## _110614a ## Source details **Canonical URL:** [_110614a](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2014/_110614a.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2014/_110614a.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2014/_110614a.pdf.json) --- ### Executive summary — purpose, scope, and use - Purpose: - Handbook for staff on macroprudential advice for a given constellation of systemic risks. - Covers detailed guidance on use of: Broad-based tools; Household sector tools; Corporate sector tools; Liquidity tools; Structural tools. - Each chapter: - Discusses transmission and likely effectiveness of tools. - Identifies surveillance indicators to assess need for changes in macroprudential settings. - Highlights potential for leakages and strategies to address them. - Key operational points: - Largely refrains from providing specific universal thresholds; emphasizes in-depth country-specific analysis and engagement with authorities. - Notes interactions and sequencing across tools, need to assess leakages ex ante, and that the note should not be used mechanically. ### Broad-based tools (CCB, leverage ratio, DPR, credit caps) - Roles and mechanics: - Countercyclical capital buffer (CCB): built in “good times” to absorb “unexpected” losses in stress; release can help avoid credit crunches. - Leverage ratio: limits total exposures relative to equity; not risk-weighted; complements risk-based capital. - Dynamic loan loss provisioning (DPR): forward-looking general provisions that build reserves in good times to cover realized losses in bad times. - Caps on credit growth: used where capital tools unavailable/ineffective; primary objective to slow excessive credit growth. - Empirical findings and transmission: - Lending spreads might increase only between 2 and 20 basis points in response to a one percentage point increase in capital ratios (MAG, 2010a; MAG, 2010b). - A one percentage point rise in capital requirements is estimated to reduce likelihood of systemic crises by 20–50 percent (CGFS, 2012). - Banks with larger capital buffers better able to continue lending when faced with loan losses (Nier and Zicchino, 2008). - IMF (2013a): capital requirements have stronger effects on credit in bad times. - Factors weakening CCB effect on credit growth: - (i) substitution of voluntary capital with the CCB; (ii) ease of building capital; (iii) asset shifts toward low risk-weight exposures; (iv) nonfinancial firms borrow from non-regulated sector. - Practical staff guidance: - Prefer country-specific analysis; broad-based tools more effective in bank-based systems or where regulation can be extended to nonbanks. - Anticipate/monitor leakages to domestic nonbanks, off-balance-sheet vehicles, and foreign financial institutions; develop strategies where feasible. - Use CCB, leverage ratio, DPR and caps as complementary instruments. ### Countercyclical Capital Buffer (CCB) — BCBS framework, indicators, calibration, activation/release - BCBS framework and reciprocity: - CCB determined nationally; met with common equity tier 1; international reciprocity mandatory up to 2.5 percent of RWAs. - Jurisdictions can impose CCB higher than 2.5 percent; reciprocity up to 2.5 percent mandatory, above that voluntary. - Adoption and institutional roles (selected country practices): - Early adopters include Switzerland, U.K., Peru, Norway, India, and New Zealand; central banks often play strong roles. - International phase-in: phased in gradually from 2016 to 2019 (international requirement). - Tightening — indicators and measurement: - Recommended starting indicator: “credit gap” (credit-to-GDP gap). - Empirical guidance: - Credit-to-GDP ratio ten percentage points or more above trend issues strongest signal of impending crisis (Drehmann and others, 2010). - HP filter guidance: one-sided (backward looking) HP filter with lambda equal to 400,000 for quarterly data; requires long time series (ten years of quarterly data) with no breaks. - Data guidance: use broad credit measure consistent with BIS definition; if unavailable use IFS data on credit to the nonfinancial private sector. - Complementary indicators (core + additional): - Core indicator: Credit-to-GDP gap. - Additional indicators include change in credit/GDP ratio (m-o-m and y-o-y), credit growth (m-o-m and y-o-y), asset price growth (m-o-m and y-o-y), house prices-to-income levels and gaps, real commercial property prices, spread and volatility measures (equity volatility, term premium, credit risk premium), debt-service ratio, leverage measures (LTV distributions), decomposition of liabilities and wholesale funding ratio, current account deficits. - Calibration — buffer guide: - Buffer guide uses credit gap range two to ten percentage points. - Lower threshold: two percent credit gap — start increasing buffer if surveillance supports systemic risk buildup. - Upper threshold: ten percent credit gap — set CCB at 2.5 percent of RWAs (CCB can be set higher based on macroprudential considerations). - Rationale: start building buffers at least two to three years before a crisis; pace of accumulation based on judgment. - Stress testing and activation: - Stress tests help estimate losses and capital shortfalls and inform CCB level. - In stress, required CCB may exceed 2.5 percent of RWAs to cover capital shortfalls and preserve investor confidence. - Release — indicators and considerations: - Release should be informed by near-contemporaneous indicators of banking distress (market-based indicators, credit spreads, market volatility). - Growth rate of new loans: a drop of credit growth below eight percent is the best indication for the release phase (occurs at onset of >40 percent of crises with few false alarms). - Lending standards, changes in asset quality (NPLs, provisions) are key. - Analytical checklist before release: assess impact on financial stability, funding costs, investor confidence, capital adequacy before/after release, expected/unexpected losses under stress; if post-release capital insufficient, do not recommend release. - Interaction with DPR: DPR generally released before CCB since DPR covers expected losses. ### CCB judgment, country-specific calibration and leakages - Role of judgment: - Rule-based approaches shape expectations but judgment is necessary due to imperfect signals. - Communicate buffer decisions and performance to promote accountability. - Country-specific calibration factors: - Higher CCB for economies with high indebtedness and asset price overvaluation (examples cited: Netherlands, New Zealand, Sweden and South Africa). - Stage of financial sector development: trend credit-to-GDP captures gradual deepening; staff must judge whether trend reflects healthy or excessive deepening (example: India sets different thresholds). - In highly concentrated/volatile economies consider permanently higher buffers instead of frequent CCB changes. - Addressing leakages: - Domestic: expand regulatory perimeter; consolidate nonbank subsidiaries/off-balance sheet vehicles; example: U.K. FPC monitors leakages and can recommend expanding scope. - Cross-border: reciprocity (mandatory up to 2.5 percent) and greater host control (encourage subsidiarization) are remedies; staff should consider subsidiarization recognizing capital/liquidity ring-fencing costs. - Accounting/Supervisory context: IFRS derecognition changes have reduced some circumvention (example: Canadian banks and mortgage-backed securities in 2011). ### Leverage ratio (Basel III) — purpose, design, and implementation - Basel III leverage ratio: - Minimum leverage ratio set at three percent. - Implementation began January 1, 2013 with bank-level reporting to supervisors. - Public disclosure required from January 1, 2015. - Any final adjustments expected by 2017; leverage ratio to become a requirement from 2018. - Definition and scope: - Numerator: Tier 1 capital (taking account of transitional arrangements). - Denominator: exposure measure including on-balance sheet assets, on-balance sheet collateral for derivatives and securities finance transactions, and off-balance sheet exposures. - Objectives and roles: - Constrain excess leverage, act as a simple transparent back-stop to risk-weighted measures. - Use cases: static back-stop; structural tool (supplementary leverage ratio for SIFIs); complement to capital requirements. - Evidence and rationale: - Secular fall in average risk weights since mid-1990s; IRB approaches created variability/opacity; leverage ratios often outperform risk-weighted measures in predicting bank failure. - Leakages and mitigation: - Similar leakage channels as other capital tools: nonbanks, off-balance-sheet credit, foreign lending; responses include expanding perimeter, consolidation, or greater host control. - No reciprocity arrangement analogous to CCB exists for the leverage ratio. ### Dynamic Provisioning Requirement (DPR) - Objective: - Smooth provisioning costs over the cycle by building countercyclical loan loss reserves in good times and using them in bad times. - Spain evidence: DPR helped smooth credit supply cycles; better-provisioned banks lent more and at lower cost during downturn. - Approaches: - Through-the-cycle accumulation (least data-intensive). - Trigger-based (activation/deactivation tied to indicators). - Expected loss provisioning (requires PD and LGD estimates). - Hybrid (through-the-cycle with trigger-based deactivation). - Calibration notes: - Map new loans to outstanding loan stock; set parameters as average credit losses and historical specific provisions; set floor/ceiling for general provisions (ceiling usually matches expected losses). - Trigger-based systems require reliable indicators for activation/release. - Expected loss provisioning needs granular borrower data; periodic recalibration required. ### Caps on credit growth - Use and limits: - Applied when credit growth is strong and systemic risks build fast and other tools are unavailable/ineffective. - Aim to directly constrain supply of credit by imposing a ceiling on quarterly or annual credit growth. - Should not substitute for sound macroeconomic policy; monetary/fiscal policy remain first line of defense. - Country experience examples: - Croatia: credit growth ceiling of "16 percent" in "2003 to 2004", reintroduced "2007" at "12 percent", abandoned in "2009"; evidence that cap did not reduce total private sector debt growth due to substitution by foreign credit. - Turkey: moral suasion targeting "25 percent" annual loan growth since "2011" (not binding cap per se), complemented