus market discipline; the obligations of stakeholder and beneficiaries enshrined with the powers to make decisions to determine objectives of statutory regulation; and whether there are controls available to successfully challenge the status quo that are supportive, and effective.

The mechanisms of macroprudential regulation are complemented by initiatives to increase the resilience of the financial system and thus impose obligations on financial institutions and the financial system. Some of these initiatives[2] include the fundamental reform of OTC derivatives trading, clearing and reporting[3], requiring a risk-based approach for remuneration in financial institutions, and regulation of credit ratings and Credit Rating Agencies. [4]

As at end-2008, OTC derivatives had reached USD 598 trillion (GBP 460 trillion) measured by notional value and USD 35 trillion (GBP 27 trillion) by gross market.[5] Owing to the scale of OTC derivatives and their impact on destabilising the financial system, reforms on OTC derivatives markets imposed obligations on financial participants and the financial system to improve their transparency, prevent market abuse and reduce systemic risks. The implementation of the EU Market Abuse Regulation (“MAR”) in 2016 was one reform which caused a further expansion in the scope of insider trading and market manipulation prohibitions in order to respond to the changing nature and structure of financial markets. An example of a key driver towards the implementation of MAR was an increase in the focus on fixed income and commodity markets and related benchmarks in the wake of the financial crisis and a success of scandals in markets previously untouched by insider dealing, and arguably, market manipulation laws (FX, LIBOR etc.).

Another fundamental reform of OTC derivatives trading, clearing and reporting which was motivated by macroprudential policy objectives was to ensure that central counterparties (“CCPs”) do not expose shocks to the financial markets when under stress. CCPs by their very objective, are heavily exposed to the counterparty credit risk of their members. However, CCPs needs strong internal systems and controls to ensure that over time, commercial pressures and competition from other CCPs do not lead to inadequate margining.[6] CCPs hold collateral from their members and are able to call for further resources from their members under their recovery plans if these funds are exhausted, however this could impact a counterparty’s credit and liquidity profile if they are unable to meet the demands to fulfil their notional obligations as well as initial margin required by CCPs. This, in turn, could impact the CCPs counterparty credit risk and liquidity risk and could risk the credit markets grinding to a halt, leading to moral hazard as counterparties have limited scope to monitor each other’s credit quality and act properly because a third party (the CCP) is bearing all the responsibilities. Therefore, it would be prudent to consider the development of further arrangements for the recovery and resolution of CCPs.

There is a strong prima facie case that inappropriate incentive structures played a role in encouraging behaviour which contributed to the financial crisis. It is very difficult, however, to gauge precisely how important that contribution was. High levels of remuneration in banks, and in particular high bonuses paid both to top executives and to traders involved in trading activities which subsequently generated large losses, have been the subject of intense public focus as the financial crisis has developed.

There are two distinct issues. The first and short-term issue concerns the total level of remuneration paid to executives in banks which have received taxpayer support. This is a legitimate issue of public concern, and one where governments as significant shareholders have crucial roles to play. But it is not an issue for the long-term nor for bank regulators. The second being that the long-term issue concerns the way in which the structure of remuneration can create incentives for inappropriate risk taking. It is on this issue that the FSA and financial regulators across the world are now focused. Regulators should therefore include a strong focus on the risk consequences of remuneration policies within their overall risk assessment of firms, and should enforce a set of principles which will better align remuneration policies with appropriate risk management and accountability, as can be seen with the implementation of the Senior Managers Regime[7] which is part of the UK governments drive to improve culture, governance and accountability within financial services firms.[8] It fundamentally aims to encourage individuals to take personal responsibility for their accounts; improve conduct at all levels; and make sure firms and individuals clearly understand and can demonstrate who does what. However, the success such a regime will be in in regulators ability to ensure it takes action within its regulatory remit and to ensure that the regulator does not adjudicate on behaviour beyond its scope. It would al achieving international acceptance to implement similar regimes is important part of and retaining and attracting the right talent for the roles.

