Donald Kohn of BoE Speaks on Use of Macro-Prudential Policy Tools

Mr. Kohn highlighted that the use of concurrent bank stress tests helps to judge whether further steps are needed to better assure that banks will be able to continue providing UK households and businesses with credit and other financial services in a severe stress. The scenarios used to test bank resilience are explicitly countercyclical—larger deltas in better times—and keyed to a very severe levels of stress; historical experience with economic and financial cycles explicitly informs scenario design. The scenarios also incorporate specific risks that appear important at the time, such as a global recession or a combination of recession and higher interest rates as might result from capital flight post Brexit. The tests are well-adapted for one of their major uses—setting the countercyclical capital buffer (CCyB) for the UK banking system. The stress test results have been used to evaluate how banks are gauging the capital they hold against particular risks, such as those from consumer credit. In between stress tests, an array of indicators is used to judge risk environment for banks and the appropriate CCyB. Several actions have been taken in mortgage markets, but there the steps were targeted more toward preserving borrower rather than lender resilience.

Mr. Kohn mentioned that risks have been identified in other ways as well. For example, BoE staff and the micro-prudential and conduct authorities were asked to perform deep dives on a variety of possible risks and their reports were used to gauge the salience of these risks for financial stability. This year, information is being gathered about the financial stability implications of exchange-traded fund (ETFs), fintech, fast markets, and provision of cloud services to the financial sector. Some tail risks are very clear without the need for extra information or indicators; these are risks related to cyber-attacks, cliff-edged Brexit, and the eventual disappearance of London Inter-bank Offered Rate (LIBOR). For these risks, steps for risk mitigation and building resilience have been identified. For Brexi, without transition, there are a number of ways with which cross-border flows of financial services could be disrupted. FPC has identified ways to mitigate these risks and has kept track of the progress toward mitigation of these risks.

He discussed the importance of improving the ability to identify risks and building the necessary degree of resilience. In this context, he outlined the following four areas of priority for researchers and practitioners:

• Make the stress tests more macro-prudential. Stick to the discipline of countercyclical scenarios, with as many variables as possible stressed to the same severe level each round so that the deltas rise and fall with the cycle. Within that basic framework, attention should be paid to asset categories or lines of business that are growing especially rapidly or are seen as unusually profitable. One should also be looking for correlated positions and important interconnections among stress-tested banks that could amplify shocks.
• Refine the list of indicators. The indicators should reflect recent research and experience and incorporate information on risk distributions—the size and shape of the tails. These indicators can play an important role in making the actions more systematic.
• Continue to develop metrics and techniques for identifying and analyzing risks in non-bank financial channels. Visibility on these increasingly important channels is sometimes limited and oversight responsibility non-existent or not well-focused.
• Work on indicators of overall risk that aggregate across an array of risk metrics to inform policymaker assessments. Aggregate indicators cannot replace the kind of detailed analysis that is required to identify specific risks and take appropriate action to build resilience. However, they can be a useful check on the overall state of the financial sector and the judgment and decisions of the policymakers. Reasonably reliable aggregate measures would be an important focus area for communication with the legislature and the public, aiding accountability and understanding.

Related Links: Speech

Keywords: Europe, UK, Banking, Brexit, Fintech, Stress Testing, Systemic Risk, Financial Stability, CCyB, Macro-Prudential Policy, FPC, BoE