by other macroprudential tools. ### Household-sector tools — sectoral capital, LTV, DSTI, LTI - Sectoral instruments: - Sectoral capital requirements (risk weights or LGD floors). - LTV (loan-to-value) limits. - DSTI (debt-service-to-income) caps; LTI (loan-to-income) caps as alternative. - Transmission channels and comparative advantages: - LTV limits: constrain loan size relative to property value; reduce credit demand, housing demand and house-price growth; bolster borrower resilience via higher equity; reduce incentive for strategic default. - DSTI caps: restrict debt service payments to a share of income; enhance borrower resilience to interest-rate and income shocks; act as automatic stabilizer when house prices grow faster than incomes. - LTV limits can become less binding as house prices rise; DSTI caps tighten automatically in such scenarios. - Empirical evidence and magnitudes: - A ten percentage point increase in maximum LTV associated with a 13 percent increase in nominal house prices (Crowe and others, 2013, U.S. state-level data). - A ten percentage point decrease in LTV for first-time buyers associated with a ten percentage point decline in house price appreciation (Duca and others, 2011). - Incremental tightening in DSTI associated with four to seven percentage point deceleration in credit growth over the following year (Kuttner and Shim, 2013). - Cross-country: an aggregate DSTI ratio above 20–25 percent reliably signals risk of a banking crisis in a global sample. - RBNZ (2014): cap on share of high LTV loans effective—dramatic fall in share of mortgages over 80 percent LTV since August 2013. - Korea: housing prices fell from 2008 while delinquency ratio on household loans remained below one percent into 2012—attributed to strict LTV and DSTI limits. - Indicators for tightening: - Core indicators: household (mortgage) loan growth (m-o-m and y-o-y), share of household loans to total credit, house price growth (real and nominal, m-o-m and y-o-y), house price-to-rent gap, house price-to-disposable income gap. - Additional indicators: regional house price growth, LTV distributions (new and existing loans), DSTI distributions, LTI distributions, household credit gap, share of banks’ vs nonbanks’ household loans, exposures and capital buffers, share of foreign-currency loans or interest-only loans. - Rule-of-thumb: persistent DSTI above its 15-year trend is an early warning about one year in advance. - Design, targeting, and enforcement: - Combine tools (LTV + DSTI + sectoral capital) to leverage multiple channels and reduce single-tool shortcomings. - Targeting options: differentiated limits by borrower (e.g., lower LTV for second homes) or by region; caps on lenders’ exposures to high LTV/LTI loans. - Information needs: credit registers, borrower income data, regional house prices for enforcement. - Product-specific risks: - Address interest-only and FX loans by tighter LTV/DSTI or higher risk weights; examples: Poland, Hungary ban on FX mortgages (Aug 2010–May 2011). - Unintended consequences and sequencing: - Tighter LTV can induce unsecured loan growth; DSTI caps can increase interest-only loans—respond with product-specific restrictions. - Sequence tightening: less distortionary measures (sectoral capital) first, then LTV/DSTI as needed. - Relaxation in downturns: - Sequential loosening recommended: relax sectoral capital first, then LTV and DSTI if needed, respecting prudential minima (safe floors). - Suggested safe floors: maximum LTV and DSTI considered safe in downturn conditions perhaps not higher than 85 percent and 45 percent, respectively. - Evidence on loosening limited; IMF (2013a) finds tightening and loosening effects on credit similar in magnitude, though tightening LTVs may have stronger effect on house prices than loosening. ### Unsecured household loans - Nature and risks: - Unsecured loans (credit cards, personal loans) have higher LGD and interest rates; proliferation has caused systemic episodes (Korea 2002–03; Mexico 2008). - When LTV limits only cover mortgages, lenders may top up with unsecured loans. - Tools: - Higher risk weights, DSTI limits, and exposure caps applied to unsecured lending (examples: Brazil 2010; Korea 2002; Mexico 2011; Russia 2013). - Some countries apply DSTI caps to total outstanding household debt (UAE 2011; Canada 2012); Romania introduced maximum DSTI 40 percent on total loans and 30/35 percent on consumer/mortgage loans (Aug 2005). - Monitoring indicators: growth and share of unsecured loans; DSTI on unsecured loans. ### Corporate-sector tools (risk weights, caps, LTV/DSC on CRE, FX exposures) - When corporate exposures drive systemic risk: - Use increased risk weights on corporate exposures, limits on corporate credit growth, LTV and debt-service-coverage (DSC) caps for CRE exposures. - Indicators: - Core: share of corporate credit in total credit (flow and stock, level and growth). - Additional: leverage on new/old loans, debt service ratio (distribution and gap), corporate credit/operating surplus, corporate credit gap, lending standards. - Use firm-level metrics like Altman z-score when granular data available. - Calibration and sequencing: - Use judgment; tighten gradually. - Calibrate risk weights informed by stress tests of losses from corporate exposures. - Prefer applying higher risk weights to new exposures when new loans judged riskier; preannounce stock-applied changes. - FX corporate loan tools: - Vulnerability: un-hedged FX borrowing exposes firms to depreciation and rollover risk; build-up can impair monetary transmission. - Tools: higher risk weights and exposure caps targeted at un-hedged FX borrowers; where enforcement is hard, apply to all FX loans but calibrate carefully. - Core indicators for FX tools: share/growth of FX corporate credit in total credit, corporate FX credit/GDP, corporate FX credit gap, fraction of hedged borrowers. - Leakages and mitigation: - Domestic leakages: expand regulatory perimeter to unregulated entities; consolidate activity. - Cross-border leakages: reciprocity arrangements (not currently standard for risk weights), greater host control (subsidiarization), targeted CFMs, fiscal measures to correct incentives. ### Commercial Real Estate (CRE) — indicators, tools, calibration, examples - Historical CRE crises examples: - Ireland: CRE credit growth peak 2006 >60 percent; CRE prices fell >70 percent since 2007 peak. - Sweden, Norway, Finland, U.K., U.S. historical booms and busts with large bank losses tied to CRE. - Tightening indicators: - Core: share of CRE loans in total credit (stock and flow), CRE credit growth, commercial property price growth, CRE credit/GDP or CRE credit/operating surplus, CRE credit gap. - Additional: DSC ratios, LTV ratios, distributions of DSC/LTVs, underwriting standards. - Tools and calibration: - Risk weights and exposure caps (stock or flow); LTV and DSC limits applied to flows of new CRE loans. - Design LTV/DSC by property type (hotels riskier -> higher DSC, lower LTV). - Apply gradual calibration given CRE loan non-amortizing nature and refinancing risks. - Sequencing and interactions: - Increase risk weights first; design risk weights to reflect LTV/DSC; exposure caps can target high-LTV/low-DSC loans. - Leakages: - CRE lending can migrate to nonbank financial institutions or foreign lenders; mitigate via perimeter expansion, subsidiarization, reciprocity. ### Liquidity tools (LCR, NSFR, reserve requirements, levies, open FX positions) - Objectives: - Mitigate systemic liquidity risks from reliance on non-core funding (short-term, wholesale, foreign currency). - Tightening liquidity tools can slow credit growth. - Basel III tools and timelines: - Liquidity Coverage Ratio (LCR): - Definition: stock of unencumbered HQLA divided by total net cash outflows over next 30 calendar days. - Minimum timeline: 60 percent in January 2015, rises by 10 percentage points each year to reach 100 percent from January 2019 onwards. - Net Stable Funding Ratio (NSFR): - Definition: available stable funding (ASF) divided by required stable funding (RSF). - Minimum timeline: BCBS intends 100 percent on an ongoing basis from January 2018. - Other liquidity instruments: - Liquidity buffer requirements, stable funding requirements (core funding ratio, caps on LTD or LTSF), liquidity charges/levies on non-core funding, reserve requirements (differentiated by maturity/currency), constraints on open FX positions, caps on FX funding. - Tools for nonbanks: liquidity requirements for CIVs, redemption restrictions, margin regulation in securities lending. - Effects on resilience and credit: - Liquidity tools increase HQLA holdings, reduce reliance on volatile funding, and can act as brakes on loan growth. - Reserve requirement increases (especially unremunerated or below policy rate) can raise lending spreads and dampen credit growth. - Monitoring and indicators: - Core indicators: loan-to-deposit ratio; non-core-to-core funding ratio. - Additional: liquid asset ratio; maturity mismatch indicators including NSFR; gross open FX positions; volume of short-term capital inflows; securities issuance; volume of unsecured funding. - Currency-specific indicators: LCR by significant currency; monitor U.S. dollar funding where relevant. - Calibration and sequencing: - No universal thresholds; consider structural features (e.g., typical LTD levels vary cross-country). - Gradual tightening recommended; allow preparation periods for stock-based requirements. - Stress testing recommended to calibrate liquidity tools and scenario analysis for FX funding risks. - Nonbank and market infrastructure concerns: - Monitor systemic liquidity risks outside banking (MMFs, repo markets, collective investment vehicles). - Policy toolkit includes margin floors, redemption gates, liquidity fees, side pockets; FSB/SEC reforms noted for MMMFs (floating NAV, liquidity fees/gates). - Consider extending liquidity requirements to systemic nonbanks and regulating margin practices to dampen margin spirals. ### Structural dimension — systemically important institutions, interconnectedness, and structural tools - Three-step surveillance approach: - Step 1: Analyze financial system composition (aggregate and flow-of-funds). - Step 2: Identify systemically important banks using size, interconnectedness, substitutability; complement indicator-based approach with supervisory judgment. - Step 3: Extend analysis to structural risks and NBFIs; consider tools to reduce systemic risk from activities and interconnections. - Tools for systemically important