The impact and influence of credit ratings and Credit Rating Agencies be argued to exacerbate financial criticises. EU government and ECB policy makers accused the big three[9] of publishing unduly negative evaluations as the European sovereign debt crisis spread through Ireland, Portugal, Spain, and Greece. It created procyclicality within the system as a country subject to a downgrade was subjected to higher interests rates and therefore would automatically suffer in its ability to pay its debts. The monopolisation of the sector by such agencies has created an uncompetitive environment that leaves investors with few alternatives. While the big three now face oversight (in the US the US Dodd Frank legislation vested the SEC with additional oversight authority, and ESMA - the EU’s oversight mechanism) neither their market domination nor their fundamental "issuer pays" business model has been challenged by the government or policy makers.[10] This supervisory oversight should extend to requiring that rating agencies only accept rating assignments where there is a reasonable case (based on historical record and adequate transparency) for believing that a consistent rating could be produced.[11] This is important and within scope of macroprudential policy because credit ratings have played a long established role in capital markets, providing investors with an independent assessment of the comparative likelihood of default of securities. However, there are concerns about whether the governance of rating agencies has effectively addressed issues relating to conflict of interest and analytical independence. Rating agencies competing for the business of rating innovative new arrangements may not have ensured that commercial objectives did not influence judgements on whether financial instruments were capable of being rated effectively. Therefore, some measures could be taken to ease the dependency on credit ratings and to reduce the inappropriate use of ratings.

External regulation and supervision is detrimental to addressing interconnectedness of individual financial institutions and markets. The presences of statutory frameworks augment the resilience of financial systems to withstand shocks emanating from system-wide events as well as from bank failures and, where possible, prevent the occurrence of system-wide[12], macroprudential policy. Reliance on internal governance controls and market discipline is not adequate to confine bank risk-seeking and shareholder pursuit of every higher risks for higher benefits in order to achieve higher returns. Private sector goals and incentives[13] contrast vastly with public sector interests and concerns[14], for example when the public sector reacts to losses from financial institutions which spill over into areas of the economy, which results in moral hazard and therefore requires banks to use high levels of leverage which further poses risks for the solvency of the individual institutions and the stability of the financial system, banks are reliant on the provision of (frequently state-backed) deposit guarantee schemes and a central bank operated lender of last resort facility to prevent depositors runs turning into a solvency event for a bank with the possibility of ensuring contagion and system-wide panic.

Even if the default presumption or system-wide approach is that public bailouts become less frequent in the future, in view of implementation of rigour new bank resolution regimes to facilitate orderly failure which minimizes moral hazard, other strong reasons still exist to justify ex ante regulation. It is almost impossible to make a sound prior assessment of the consequences of the policies pursued, due to the complexities of the financial system. The impact of the macroprudential decisions are not visible in the short term. As a result, the role of macroprudential supervisors is difficult, especially given the objective of the tasks and of the conception of the mechanism influencing economic outcomes, and the conceptual interactions between ensuring financial stability under macroprudential policy and the soundness of individual banks under microprudential policy to effect a single supervisory mechanism.  Macroprudential supervisors need to restrain activity at the right time when the economy and financial markets are sound without visible short-term benefits to calibrate regulatory and supervisory arrangements. Otherwise, the shift in focus could lead to a conflict of interest among macroprudential supervisors/policy makers by subjecting them to political pressures to water down or postpone their policy decisions to prioritise enhancing economic growth. Banking lobbies are more likely to be opposed to increases in capital requirements (as stipulated under Basel III) or greater restrictions on loan terms with counterparties, and they could try to rally the public to their perspective by citing increased costs of credit. A public sector concerned about protecting taxpayers and deposit insurance funds will be hesitant to buy into any relaxation of regulatory and supervisory arrangements when the economy turns.

