The ECB Vice President Luis de Guindos discussed the three remaining tasks for regulators and macro-prudential policymakers with respect to global financial regulation. He discussed the importance of full and timely implementation and evaluation of Basel III standards, the need for adding a macro-prudential dimension to stress tests of the banking sector, and the necessity to actively monitor and extend the macro-prudential policy toolkit to the non-bank financial sector.
As the supervisory focus shifts to evaluating the effects of regulatory reforms, Mr. Guindos highlighted that ECB supports the evaluation work being performed under the aegis of FSB and is also conducting a number of evaluation projects of its own. It is required to keep up the efforts and strive for the full, timely, and consistent implementation of those elements of the reforms that are still missing. For EU, these include, the Fundamental Review of the Trading Book and the Basel III finalization package of December 2017. Mr. Guindos noted that macro-prudential policy should play an important role in ensuring the resilience of the banking sector to adverse shocks. In his view, at this stage of the financial cycle, it would still be desirable for a number of euro area countries to build-up macro-prudential buffers. Bank capital plays a crucial role in absorbing tail risks, it provides solvency insurance and makes it more likely that banks will be able to continue to provide credit during a downturn. From a macro-prudential perspective, then, the continued build-up of buffers could, therefore, be justified, especially in countries where the long upturn may have led to an underestimation of credit risk or where private indebtedness is particularly high or rising.
Next, he discussed the concept of macro-prudential stress testing, a key analytical tool that helps assess the resilience of financial system. He mentioned that macro-prudential stress test framework of ECB not only tracks the resilience of individual banking institutions but also accounts for how banks interact with each other and how their actions feed back to the economy. This analytical framework can also help to calibrate macro-prudential policies. The framework shows, for instance, that the timing of the activation of capital-based measures matters for their effectiveness. If a new policy tool is introduced in good times, banks are able to build-up additional capital by retaining their profits and they do not need to shrink their loan books to improve their capital ratios. A new capital policy tool that is introduced in bad times, however, is likely to trigger a reduction in credit and place an additional drag on the economy. Bad timing increases the cost of macro-prudential and regulatory interventions, potentially rendering such measures counter-productive.
Mr. Guindos believes that work on the regulatory and the macro-prudential framework for non-bank financial sector is still in its early stages. In search of higher yields, non-banks have accumulated more credit and liquidity risks on their balance sheets. Moreover, non-banks may be contributing to the current cyclical underpricing of risk and helping to amplify the upswing in the wider financial cycle. To reap the benefits of a deep and integrated European capital market, non-bank financing needs to develop in a sustainable manner. International cooperation is needed to develop tools for stress testing but now at the system-wide level, in the form of models that incorporate both banks and non-banks. From a regulatory perspective, at least two lines of defense are needed to counter evolving risks in this area. First and foremost, prudential standards must remain solid in the non-bank financial sector. An extension of the macro-prudential toolkit to the non-bank financial sector is needed to provide authorities with the means to address risks at the system level. Macro-prudential framework would need to be capable of identifying and addressing the key fragilities and externalities stemming from the non-bank sector and provide authorities with the tools that would allow them to achieve this efficiently and effectively.
Related Link: Speech
Keywords: Europe, EU, Banking, Basel III, Macro-Prudential Policy, Non-Bank Financial Sector, Stress Testing, ECB
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