banks: - Intensified supervision, improved resolvability (Key Attributes), and enhanced loss absorbency. - GSIB capital surcharges: range from 1 to 3.5 percent of RWAs; placed in five buckets. - DSIB national surcharges and discretion; principle of “equal expected impact” for calibration. - Examples and calibration: - Australia FSAP (Box 15): additional Tier 1 capital required for four major DSIBs ranged from 0.9 to 2.8 percent of RWA to achieve a one-year-ahead probability of 99.9 percent of not defaulting; 1.4 to 5.2 percent for 99.95 percent probability. - U.S. leverage buffer: systemic banks required a leverage buffer of two percentage points above minimum supplementary leverage ratio of three percent, for total of five percent; applies to covered BHCs with more than US$700 billion in consolidated total assets or more then US$10 trillion in assets under custody. - Measures to reduce interconnectedness: - Tighter risk weights for intra-financial exposures; liquidity requirements penalizing short-term wholesale funding; margin requirements in securities lending and derivatives; changes to market infrastructures (CCPs) to centralize counterparty risk. - Structural limits and trade-offs: - Options include restricting scope/size of activities, moving risky businesses to subsidiaries, or prohibiting certain activities. - Trade-offs: potential loss of scale/scope efficiencies, reduced market liquidity, migration of risks to less-regulated sectors. - Addressing cross-border spillovers: - Need bilateral/multilateral coordination, supervisory colleges, regional forums (e.g., ESRB, Nordic-Baltic Macroprudential Forum), ad hoc structures (e.g., Vienna Initiative). - Shadow banking and nonbanks: - Monitor and collect data on nonbank credit intermediation; tailor regulation to bank-like activities; consider exposure limits, liquidity buffers, leverage limits, and margin floors for shadow banking activities. ### Key numeric thresholds and country-practice highlights (selected, preserved exactly) - CCB activation guide: lower and upper credit gap thresholds "2 and 10 percent respectively"; CCB range "0-2.5 percent of RWAs"; CCB set at "2.5 percent of risk-weighted assets" at upper threshold. - Hodrick-Prescott filter: smoothing parameter lambda equal to 400,000 (quarterly data) recommended (BCBS). - Empirical effect ranges: - Lending spreads: "between 2 and 20 basis points" per one percentage point capital increase (MAG). - Crises reduction: "20–50 percent" reduction in likelihood per one percentage point capital increase (CGFS). - Leverage ratio: minimum "three percent"; implementation reporting from "January 1, 2013"; public disclosure from "January 1, 2015"; requirement expected from "2018". - LCR timeline: starts at "60 percent in January 2015", rises by "10 percentage points each year" to "100 percent from January 2019 onwards". - NSFR timeline: minimum requirement of "100 percent" intended from "January 2018". - Release-phase numeric signals: - Credit growth drop below "eight percent" is best indication for CCB release (occurs at onset of more than "40 percent" of crises). - Household tool thresholds and signals: - Aggregate DSTI ratio above "20–25 percent" reliably signals risk of banking crisis in global sample. - Persistent rise in DSTI above its "15-year trend" provides an early warning about one year in advance. - Suggested safe floors for relaxation: LTV perhaps not higher than "85 percent" and DSTI perhaps not higher than "45 percent". - Hong Kong SAR stressed DSTI test: assumed "300 basis point" interest rate hike; stressed DSTI caps "50 (60) percent for loans to borrowers with (without) outstanding mortgage loans", base DSTI caps "40 (50) percent". - Country examples (selected table excerpts preserved): - India: implementation "December 2010"; lower threshold credit gap set at "3 percentage points"; upper threshold "15 percentage points" (as presented in table). - New Zealand: implementation "January 2013"; notice period "4-quarters." - Norway: implementation "October 2013"; CCB level "1 percent (decision in December 2013; will be implemented from July 1 2015)"; credit gap thresholds "2 and 10 percent respectively." - Switzerland: CCB sectoral level "2 percent" for mortgage-backed positions; banks required to build "100 percent of the CCB over the next 4 years (in increments of 15 pp)"; banks can request to accumulate up to "75 percent" of the CCB in return for committing that at least "50 percent of the net income will not distributed". - Croatia credit caps: "16 percent" (2003–2004); "12 percent" in "2007"; abandoned "2009". - CRE and corporate historical magnitudes: - Ireland CRE credit growth at peak in 2006: "growing by more than 60 percent". - CRE real property price falls exceed "70 percent" since 2007 in Ireland. - Historical corporate leverage in Asia (1996): Thailand close to "250 percent"; Korea "350 percent"; Indonesia close to "200 percent"; Malaysia around "120 percent". - Sectoral tool usage counts (numbers preserved exactly): - Sectoral Capital Requirements: 23 (50 percent) - Limits on LTV ratio: 25 (54) - Caps on DSTI Ratio: 15 (33) - Limits on LTV and DSTI ratios: 13 (28) - At least One tool: 38 (83) - More than two tools: 20 (43) - All three tools: 5 (11) *Source: STAFF GUIDANCE NOTE ON MACROPRUDENTIAL POLICY—DETAILED GUIDANCE ON INSTRUMENTS (excerpt).* ### EXECUTIVE SUMMARY ### EXECUTIVE SUMMARY ### Purpose and scope - This note is intended as a “handbook” that staff can consult when considering what macroprudential advice may be appropriate for a given constellation of systemic risks. - It covers detailed considerations that can guide staff policy advice on the use of: - Broad-based tools - Household sector tools - Corporate sector tools - Liquidity tools - Structural tools - Each chapter: - Discusses the transmission and likely effectiveness of these tools in mitigating systemic risks. - Identifies the set of indicators that can be used in surveillance to assess the need for changes in macroprudential policy settings. - Highlights potential for leakages as activity migrates outside the scope of macroprudential tools and identifies strategies to address such leakages where available. - The note largely refrains from providing specific thresholds for the use of macroprudential policy tools and emphasizes the need for in-depth analysis of country-specific circumstances. - The material is not a substitute for in-depth analysis and engagement with authorities to arrive at sound, country-tailored policy recommendations. ### Implementation issues emphasized - Interactions and sequencing: - The note explores interactions between different tools when used in combination to mitigate risks, and considers sequencing of tools appropriate in responding to changes in systemic risk. - Leakages: - Potential for leakages should be assessed ex ante and policy advice adjusted accordingly. - Strategies to address domestic and cross-border leakages of broad-based tools are considered in detail. - Use of the note: - The note should not be used mechanically; engagement with authorities and country-specific analysis remain critical. ### Broad-based tools — description and transmission - Broad-based tools affect all credit exposures of the banking system and can include: - Countercyclical capital buffers (CCBs) - Leverage ratios - Dynamic loan loss provisioning requirements (DPRs) - Caps on credit growth (used in some countries) - Roles and interactions: - CCB, leverage ratio, and DPR aim to enhance banking system resilience to adverse shocks and may reduce the procyclicality of bank lending. - DPR covers losses expected over an average economic cycle; CCB covers additional “unexpected” losses in times of financial stress. - The leverage ratio complements risk-based capital requirements by constraining total exposures relative to loss-absorbing capacity and acting as a simple, transparent backstop to model/measurement error. - Caps on credit growth have been used where capital tools were unavailable or ineffective in reducing excessive credit growth. - Specific tool descriptions: - CCB: - Meant to be built up in “good times” when financial imbalances are growing to help banks withstand losses in times of financial stress. - Objective: increase system resilience and help reduce procyclicality of bank lending. - Release of the CCB in tightening can avoid credit crunches by helping banks absorb losses and reducing deleveraging pressure. - Leverage ratio: - Limits a bank’s total exposure (on- and off-balance sheet) in relation to its equity. - Is not risk-weighted, counteracts cyclical erosion of risk-weighted assets, and can act as a backstop (or, per some views, a front stop). - DPR: - Forward-looking general (collective) provisions for performing loans that build a “dynamic loan loss reserve” from profits in good times to cover realized losses in bad times. - Like the CCB, can restrain credit growth by increasing the cost of new loans. - Caps on credit growth: - Applied where credit growth is strong and systemic risks are building fast and other tools are unavailable or ineffective. - Primary objective: slow excessive credit; may indirectly enhance resilience if banks prioritize higher-quality borrowers. - Should not substitute for appropriate policies in other areas; often applied sectorally. ### Effectiveness, transmission channels, and empirical findings - Transmission of the CCB is suggested to operate mainly via higher resilience rather than substantially lower credit growth. - Empirical evidence and estimates cited: - Lending spreads might increase only between 2 and 20 basis points in response to a one percentage point increase in capital ratios (Macroeconomic Assessment Group (MAG), 2010a; MAG, 2010b), though some studies suggest larger short-term effects. - A one percentage point rise in capital requirements is estimated to reduce the likelihood of systemic crises by 20–50 percent (with marginal benefits decreasing at higher initial capital levels, CGFS, 2012). - Banks with larger capital buffers are better able to continue lending when faced with loan losses (Nier and Zicchino, 2008). - IMF (2013a) provides additional evidence that capital requirements have stronger effects on credit in bad times. - Factors that can weaken the effect of building up the CCB on credit growth: - (i) Banks can substitute voluntary capital with the CCB. - (ii) Building up capital (retained earnings or issuing new equity) is easy. - (iii) Banks change asset structures toward low risk-weight exposures, lowering risk-weighted assets but not overall lending. - (iv) Nonfinancial firms can borrow from the non-regulated financial sector. - Expectations channel: - Laying out framework details ex ante may change banks’ behavior in expectation of policy change (CGFS, 2012). ### Practical guidance and focus areas for staff advice - Emphasize in-depth, country-specific analysis rather than mechanical rule application. - Consider scope of regulation and structure of the financial system: - Broad-based tools are more effective in bank-based systems or where regulation can be extended to nonbanks and consolidated supervision standards are high. - Anticipate and assess leakages: - Monitor migration of credit provision to domestic nonbanks, off-balance-sheet vehicles, and foreign financial institutions. - Develop strategies to address domestic and cross-border leakages where feasible. - Use CCB, leverage ratio, DPR, and, where appropriate, caps on credit growth as complementary instruments, recognizing their different coverage and transmission mechanisms. *Approved By Jan Brockmeijer and Mary Goodman; Prepared by a staff team led by Erlend Nier and comprising Nicolas Arregui, Chikako Baba, Heedon Kang, and Ivo Krznar (MCM), in collaboration with Gavin Gray, R. Sean Craig, and Nadege Jassaud (SPR), with assistance by Jessica Allison and Ricardo Cervantes (MCM). November 6, 2014.