Macroprudential policy is a promising addition to the regulator tool-kit that should help to mitigate the risk of a global liquidity meltdown, thus enabling the financial system to retain the benefits of monetary policy focused on sustaining price and economic stability. However, regulatory tool-kits do have their challenge in identifying and dealing with financial vulnerabilities outside of the banking system where they could be lodged in lightly regulated entities and avoiding regulatory arbitrage[15] across geographical jurisdictions that simply pushes the boundaries, and risk, around globally integrated financial markets. In addition, as previously discussed on the issue of public sector concerns versus the incentives of policy makers, a critical element to the toolkit for the implementation of macroprudential policy is public understanding and support in order to sustain effective policy.

The emergence of lack of consensus as to the type of macroprudential tools that should form part of a macroprudential toolkit reflects the need to better under how macroprudential tools are designed or should be designed and calibrated. These challenges, global financial stability and accountability, would be better assured if more jurisdictions, globally (such as including the United States), adopted more active use of tools such as the countercyclical capital buffer (CCyB) of Basel III.  For example, some of the confusion with regard to a macroprudential toolkit could lie in the lack of clarity as to which tools can be considered macroprudential, and which tools cannot. Macroprudential tools are defined to fall into two categories[16], time dimensions[17] and cross-sectorial dimensions.[18] To illustrate, the Basel III capital adequacy rules, which if applied to all financial institutions and initiated before a systemic event would be microprudential; if it were to only apply to systemically important financial institutions would be macroprudential; and if triggered in response to a systemic event would be a disaster recovery management tool. However, whilst global inconsistency in the implementation of macroprudential tools seems problematic, this is not surprising given the considerations that could affect the choice and combination of policy tools incorporated globally due for example to country specific circumstances such as the degree of honesty relating to capital justification, and the breath and depth of the financial system, signifying that there is a no one-size-fits-all solution.[19]

Macroprudential analysis should cover all sectors: problems in the banking industry and trends in specific markets, for example, bond prices can, for instance, have significant implications for insurance companies. And any separation of prudential regulation and supervision creates the risks of inadequate accountability, coverage and regulatory arbitrage, clearly illustrated by the case of AIG.[20]

It can be argued that market discipline can play a key role in incentivising banks to constrain capital and liquidity risks. The Basel II capital adequacy framework adopts the theory that improved disclosure under ‘Pillar 3’ will play a vital role alongside regulation and accountability development, in incentivising appropriate behaviour. But a strong case can be made that the events of the last five years have illustrated the inadequacy of market discipline and lack of accountability.

In conclusion, macroprudential policy is an accompaniment to microprudential policy and it interacts with other types of public policy that have an effect on financial stability such as monetary or fiscal policy, but it is no substitute for them. The central role of capital-based tools, have distinct property, and tend to complement each other in addressing the same externality, as such a combination of instruments may seem, instead, more appropriate to correct the same externality.

Excessive risk taking, at least at the top management level, may be driven more by broad behavioural and cultural factors than by a rational consideration of the precise incentives inherent within remuneration contracts: dominant executive personalities have a strong tendency to believe in their own strategies. And the reality of excessive risk can often only be spotted at a systemic level.

That being said, bank regulation cannot (and should not seek) create a zero failure environment but an environment where institutional failure can be managed so that it does not endanger the stability of the financial system and create market dislocation.[21] Macroprudential supervisors and other authorities are still facing major challenges in coming to grips with financial instability. The basic lessons of the evolution of the tools, tasks and measures taken by policy makers is crucial to the development of the regulatory framework. After all, anchors are no better than the soil in which they are planted. And that soil could, at worst, turn out to be quick sand, if it comprises of insufficient risk observations and overstated asset values.[22]

Bibliography

Books

• Ross Cranston, Principles of banking law, Second Edition, 2017
• John Armour, Principles of Financial Regulation, First Edition, 2016

