When decision-makers have asked themselves why the global crisis had hit the economy, one of the answers was that there was a lack of effective macroprudential supervision which could warn in advance of the dangerous developments in the financial markets. This is what the International Monetary Fund and the World Bank claim. No institution viewed the boom in the US mortgage market developing for a number of years from the point of view of potential effects for the whole economy. These, however, have been lamentable.
Why has no one issued a warning?
The speculative bubble in the mortgage market continued to grow for years but there was no institution designated to collect data enabling to assess the boom-related risks. The direct reason behind the crisis was insolvency arising from mortgage backed bonds, i.e. CDSs.
When Lehman Brothers sought court protection from creditors no one knew how big the issue of securitised bonds and CDSs was, how many of them were in circulation and what their hypothetical value was. This lack of knowledge was an additional fear-enhancing element. The macroprudential supervision is now meant to monitor similar developments and find a remedy for them. And first of all it is to issue warnings.
Following the collapse of Lehman Brothers banks stopped lending to each other out of fear that the counterparty would become insolvent. From its point of view each bank acted in a rational and prudent way. Banks’ behaviour was justified, they properly assessed the risk but halted the circulation of money in the whole economy which may have led to a total disaster if it had not been for central bank loans.
The second reason for the need for macroprudential supervision is the expansion of the financial system in times of prosperity preceding the crisis. While in the 1980s the ratio of financial system assets to GDP amounted to around 100% in developed countries, it is currently several times the size of GDP. The huge size of the financial system has a significant impact on the real economy. We experienced it first-hand only due to the crisis, Olga Szczepańska, deputy director of the Financial System Department of the NBP, told the Financial Observer.
We also had our bubbles
Examples need not be looked for overseas. Poland also experienced a boom in foreign currency mortgage loans which was luckily curbed by Recommendation S of the Polish Financial Supervision Authority. However, there was no one to warn us of another risk. One of the key reasons for the mass bankruptcies of construction companies, delays in performing contracts, and, perhaps, the loss of EU funds was the lowest price as the award criterion in tenders for the construction of roads, highways and infrastructure.
In 1992 Credit Unions (SKOK) were established in accordance with the cooperative law. They were to collect funds only from their members but, with time, they started operating like banks. However, they were not subject to banking supervision and their deposits were not guaranteed by the Bank Guarantee Fund. They became subject to supervision only 20 years after their creation. Why? Politicians were afraid to take such a decision and, apart from the supervisory authority, there was no institution that could warn of the risks underlying SKOKs’ operations.
The Amber Gold scandal did not generate systemic risk, it was “just a scam”, similar to those that are disclosed every day in the releases of the US Securities and Exchange Commission. It has demonstrated, however, that there are huge gaps in legislation and in the scope of responsibilities of public institutions. The situation is different as regards lending companies. Here the developments may not only lead to unpredictable consequences for the financial system but may also result in economic degradation of hundreds of thousands of families. The consequences would not only be of a financial and economic but also of a social nature.
European conclusions drawn from the crisis
International financial institutions and politicians, first from the G-20 group of countries and then also from the European Commission, have come to the conclusion that it is necessary to establish a net of institutions to carry out macroprudential supervision that would issue warnings of different types of mounting risks in the macro scale.
Since the beginning of 2011, the European Systemic Risk Board (ESRB) has been operating in the EU. By the middle of 2013, similar institutions are to be established in all the EU Member States. The idea is to view the financial sector as a whole, pay attention to its ties with the real economy, promptly identify threats to financial stability and respond to them. The ESRB, composed of governors of central banks of all EU countries, issues recommendations and warnings. There is no counterparty to ESRB in Poland, though.
EU regulations do not impose the obligation to establish a new institution. However, they call on the countries to clearly indicate an authority responsible for pursuing macroprudential policy. It may be the central bank, as it generally has the best substantive and analytical experience to carry out such a policy, and, at least in the majority of European countries, enjoys a constitutional guarantee of independence. In order to play this role the institution would need to have a legal mandate.
Will supervisory colleges be created in Poland?
According to the EU legislation, macroprudential policy makers must not be put under political pressures not to tighten macroprudential policy when the economic situation is good. For many a politician becoming aware of the fact that trees never grow up to the sky tends to be unbecoming.
The NBP has made a legislative proposal regarding macroprudential supervision according to which a Systemic Risk Board is to be established in Poland. It would be a collegiate body composed of the representatives of the NBP, the Ministry of Finance, the Bank Guarantee Fund (BGF) and the Polish Financial Supervision Authority (PFSA).
The legislative proposal was developed in the course of discussions with the above mentioned institutions. The authors, backed by the International Monetary Fund, came to the conclusion that in Poland, the role of institutions such as the PFSA and BGF is critical for the financial system stability, said Olga Szczepańska. She added that the idea was that the Board would not take away any instruments the institutions have at their disposal but would supplement them as it had a broad perspective on the economy.
The most important tool of macroprudential supervision is to be the countercyclical capital buffer.
The concept was developed as a result of the work, i.e. regulations called Basel III, of the Basel Committee on Banking Supervision. The idea is that in times of an economic boom banks have to increase by up to 3% the ratio of Common Equity Tier 1 (i.e. common stock, reserves and retained earnings) to risk-weighted assets. The purpose is to cool overheated economy and prevent speculative bubbles in asset markets.
Macroprudential supervision is aimed at mitigating cyclical fluctuations in the economy to avoid excessive booms and downturns. Banks would have to hold adequately higher level of capital if the regulator came to the conclusion that a credit boom starts, growth rate is too high and the economy is in danger of overheating. The regulator would increase the buffer and banks would have to put aside additional capital for each loan extended, which is costly and weakens the willingness to extend loans. On the other hand, it increases banks’ resilience to shocks due to higher capital held which is the source of covering potential losses in the future, Olga Szczepańska said. When the economic situation deteriorates, as is the case now, the regulator would reduce the capital requirement and thus encourage banks to extend loans.
The countercyclical capital buffer may be implemented to European legislation through the CRD IV directive. It provides that the buffer is to be set in individual EU Member States by a designated institution responsible for macroprudential supervision.
Other instruments of macroprudential character used in the world are the pre-determined LTV ratio, i.e. the relation of the loan value to the value of collateral, and the DTI, i.e. the relation of the loan value to the borrower’s income. If the rules are eased, demand for loans may rise; if they are tightened, the group of clients who can afford a loan will be reduced, Olga Szczepańska said.
Warnings and recommendations
The Board, like the European Systemic Risk Board, would also dispose of “soft” instruments of influencing the market. One of them is warnings. For example, it could inform the market which activities it regards as too risky and call for abandoning them. It would also issue recommendations to public institutions, e.g. to regulators.
The Board would formulate recommendations in such a way as to make it clear which activities it deems necessary for the systemic risk not to increase. For example, the Board notices the risk related to excessive growth of asset prices in a given market and calls the regulator or the financial supervisor for implementing instruments that may prevent such developments, Olga Szczepańska said.
A recommendation indicates the risk source and the addressee. The Board may name the desired measures. It may also be up to the addressee to choose the instrument, added Ms. Szczepańska. The legislative proposal is also to guarantee that the Board’s recommendations are not addressed to institutions in vain. The addressees have to inform the Board of the measures taken to fulfil the recommendations.
– The legislative proposal is now being internally consulted and the remarks submitted are being analysed. It is difficult to say when the proposal will be submitted to inter-ministerial consultations – the Press Bureau of the Ministry of Finance said in response to the question asked by the Financial Observer of when the proposal may be ready.