* ### 5. Staff’s advice on the CCB should use the guidance of the BCBS as a starting point. ### 5. Staff’s advice on the CCB should use the guidance of the BCBS as a starting point. ### A. BCBS framework and international reciprocity - The Basel framework stipulates that the CCB should be determined at the national level for all exposures to counterparties in that country. - Banks should have to meet the CCB with common equity tier 1 and would otherwise be subject to restrictions on dividend distributions. - Activation and level of the CCB is at national discretion, but the framework features mandatory international reciprocity up to levels of 2.5 percent of risk-weighted assets to ensure a level playing field where the CCB applies to both domestic and foreign banks in one jurisdiction. - Jurisdictions can impose a CCB higher than 2.5 percent. Reciprocity will be mandatory up to 2.5 percent and voluntary for the CCB higher than 2.5 percent. ### B. Adoption by countries and institutional roles - A growing number of countries are implementing a CCB framework, broadly following the BCBS guidance. - Within the referenced early adopters (Switzerland, the United Kingdom (U.K.), Peru, Norway, India, and New Zealand) central banks assume a strong role in decisions on implementing the CCB, in cooperation with banking supervisors who enforce these buffers bank–by-bank. - Peru is an exception: authorities decided to take a different guide, based on GDP growth, and different rules of activation and deactivation of the CCB because of low banking penetration. India’s thresholds of the credit gap are set higher due to a lower stage of financial system development. - The international requirement is that the CCB be phased in gradually from 2016 to 2019; however, some countries are likely to do this early. ### C. Tightening Phase — Indicators (recommended approach) - Staff is encouraged to use the “credit gap” as a starting point for assessing build-up of systemic risks and recommending activation of the CCB, in the context of broader surveillance. - Evidence cited: - Drehmann and others (2010 and 2011) found the credit gap is the single most powerful indicator of banking crises among potential variables (credit growth, GDP growth, property prices, banks’ profitability). - Drehmann and others (2010) show that a credit-to-GDP ratio of ten percentage points or more above trend issues the strongest signal of an impending crisis (in terms of noise to signal ratio). - Recent literature confirmed signaling properties for emerging market economies (Drehmann and Tsatsaronis, 2014; ESRB, 2014). - Data and measurement guidance: - Credit-to-GDP ratio should ideally be a broad measure comprising all lending by domestic and foreign financial institutions as well as debt raised in financial markets. - Where broad credit data are unavailable, staff should try to construct a credit measure consistent with the Bank for International Settlements (BIS) definition, or alternatively use International Financial Statistics (IFS) data on credit to the nonfinancial private sector. - Trend estimation: - To estimate the trend credit-to-GDP ratio a Hodrick-Prescott (HP) filter can be used. - The BCBS recommends calculation of a one-sided (backward looking) HP filter using quarterly data and a relatively high smoothing parameter (lambda equal to 400,000 instead of 1,600). - A reliable measure of the credit-to-GDP gap requires a long time series (ten years of quarterly data) with no breaks. - Statistical caveats and robustness: - End-of-sample uncertainty for backward-looking HP filters can be high; ex-post revisions to the credit gap in real time can be sizable (Edge and Meisenzahl, 2011). - Augmenting historical observations with forecasts can improve signaling quality for some countries (Gerdrup, Kvinlog and Schaanning, 2013) but introduces forecast uncertainty. - The start date chosen for estimating credit gaps can affect the trend substantially; staff should analyze signals using different sample sizes, smoothing parameters (lambda), and possibly recursive forecasts. - Practical implementation: - A template provided with the guidance note can be used to calculate the HP trend. Staff must enter seasonally adjusted nominal GDP (annualized, on a quarterly basis) and the stock of credit. The template calculates the HP trend and a deviation from the trend using a simple one-sided filter. - To address the end-point problem staff can estimate the HP trend with historical observations augmented by forecasts of credit and GDP. - Judgment and complementary indicators: - The credit gap should not be used mechanically; staff should rely on judgment and in-depth surveillance drawing on a range of indicators. - Additional indicators to consider (useful early warning indicators in cross-country studies) include: - Further credit growth measures: change in credit/GDP ratio (m-o-m and y-o-y change); credit growth (m-o-m and y-o-y change). - Asset prices deviations from long-term trends: asset price growth (m-o-m and y-o-y change), gaps and levels of house prices-to-income, real commercial property prices. - Market volatility and spreads: spread and volatility measures (equity volatility, term premium, credit risk premium). - Debt-service ratio. - Leverage on individual loans or at the asset level (e.g., LTV ratio—an average and a distribution across new loans over a period and existing loans at a given point in time, margin requirements). - Decomposition between core and noncore liabilities and the wholesale funding ratio (gap and level). - Current account deficits. - Table 1. CCB: List of Core and Additional Indicators - Core indicators - Credit-to-GDP gap. - Additional indicators - Change in credit/GDP ratio (m-o-m and y-o-y change); - Credit growth (m-o-m and y-o-y change), asset price growth (m-o-m and y-o-y change), gaps and levels of house prices-to-income, real commercial property prices; - Spread and volatility measures (equity volatility, term premium, credit risk premium); - Debt service ratio; - Leverage on individual loans or at the asset level (e.g., LTV ratio—an average and a distribution across new loans over a period and existing loans at a given point in time, margin requirements); - Decomposition between core and noncore liabilities and the wholesale funding ratio (gap and level); and - Current account deficits. ### D. Tightening — Calibration of the Tool (buffer guide) - Staff should consider the BCBS “buffer guide” formula, using the credit gap as part of an in-depth analysis. - The buffer guide approach: - Consider a two to ten percentage point range for the credit gap. - When the credit gap breaches a “lower threshold” of two percent a decision to start increasing the buffer could be taken if surveillance supports a judgment that systemic risk may be building up. - When the credit gap reaches the “upper threshold” of ten percent, the CCB should be set at 2.5 percent of risk-weighted assets. - The CCB can be set higher based on broader macroprudential considerations. - Rationale for a lower threshold: - A lower threshold is needed so banks can build up capital gradually, sufficiently ahead of a crisis. - Given that banks typically need notice of one year to start to raise additional capital, the process of building buffers should start at least two to three years prior to a crisis for it to make a difference. - The pace of accumulation of the CCB need not be linear with the credit gap and should be based on judgment of the pace at which systemic risks are rising. - Timeliness concern: - Timely activation is critical to avoid procyclicality from a tightening of the CCB. - As a financial crisis approaches, GDP growth often falls while credit keeps rising as borrowers draw on credit lines, which could increase the credit gap reading and reduce signal reliability, risking activation or tightening that comes too late and that could inadvertently induce additional pro-cyclicality if banks curtail lending. ### E. Stress testing and the activation phase - Stress-testing tools can inform judgments on the appropriate level of the CCB. - Stress tests can help estimate losses and capital shortfalls under a stress scenario. - During a period of stress the market might require additional capital to compensate for uncertainty about the solvency of the banking system. - Therefore, the level of the CCB in the activation phase should reflect both the capital shortfall and the extra capital needed to maintain investors’ confidence in a downturn, potentially exceeding 2.5 percent of risk-weighted assets. *Source: STAFF GUIDANCE NOTE ON MACROPRUDENTIAL POLICY—DETAILED GUIDANCE ON INSTRUMENTS (excerpt).