Online Articles

• Dion Bongaerts, 2014, ECB Alternatives for Issuer-Paid Credit Rating Agencies, ECB Working Paper Series, < https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1703.pdf> 20th December 2019
• ECB, 2019, Derivatives transactions data and their use in central bank analysis <https://www.ecb.europa.eu/pub/pdf/other/eb201608_article02.en.pdf> 20th December 2019
• BIS, 2018, Incentives to centrally clear over-the-counter (OTC) derivatives, A post-implementation evaluation of the effects of the G20 financial, regulatory reforms <https://www.bis.org/publ/othp28.pdf> 20th December 2019
• Martyn Hopper, 2017, The EU Market Abuse Regime – is it fit for purpose? <https://www.fca.org.uk/publication/research/eu-market-abuse-regime-is-it-fit-for-purpose.pdf> 20th December 2019
• FSA, 2009, A regulatory response to the financial global banking crisis, The Turner Review <http://www.actuaries.org/CTTEES_TFRISKCRISIS/Documents/turner_review.pdf> 20th December 2019
• FCA Handbook: Senior Managers Regime. Chapter 23 Senior managers and certification regime: Introduction and classification < https://www.handbook.fca.org.uk/handbook/SYSC/23/3.pdf> 20th December 2019
• ESMA, 2019, Questions and Answers On the Market Abuse Regulation (MAR) <https://www.esma.europa.eu/sites/default/files/library/esma70-145-111_qa_on_mar.pdf> 20th December 2019
• FSB, 2011, Macroprudential Policy Tools and Frameworks, Progress Report to G20, <https://www.imf.org/external/np/g20/pdf/102711.pdf> 20th December 2019
• Bank of England, 2017, Global pipes – challenges for systemic financial infrastructure, <https://www.bankofengland.co.uk/-/media/boe/files/news/2017/february/global-pipes-challenges-for-systemic-financial-infrastructure-speech-by-jon-cunliffe.pdf> 20th December 2019

[1] Cranston, Ross. c2017 “Principles of banking law” Ch. 2 pp27-36.

[2] Also include a realignment of banker’s incentives in the securitization process, and initiatives to overhaul bankers’’ compensation.

[3] e.g. Regulation (EU) No. 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties, and trade repositories OJ L201/1, 27 July 2012.

[4] e.g. Regulation (EU) No. 462/2013 of the European Parliament and of the Council of 21 May 2013 amending Regulation (EC) No. 1060/2009 on credit rating agencies OJ L146/1, 31 May 2013.

[5] Looking back at OTC derivative reforms – objectives, progress and gaps  - ECB, 2019, Derivatives transactions data and their use in central bank analysis.

[6] Bank of England, 2017, Global pipes – challenges for systemic financial infrastructure.

[7] FCA Handbook: Senior Managers Regime. Chapter 23 Senior managers and certification regime: Introduction and classification

[8] The Senior Managers Regime comes off the back of the UK Banking Reform Act 2013, important legislation that brings into law requirements for a diverse range of reforms in the financial services sector.

[9] Namely the tree major ones: Fitch Ratings, Moody’s Investors Service and Standard & Poor’s.

[10] ECB, Alternatives for Issuer-Paid Credit Rating Agencies, Dion Bongaerts, August 2014.

[11] FSA, 2009, A regulatory response to the financial global banking crisis, The Turner Review.

[12] ibid.,1.

[13] i.e.: profits and compensation.

[14] i.e.: institutional safety, resilience and stability.

[15] For example the emergence of the lack of consensus as to the type of macroprudential tools that should form part of a macroprudential toolkit reflects to the need to better under how macroprudential tools are designed or should be designed and calibrated. 

[16] FSB, 2011, Macroprudential Policy Tools and Frameworks, Progress Report to G20.

[17] Tools specifically tailored to mitigate the time-varying or cross –sectional elements of systemic risk.

[18] Tools not originally developed with systemic risk in mind, but that can be modified to become party of the macroprudential toolkit provided that, (a) they target explicitly and specifically systemic risk; and (b) the chosen institutional framework is underpinned by the necessary governance arrangements to ensure there is no omission in their use.

[19] IMF, Macroprudential Policy: An Organizing Framework, Jose Vinals, March 14, 2011.

[20] ibid., 9.

[21] ibid., 1.

[22] Andrew D Crockett, Marrying the micro- and macro-prudential dimensions of financial stability, 2000 BIS Speech.