February 15, 2018

Sabine Lautenschläger of ECB spoke about stable financial system at the Dutch Banking Day in Amsterdam. She mentioned that the business of banking is ripe with externalities, with potential herding and with contagion. These factors may not be visible when looking at individual banks, but they can threaten the stability of the entire system.

Sabine Lautenschläger explained that the financial crisis showed that the system as a whole had to be taken into account and not just each part of the system. The micro-prudential approach must be complemented by a macro-prudential approach. Over the past few years, macro-prudential framework for Europe has been set up; objectives and tools have been defined. She further mentioned two goals of macro-prudential policy. First, make the financial system as a whole more resilient. Second, dampen the cycle of booms and busts. In very general terms, this is what macro-prudential policy aims to do in Europe. The tools of macro-prudential policy reflect these objectives. Some of them focus on increasing the resilience of market participants. Other tools focus on the general resilience of the financial system, going beyond the financial cycle. Various capital buffers have been designed for that purpose. There is, for instance, the systemic risk buffer, which can be applied to all banks or to specific groups of banks. It aims to make banks more resilient to structural risks that affect the entire system. And then there are buffers for globally systemic banks, the G-SII buffers, and for locally systemic banks, the O-SII buffers. By making systemic banks more resilient, these buffers address potential sources of contagion. At the same time, the buffers put a price on the impact systemic banks would have on the financial system and the economy should they fail. This helps to internalize this impact.

Ms. Lautenschläger said, "....the distinction between micro and macro is less clear than it should be. This ambiguity might cause conflicts of interest, and this leads us to the question of how to deal with them. The answer is simple: we have to clearly separate the tools of macro and micro-prudential policy. To channel the spirit of the famous Dutch economist Jan Tinbergen: each risk needs its own tool. Let’s start with what is known as Pillar 2 in the context of the Basel framework. Under Pillar 2, supervisors can apply a range of measures to individual banks. The goal is micro-prudential: address bank-specific risks and bank-specific resilience. Now, under current European rules, Pillar 2 measures could also be used to achieve macro-prudential goals. And this could lead to a conflict of interest......" Further she explained that harmonizing the tools at European level might be a good next step. At the same time, it is required to acknowledge that there is a drawback to tools which only focus on banks. The crisis has shown that the financial sector reaches far beyond banks. And when only rules for banks are tightened, certain activities might be shifted to other, less strictly regulated parts of the financial system, namely the non-bank sector. Consequently, risks build up outside the scope of banking regulation and supervision. Eventually, these risks might spill over into the banking sector. So banks might be protected from the first wave of a crisis, but would be hit by the second wave. It is a necessity to clearly separate micro and macro tools, and to expand the macro toolbox.

But there is more it is also required to clearly separate macro tools from each other. This is particularly relevant in respect of various structural buffers, the O-SII, the G-SII and the systemic risk buffers. Each of these buffers is meant to address a specific structural risk. In practice, however, they are often used to achieve the same goals. In this context, the fact that currently all three buffers are treated in combination might play a role, only the highest of them applies. Given that the buffers for systemically important institutions and the systemic risk buffer are supposed to address different risks, they should rather be set up separately and then added up. Additionally, Ms. Lautenschläger explained, "The process of activating macroprudential tools is a long and complex one, and it does not promote the proactive and timely use of those tools. In addition, each tool comes with a different activation mechanism. So I am convinced that these activation procedures need to be simplified. And the notification and information procedures need to be harmonized and streamlined too. This could be done, for instance, by establishing the ESRB as the central information hub for all notifications regarding macroprudential measures in the EU. This would reduce the overall notification burden on national authorities." She further mentioned that the framework is just a means to an end. And that end is to ensure a stable financial system. ECB currently finds four major risks including low profitability of banks; liquidity risks in the non-bank sector; sudden reversal of risk premia; markets might again doubt the ability of public and private borrowers to service their debt. So, there are risks, but, from the ECB’s point of view, they are not too pronounced. In addition, the euro area economy is recovering, and this will help to alleviate some financial stability concerns. In the end she concluded, "Macroprudential policy is a relatively new thing. And what is new is almost never perfect; that is also true of macroprudential policy. It still has to mature. We still need to refine the theory and translate it into tools that are fit for purpose, policies that work and an institutional architecture that is both lean and stable. All this requires further work and regular reviews of the status quo."


Related Link: Speech

Keywords: Europe, EU, Banking, Stable Financial System, Macro-Prudential Policy, Macro-Prudential Framework, Pillar 2, ECB