* ### 19. Judgment in setting the buffer is necessary for a number of reasons. While rule- ### 19. Judgment in setting the buffer is necessary for a number of reasons. While rule- ### Role of judgment and communication - Rule-based approaches better shape expectations and promote accountability, but judgment is necessary because of the imperfect nature of the indicators’ signal. - Communicating buffer decisions and evaluating the buffer’s performance is key to promoting accountability and helping banks manage uncertainty about future capital requirements. ### Country-specific calibration of the Countercyclical Capital Buffer (CCB) - Staff should take country-specific characteristics into account when recommending how to calibrate the CCB; the CCB should vary with the extent of the build-up of systemic risk. - Factors affecting calibration: - High indebtedness and asset price overvaluation: - The CCB should be set higher for economies where historically high growth of credit resulted in large indebtedness, possibly with asset price overvaluation (examples cited: Netherlands, New Zealand, Sweden and South Africa in Figure 2). - Even when credit growth has slowed and the credit gap is closing, high indebtedness can amplify vulnerability; current credit growth or the current credit gap may not adequately capture elevated vulnerability. - Other tools targeting the level of debt (e.g., LTVs, DSTI) should also be used to support gradual deleveraging. - Stage of financial sector development: - Generally should not have a major influence on decisions to activate or calibrate the CCB. - Gradual financial deepening is reflected in the trend of the credit-to-GDP ratio (Drehmann and Tsatsaronis, 2014). - Staff must judge whether high trend growth in credit-to-GDP is healthy financial deepening or excessive financial deepening that breaches the sustainable level of credit (see further note on low-income countries). - Some countries set different thresholds than BCBS on the basis of development stage, market maturity and structural transformation (example: India; Table 2). - Highly concentrated economies with volatile business and credit cycles: - Implementing a CCB may be difficult if it must change very frequently. - Alternative: set permanently higher capital buffers reflecting through-the-cycle losses, and release them only in periods of severe stress. ### Release — Indicators for releasing the CCB - Principle: - The CCB should be released in times of financial stress to absorb losses or reduce the risk of a credit crunch (BCBS, 2010). Dividend distributions should be restricted when the CCB is fully released to ensure banks use released capital to absorb losses. - Release decisions should draw on near-contemporaneous indicators of banking distress rather than the leading indicators used for activation. - Useful indicators (possibly combined): - Market-based indicators: - Use high frequency, forward-looking market-based indicators where available. - Credit spreads found to be good contemporaneous indicators of banking sector distress, though noisy (Drehman and others, 2011). - Price-based measures of default or distress and “near-coincident” indicators of systemic stress can be useful. - Measures of market volatility in equity and foreign-exchange markets generally rise during stress. - Stress indices aggregating multiple market variables are recommended for crisis detection (see Oet and others, 2012); judgment needed due to noise. - Growth rate of new loans: - During a crisis, growth rate of new loans typically slows sharply and can indicate when to release the CCB. - Giese and others (2013) note credit growth variables provide timelier signals than the gap variable for turning and release points. - Caveat: credit may not slow if corporations have undrawn credit lines. - Drehmann and others (2011) find a sharp slowdown of credit growth is the best indicator for the release phase. - Specific numeric guidance: a drop of credit growth below eight percent is the best indication for the release phase; this happens at the onset of more than 40 percent of crises and yields few false alarms. - Lending standards: - Leverage on new loans (e.g., required down-payments, margin requirements) and measures from credit conditions surveys help determine whether a slowdown reflects supply contraction. - Staff should encourage data collection including credit conditions surveys. - Changes in asset quality: - Incipient increases in nonperforming loans (NPLs) and loan-loss provisions can signal onset of stress and may call for release of the buffer. - Where market-based measures provide more timely signals, they may be preferable. - Analytical considerations before recommending release: - Assess how release affects financial stability, funding costs and investor confidence. - Ensure capital after release remains sufficient to absorb unexpected future losses. - Advice should be informed by indicators of capital adequacy (before and after release), estimates of expected and unexpected losses under stress, market-based indicators of resilience, credit conditions, and outlook for growth and banks’ profitability. - If post-release capital is insufficient or funding costs would rise materially, staff should not recommend release and might recommend measures to increase capital levels (note: recommend corrective action targeted at dollars of capital and not capital ratios). - Timing matters: - Release too late: ineffective at supporting credit if capital constraints already reduce credit supply. - Release too early: may provide additional support to an ongoing boom. - Interaction with the DPR (Dynamic Provisioning Regime): - If CCB is used with the DPR, the DPR generally should be released first. - DPR covers expected losses; general provisions will often have been used before CCB release. - Releasing the DPR is a built-in feature and likely has less impact on investor confidence than CCB release. - Benign scenario: - CCB might be reduced gradually where systemic risks dissipate and financial imbalances unwind without financial stress; assessment can draw on similar indicators used for activation. ### Assessing and addressing leakages - Potential for leakage: - Capital tools like the CCB and the DPR can raise the cost of lending and lead to arbitrage by institutions not covered by the tool, including domestic nonbanks, off-balance sheet credit provision, and foreign financial institutions. - Domestic leakages: - Address by expanding the perimeter of regulation to nonbanks or consolidating such activity under consolidated supervision. - Implication: impose capital requirements on domestic nonbanks or ensure material nonbank subsidiaries and off-balance sheet vehicles are consolidated with the sponsoring bank. - Example: U.K. Financial Policy Committee (FPC) monitors leakages and can recommend to the treasury expanding the set of institutions to which tools apply. - Cross-border leakages: - Empirical evidence of substitution of local bank lending by foreign bank branches in response to differing local capital requirements (Aiyar and others, 2012). - Remedies: - Reciprocity: - Reciprocity is a cornerstone of the BCBS framework for the CCB: each supervising authority ensures banks they supervise apply the CCB on exposures in host jurisdictions. - Reciprocity applies while the buffer does not exceed 2.5 percent; above 2.5 percent reciprocity is voluntary or based on bilateral/regional agreements. - For internationally active banks, consolidated CCB is a weighted average of CCBs faced in all exposure countries; reciprocity aims to preclude circumvention and level the playing field between domestic and foreign banks. - Branches of foreign banks are treated the same as subsidiaries under reciprocity. However, practical effectiveness remains to be seen. - Greater host control: - Foreign branches can act as “shadow banks” from host authorities’ perspective, reducing host ability to assess systemic risk and control contributing activities. - Some host countries (e.g., Brazil, Mexico, New Zealand) encourage or require subsidiarization of local business units to subject them to host regulatory control. - Staff should consider recommending subsidiarization to contain leakages, recognizing costs to parent institutions (capital and liquidity ring-fenced). - Staff advice should align with principles governing analysis of spillovers and with the Integrated Surveillance Directive (ISD); members need not change policies that promote their stability but staff should recommend alternatives that attain objectives at reduced costs to other countries. - Supervisory and accounting context: - Past practices (e.g., securitization originators not reporting securitized receivables on balance sheet) enabled circumvention; IFRS now mandates on-balance-sheet reporting where risks are not fully transferred, making derecognition more difficult (example: Canadian banks required to bring mortgage-backed securities back onto balance sheet with IFRS implementation in 2011). *STAFF GUIDANCE NOTE ON MACROPRUDENTIAL POLICY—DETAILED GUIDANCE ON INSTRUMENTS, INTERNATIONAL MONETARY FUND* ### 30. The Basel III framework introduces a minimum leverage ratio to supplement the ### The Basel III framework introduces a minimum leverage ratio to supplement the risk-weighted capital requirements ### Leverage ratio: purpose, design, and implementation - Basel III sets a leverage ratio that requires banks to fund their total exposures, weighted equally, with at least a minimum amount of capital, set at three percent. - Implementation timeline and reporting: - Implementation of the leverage ratio began on January 1, 2013 with bank-level reporting to national supervisors of the leverage ratio and its components. - Public disclosure will be required from January 1, 2015. - It is expected that any final adjustments to the definition of the leverage ratio will be completed by 2017 and that the leverage ratio should become a requirement from 2018. - Definition and scope: - The Basel III leverage ratio is defined as the capital measure (the numerator) divided by the exposure measure (the denominator). - The capital measure for the leverage ratio is the Tier 1 capital of the risk-based capital framework taking account of the transitional arrangements. - Exposures include on-balance sheet assets, including on-balance sheet collateral for derivatives and securities finance transactions and other off-balance sheet exposures. - Main objective: - To constrain excess leverage—banks’ ability to increase the overall size of their exposures relative to their capacity to absorb losses. - To address weaknesses in risk-weighted requirements that can allow overall leverage to increase undetected. - Evidence and rationale: - There is evidence of a secular fall in average risk weights at international banking groups since the mid-1990s, consistent with banks managing these weights to increase reported capital ratios. - The 2008/09 crisis showed that the fall in average risk weights observed before the crisis did not represent a systematic reduction in risk. - Internal ratings-based (IRB) approaches provide flexibility in calculating RWAs but can produce unintended variation and opacity; the BCBS (2013) found variability in RWAs of U.S., European, and Asian banks even when portfolios are similar. - Tarullo (2014) argues that combined complexity and opacity of IRB risk weights create risks of gaming, mistake, and monitoring difficulty. - Evidence indicates that while the predictive power of all solvency metrics is low, leverage ratios perform as well, and in most cases outperform risk-weighted capital measures in predicting bank failure. - Example: when faced with a mandatory floor on risk weights on mortgages in Sweden, major banks increased mortgage risk weights in anticipation but lowered average corporate lending risk weights, improving the average risk weighted capital ratio by about 3½ percentage points. - Use cases and modalities: - Static back-stop: a minimum requirement as stipulated by Basel, or adjusted flexibly over time to build resilience where authorities are concerned about heightened risks. - Structural tool: a supplementary leverage ratio can be applied to a subset of systemically important banking institutions to complement capital surcharges. - Not a standalone tool: intended to reinforce and complement capital requirements; no single capital metric captures all risks. - Leakages and mitigation: - Leakages similar to other capital tools: provision of credit by domestic nonbanks, off-balance sheet provision of credit, and lending by foreign financial institutions. - Responses: expand the perimeter of regulation to nonbanks, consolidate such activity, rely on the Basel III international agreement on a minimum leverage ratio, or exercise greater host control over foreign branches (subjecting them to the local capital regime). - Note: a reciprocity agreement for the leverage ratio similar to the one for the CCB does not exist. ### Dynamic Provisioning Requirement (DPR): objectives, approaches, and design choices - Main objective: - Smooth provisioning costs over the cycle by gradually building a countercyclical loan loss reserve in good times and using it to cover losses in bad times. - Evidence from Spain: dynamic provisioning helped smooth credit supply cycles and had positive real effects, with better-provisioned banks providing credit in greater volumes and at lower cost during the downturn. - Four main DPR approaches: - Through-the-cycle accumulation. - Trigger-based. - Expected loss provisioning. - Hybrid. - Through-the-cycle accumulation (least data-intensive): - Builds general provisions that account for: (i) expected losses in new loans extended in a given period; and (ii) the average provision over the cycle applied to the outstanding stock of loans at the end of that period, after netting off specific provisions incurred during the period. - Framework uses three variables: outstanding amount of loans, growth rate in loans, and specific provisioning. - Behavior across the cycle: - In good times, loan loss reserves increase because specific provisions are very low. - In bad times, specific provisions surge as NPLs increase and dynamic loan loss reserves are drawn down. - Calibration aspects: - Requires mapping between new loans and loans outstanding to the size of the change in general provisions. - For each risk category, parameters can be calibrated as the estimated average of credit losses (collective assessment for impairment in a cyclically neutral year) and as the historical average of specific provisions. - Parameters can be calibrated across risk categories and separately for each bank. - Floor and ceiling values are set for the fund of general loan loss provisions: the ceiling is usually calibrated to match the estimate of the expected losses. - Banks may use their own models (subject to supervisory validation) or receive regulator-provided coefficients. - Trigger-based systems: - DPR is deployed and deactivated following a trigger rule tied to indicators (examples: GDP growth rate, credit growth, change in provisions, ratio of provisions to net interest income or gross financial margin). - Typically produces rapid deployment and rapid release: higher provisioning costs in activation phase and faster cushioning of profits upon release. - Examples of adoption: Peru (introduced 2000), Bolivia (2008), with Peru’s framework including a fixed component of general provisions. - Requires estimation of indicator thresholds for activation and release. - Expected loss provisioning: - Specific provisions on new loans reflect through-the-cycle losses from origination and do not change over the loan life. - Simpler in mechanics but requires granular borrower data and reliable PD and LGD estimates; where PD and LGD data are unavailable, NPLs and LGDs from comparable jurisdictions may be used. - Periodic recalibration needed. - Introduced in Mexico and Chile. - Choosing a framework: - Country-specific factors (data availability, quality of early warning indicators, bank heterogeneity) should determine choice. - Through-the-cycle accumulation suits cases with limited granular data and poor early warning quality. - Where bank-specific data exist and heterogeneity is large, bank-specific through-the-cycle formulas perform better than aggregate formulas. - Trigger-based systems depend on the reliability of chosen indicators for activation and release; caution advised given indicator weaknesses. - Hybrid systems: combine through-the-cycle accumulation formula with a trigger rule for deactivation so dynamic provisions can be accessed only when indicators signal a downturn; surveillance must monitor and allow overriding indicators when they fail. ### Caps on credit growth: use, limits, and policy context - Application: - Broad-based caps on credit growth have been used where credit growth was strong and systemic risks built up fast and other tools (CCB, DPR, leverage ratio) were unavailable or not expected to be sufficiently effective. - Aim: directly constrain the supply of credit by imposing a ceiling on the (quarterly or annual) rate of growth of credit; can in theory enhance lending standards if banks prioritize best borrowers before hitting the cap. - Policy guidance and limits: - Caps on credit growth should not substitute for sound macroeconomic policy. - Monetary and fiscal policies remain the first line of defense against macroeconomic distortions and external imbalances. - If fiscal and/or monetary policies are too loose and cause overheating or growing current account deficits, staff should recommend adjustments in macroeconomic policies rather than endorsing caps as substitutes. *Source: STAFF GUIDANCE NOTE ON MACROPRUDENTIAL POLICY—DETAILED GUIDANCE ON INSTRUMENTS (excerpt).* ### 46. Country experiences with broad-based caps on credit growth to address rising ### 46. Country experiences with broad-based caps on credit growth to address rising ### Summary of country experiences with broad-based credit growth caps - Croatia: - A credit growth ceiling of "16 percent" was imposed in the period "2003 to 2004". - The speed limit was reintroduced in "2007" and set as "12 percent". - The cap was abandoned in "2009" after the outbreak of the crisis slowed credit growth in Croatia. - Evidence cited: the Croatian National Bank credit cap aimed "to slow down the credit growth and subsequently to resolve external imbalances (IMF, 2006)". Galac (2010) shows the credit cap "did not affect the rate of growth of the total debt of the private sector" — domestic credit slowdown was substituted by higher foreign credit growth, changing the structure of external debt (corporate firms contributing more and banks less), and was "not effective in resolving the underlying problem of increasing external imbalances." - Turkey: - Authorities used moral suasion to target a uniform "25 percent" increase on banks’ annual loan growth since "2011", adjusted for exchange rate movements. - This was "not a binding cap per se" and was complemented by an increasing range of macroprudential tools. - General note: - The text emphasizes that "credit caps should be expected to be most effective when applied on a sectoral basis to address specific risks" and indicates sectoral caps are discussed further in the chapters on sectoral tools. ### Countercyclical capital buffer (CCB) frameworks — key parameters and practices (selected excerpts) - General BCBS guidance: - CCB range: "0-2.5 percent of RWAs"; a buffer in excess of "2.5%" can also be implemented. - For the credit gap indicator: low and high thresholds are "2 and 10 percent respectively". - The credit gap should serve as a common starting point; authorities should use other quantitative and qualitative information. - India: - Date of framework's implementation: "December 2010" (Draft Report published "December 2013"). - Authority: Reserve Bank of India (with consultations with the Minister of Finance under a 2013 Memorandum of Understanding). - CCB level: "Not actived yet." / "Not activated yet (will be available from January 2014)" (text shows both formulations in table). - CCB range: "Linearly from 0 to 2.5 per cent of the RWAs". - Institutions affected: Both domestic banks and foreign incorporated banks based on their exposure in India; maintained on "solo basis as well as on consolidated basis in India". - Notice period (increasing the CCB): "Up to 12 months.4-quarters." (as shown). - Indicators for increasing the CCB include: "The credit-to-GDP gap, Gross Non-Performing Assets (GNPA) growth, incremental credit-to-deposit ratio for a moving period of three-years, industry outlook assessment index and interest coverage ratio, house price index and credit condition survey." - Low and high threshold of indicators behind activation/deactivation: "Lower threshold is set at the credit gap of 3 percentage points... and the upper threshold is set at 15 percentage points of credit gap". - New Zealand: - Date of framework's implementation: "January 2013". - Authority: Reserve Bank of New Zealand. - CCB level: "Not activated yet (will be available from January 2014)". - CCB range: "Linearly from 0 to 2.5 per cent of the RWAs". - Institutions affected: Initially registered banks; could potentially extend to other lenders. - Notice period (increasing): "4-quarters." - Indicators for increasing the CCB: "Broad range of financial indicators and other evidence." - Norway: - Date of framework's implementation: "October 2013". - Authority: Ministry of Finance based on advice of Norges Bank; decision on CCB is made each quarter. - CCB level: "1 percent (decision in December 2013; will be implemented from July 1 2015)." - CCB range: "Expected to vary between 0 and 2.5 percent of RWAs; no formal limit will be set on the maximum size of the buffer" - Institutions affected: "All banks operating in Norway and branches of foreign bank (from 2016; however the supervisory authorities in the home countries of the foreign branches can determine whether the CCB should be applied before 2016)" - Notice period (increasing): "Up to 12 months." - Indicators for increasing the CCB include: "Total credit to households and non-financial enterprises -to-GDP ratio, the ratio of house prices to household disposable income, commercial property prices and the wholesale funding ratio (levels and gaps calculated using both one-sided and two-sided, forecast augmented HP filter)." - Low and high threshold of indicators behind activation/deactivation: "Credit gap of 2 and 10 percent respectively." - Peru: - Date of framework's implementation: "December 2010" - CCB: "Activated in July 2012 ("75 percent CCB")" - Notice period (increasing): "Up to 12 months." - Indicators for increasing the CCB: "GDP growth rate." - Switzerland: - Date of framework's implementation: "July 2011" - Authority: Swiss National Bank submits proposal to the Federal Council; FINMA supervises implementation. - CCB level (sectoral): "2 percent of financial institutions' risk-weighted, direct or indirect mortgage-backed positions secured by residential property in Switzerland (decision in February 2013 and January 2014; implemented from September 2013)." - CCB range: Internal methodology; "The CCB does not need to fall within the range proposed by BCBS." - Institutions affected: "Swiss banks and subsidiaries of foreign banks in Switzerland. The CCB must be fulfilled at single entity level and at the level of the financial group and financial conglomerate." - Notice period (increasing): "Banks need to build 100 percent of the CCB over the next 4 years (in increments of 15 pp) once the rule is activated; banks can request to accumulate up to 75 percent of the CCB; in return they have to commit that at least 50 percent of the net income will not distributed" - Indicators for increasing the sectoral CCB: domestic mortgage volume indicators, domestic residential real estate price indicators, and measures of banks’ risk-taking (interest-rate risk, interest-rate margins, credit-condition indicators and leverage). - United Kingdom: - Date of framework's implementation: "July 2012. The CCB can be implemented on a broad basis or it can target specific segments of the credit market" and "September 2012" appears in table. - Authority: Financial Policy Committee of the Bank of England (as of May 2014). - CCB level: "Not actived yet." / "Not actived yet." (as shown). - CCB range: "0-2.5 percent of RWAs" - Institutions affected: "All UK incorporated banks, building societies and large investment firms (broker dealers). The CCB will be applied at both the individual entity and consolidated group level." - Notice period (increasing): "Up to 12 months." - Indicators for increasing the CCB: "Measures of balance sheet stretch (including the credit-to-GDP gap) within the financial system and among borrowers, and measures of terms and conditions in financial markets." - Reciprocity: The FPC "will set the CCB rate to be applied to all lending by banks in the United Kingdom, irrespective of the country of origin of the lender." The FPC can set rates higher than overseas authorities when risks justify such action. ### Household-sector sectoral tools: description and transmission mechanisms - Sectoral tools listed: - Increases in sectoral capital requirements (risk weights). - LTV (loan-to-value) limits. - DSTI (debt-service-to-income) limits. - Effectiveness and adoption: - These tools "have been used in several countries" and "a range of empirical studies show that these instruments were effective in addressing systemic risk externalities when used appropriately (Box 1)." - Since the global financial crisis, sectoral tools are "increasingly being adopted in both emerging market economies (EMEs) and advanced economies (AEs) (Box 5)." - Sectoral capital requirements: - Force lenders to hold extra capital against exposures to a specific sector (examples: residential mortgage loans, unsecured consumer loans, foreign currency loans to unhedged households). - Can take the form of higher risk weights (or LGD floors) or additional capital requirements. - Consequences: lenders must raise more capital (increasing resilience) or reduce risk-weighted assets; tighter capital requirements can translate into higher funding costs and lending rates, restraining credit growth (credit supply channel). - Implementation note: "Increases in capital requirements should ideally be implemented under 'Pillar 1' of the capital framework... An implementation under 'Pillar 2' can be considered where the legal basis for variations in capital requirements is missing." - LTV limits: - Cap the size of secured loans relative to the appraised (or transaction) value of a property. - Often applied to mortgage markets; can also apply to other secured loans such as vehicles. - Effects and channels: - Directly reduce funding available to borrowers and screen marginal borrowers out (credit demand channel). - Reduce housing demand, decrease credit and house price growth, and help contain procyclical feedback between credit and asset prices. - Tightening LTV can lead households to revise down expectations of future house prices and reduce speculative incentives (expectation channel). - Bolster borrower resilience by increasing equity in residential property, containing both PD and LGD faced by lenders (resilience channel). - Enforcing a minimum down payment reduces borrowers’ incentive to default strategically when house prices fall (anti-default channel). - Cross-application: Car loans with high LTV ratios became subject to higher risk weights in Argentina ("2003") and Brazil ("2010"), and lower LTV limits were imposed in Hungary ("2010"). The text notes "All the arguments on mortgage loans will be applicable to vehicle loans because they are secured loans." *STAFF GUIDANCE NOTE ON MACROPRUDENTIAL POLICY—DETAILED GUIDANCE ON INSTRUMENTS, INTERNATIONAL MONETARY FUND* ### 50. Caps on DSTI ratios restrict the size of debt service payments to a fixed share of ### _110614a - 50. Caps on DSTI ratios restrict the size of debt service payments to a fixed share of ### Mechanisms and comparative advantages - Caps on DSTI ratios restrict the size of debt service payments to a fixed share of household incomes, ensuring affordability. - A close alternative is a cap on the loan-to-income (LTI) ratio which restricts the size of a loan to a fixed multiple of income. - Shared transmission channels with LTV limits: credit demand, expectation, and resilience channels. - Key differences: - DSTI caps enhance borrowers’ resilience to interest rate and income shocks; low DSTI lending is associated with lower delinquency rates and PD. - LTV limits can become less binding when house prices rise, potentially requiring successive tightening. - DSTI caps become more binding when house prices (and mortgage loans) grow faster than households’ disposable income — an automatic stabilizer feature that can smooth credit booms even without time-varying elements (credit demand channel: automatic stabilizer). ### Leakage, scope, and enforcement considerations - Sectoral capital requirements can induce arbitrage: domestic nonbanks, off-balance-sheet vehicles, or foreign financial institutions may provide loans instead. - Capital tools are more effective in systems with few nonbanks, broad scope of regulated entities, and effective consolidated supervision. - Customer-targeted sectoral tools (LTV and DSTI limits) are in principle less subject to domestic leakage because borrower eligibility criteria can be applied to all products offered by any financial institution and enforced by supervisory agencies, including on foreign branches as necessary. - Customer regulation may entail other leakage risks, e.g., toward unsecured or interest-only loans. ### Evidence on effectiveness (Box 1 summary) - Higher sectoral capital requirements increase resilience via additional buffers; cross-country evidence on credit growth effects varies: - Australia: increase of risk weights on uninsured ‘low-doc’ mortgage loans (from 50 to 100 percent) was effective in limiting growth of low-doc mortgage loans. - Brazil: higher capital requirements on new vehicle loans with high LTV ratios decreased growth of targeted consumer loans. - Crowe and others (2013): higher capital requirements failed to stop credit booms in Bulgaria, Croatia, Estonia, and Ukraine. - Reasons for limited effectiveness: banks holding capital well above regulatory minimum; intense competition causing lenders to internalize costs. - Limits on LTV and DSTI ratios have been associated with declines in mortgage lending growth and reductions in the financial accelerator between credit growth and house price inflation: - Crowe and others (2013): a ten percentage point increase in maximum LTV ratio is associated with a 13 percent increase in nominal house prices (U.S. state-level data). - Duca and others (2011): a ten percentage point decrease in LTV ratio for first-time buyers is associated with a ten percentage point decline in the house price appreciation rate. - Kuttner and Shim (2013): an incremental tightening in DSTI ratios is associated with four to seven percentage point deceleration in credit growth over the following year. - RBNZ (2014): cap on the share of high LTV loans effective; dramatic fall in share of mortgages over 80 percent LTV since August 2013. - Evidence on resilience and default mitigation: - Korea: housing prices fell from 2008, but delinquency ratio on household loans remained below one percent well into 2012, attributed to strict LTV and DSTI limits. - U.K. (2008): correlation between higher LTV ratios and higher default rates. - Ireland loan-level data: default rate higher for loans with higher LTV and LTI at origination; LGD increases sharply for LTVs greater than 85 percent. - Cross-country: for a one percent fall in house prices, incidence of mortgage default is 1.29 basis points for countries without an LTV limit versus 0.35 basis points for those with such a tool. - Hong Kong SAR: property prices dropped by more than 40 percent from September 1997 to September 1998, but mortgage delinquency ratio remained below 1.43 percent — suggesting LTV limits reduced lenders’ default probability. ### Indicators to inform tightening decisions - In-depth analysis should draw on macrofinancial aggregates, micro-level survey and supervisory data, slow-moving financial balance sheet information, and fast-moving market data. - Household loan growth and house price growth are core indicators and should be considered jointly; their interaction signals policy action needs. - Empirical patterns: - Countries with a recent banking crisis had median mortgage loan growth of 12–15 percent for three consecutive years before the global financial crisis, and peaked in the fourth quarter of 2006. - House prices, on average, tend to rise by 10 to 12 percent up to two years before financial stress emerges. - Multiple indicators are necessary because any single indicator has signaling imperfections; thresholds trade off Type I and Type II errors. - Specific suggestions from literature: - A persistent rise in the DSTI ratio above its 15-year trend provides an early warning of financial stresses around one year in advance. - As a broad rule of thumb, an aggregate DSTI ratio above 20–25 percent reliably signals the risk of a banking crisis in a global sample of countries. ### Core and additional indicators (Table 3) - Core indicators: - Household (mortgage) loan growth rate (m-o-m and y-o-y); - Share of household (mortgage) loans to total credit; - House price growth rate (real and nominal, m-o-m and y-o-y); - House price-to-rent ratio (a gap from a long-term trend); - House price-to-disposable income ratio (a gap from a long-term trend). - Additional indicators: - House price growth rate by region and types of properties (real and nominal, m-o-m and y-o-y); - LTV ratio (an average and a distribution across new loans over a period and existing loans at a given point in time); - DSTI ratio (an average and a distribution across new borrowers (and different income classes) over a period and existing borrowers at a given point in time); - LTI ratio (an average and a distribution across new borrowers (and different income classes) over a period and existing borrowers at a given point in time); - Household credit gap (a gap between average LTI ratio and its long-term trend); - Share of banks’ and nonbanks’ household loans (changes of the share over time); - Exposures to household loans (average risk weights on household loans) and capital buffers above the minimum regulatory requirement; - Share of foreign-currency denominated loans or interest-only loans. *STAFF GUIDANCE NOTE ON MACROPRUDENTIAL POLICY—DETAILED GUIDANCE ON INSTRUMENTS* ### 57. The case for recommending macroprudential measures is strong when surveillance of ### _110614a - 57. The case for recommending macroprudential measures is strong when surveillance of ### Surveillance: when to recommend macroprudential measures - The case for recommending macroprudential measures is strong when surveillance of several indicators signals elevated systemic risk. - House prices and mortgage loans together form powerful signals of the build-up of systemic risks, predicting a crisis as early as two to four years in advance. - The probability of a crisis increases nonlinearly when both credit and house prices are growing rapidly. - Surveillance must rest on judgment, taking account of all relevant information; a single signal, or mixed signals from multiple indicators, may not be sufficient for action. - Examples where mixed signals affect the choice of response: - Strong growth of residential mortgage loans without house price growth may indicate improvement of housing penetration and elastic supply responses, reducing the need for macroprudential intervention. - Rapid house price increases without strong mortgage loan growth (e.g., due to temporary or chronic housing supply shortage) may call for structural measures to boost supply; however, since supply relief can take time, sectoral macroprudential tools can be warranted to contain increases in leverage. ### Gradual responses, preparation, and legal/operational readiness - When several indicators show signs of a gradual build-up of risk in the household sector, staff can suggest a gradual policy response: - Advise policymakers to monitor indicators closely. - Intensify supervisory scrutiny. - Step up communication to inform of the potential for systemic risk. - Issue supervisory guidance as a prior step to introducing macroprudential measures and be ready to take further action when these steps are exhausted. - Staff should encourage establishment of the legal and operational basis for sectoral macroprudential tools even when vulnerabilities appear contained: - Risks can build up rapidly, but implementing new tools takes time. - Some sectoral macroprudential tools may require prior political debate, support, and changes in legislation. - Prior development of tools, including legislation, can reduce political interference at deployment and enable timely reaction to building risks. ### Country-specific circumstances in housing risk surveillance - Legal underpinnings of mortgage contracts matter: - Full recourse for the lender can deter strategic default. - Lenders’ rights to seize assets beyond collateral or to have a quick out-of-court transfer of the title of collateral can reduce probability of default and the need for macroprudential instruments. - If strong housing demand and house price growth are financed directly by foreign cash inflows (bypassing domestic credit intermediation), sectoral macroprudential tools may be ineffective; alternative measures such as higher stamp duty or capital gains tax may have a role (examples: Hong Kong SAR and Singapore). ### Design and selection: combining and tailoring tools - Combining different sectoral tools can lessen the shortcomings of any single tool and use several transmission channels simultaneously. - Examples of complementarities and tool choices: - Limits on LTV and DSTI ratios can complement each other: - Damp cyclicality of mortgage loan demand. - Enhance resilience to house price shocks and to income and interest rate shocks, respectively. - DSTI caps enhance the effectiveness of LTV limits by restricting use of unsecured loans to attain minimum down payment. - Higher capital requirements reduce banks’ exposure to risky household loan segments and increase resilience. - After the global financial crisis, many countries used a mix of measures (examples: Norway, Israel, India, and Hong Kong SAR). - Interlinked designs exist (e.g., sectoral capital requirements on higher LTV loans). - When interest rates are kept low, DSTI ratios fall, which can lead to risk taking and excessive leverage: - Policymakers can impose stressed DSTI caps where lenders must pass an affordability test based on a higher, “stressed” interest rate. - Example: in Hong Kong SAR this test assumed a 300 basis point interest rate hike. - Stressed DSTI caps in Hong Kong SAR: 50 (60) percent for loans to borrowers with (without) outstanding mortgage loans, while base DSTI caps are 40 (50) percent. - Caps on LTI ratios can be introduced in tandem with caps on LTV and/or DSTI ratios (examples: Norway and the U.K.). ### Targeting, differentiation, and information requirements - Tools can be targeted at riskier segments while minimizing distortions: - Sectoral capital requirements (applied on lenders’ balance sheets) tend to be less distortionary (work through price of credit) but are often less effective at constraining excessive credit growth than demand-side caps (LTV, DSTI). - Drawbacks of caps: may disproportionately affect first-time home buyers and low-income households. - Tailoring options to address trade-offs: - Differentiated limits by borrowers: - Lower LTV limits for those with more than one outstanding mortgage loan (examples: Israel and Singapore) to target speculators without affecting first-time home buyers. - Differentiated limits by regions: - Tailored LTV and/or DSTI limits to focus on particular regions with risky house price appreciation. - Example: Malaysia applies lower LTV limits for luxury properties; Korea applies different LTV and DSTI caps if the property is located in a speculative zone. - A region is designated as a ‘speculative’ zone if the following two criteria are satisfied: - (a) monthly nominal house price index (HPI) rose more than 1.3 times nation-wide inflation rate (CPI) in the previous month, and - (b) either a previous two-month average of the regional HPI growth rate (y-o-y) was 1.3 times higher than the two-month average of the nation-wide HPI growth rate (y-o-y), or the twelve-month average of the regional HPI growth rate (y-o-y) was higher than the twelve-month average of the nation-wide HPI growth rate (y-o-y) in the last three years. - Caps on lenders’ exposures: - LTV limits can screen out borrowers with little equity but good debt service capacity. - Caps on lenders’ exposure to high LTV or high LTI loans can constrain provision of such credit without prohibiting it (examples: New Zealand, the U.K.). - Information and enforcement requirements: - More targeted measures require more information (individual household income, mortgage loans, house prices—preferably at a regional level). - Credit registers are needed to provide information on pre-existing secured and unsecured loans to accurately compute LTV and DSTI ratios. - In most countries with official LTV limits, the size of a mortgage loan or the sum of mortgage loans cannot be above a specified percentage of the appraised value of a property; an underwriter collects information from borrower and credit bureau(s) and examines other senior loans attached to the property to calculate loanable amount given the limits. ### Product-specific risks and measures - Sectoral macroprudential tools can target systemically important household loan products (e.g., interest-only and foreign exchange loans). - Exposures to disruptive risks (sharp interest rate or exchange rate changes) tend to increase in the run-up to crises as lending standards fall and contract terms change: - Increased prevalence ahead of crisis of interest-only and adjustable-rate mortgage loans (e.g., U.S.) and of foreign currency denominated or indexed mortgage loans (e.g., CESEE) are prominent examples. - Measures to address product-specific risks: - Impose tighter LTV and DSTI limits or risk weights for interest-only or foreign currency loans (example: Poland). - Additional measures undertaken by countries: - Limits on amortization periods and exposure caps on variable-rate loans (examples: Canada and Israel). - In Israel, the variable-rate component of mortgage loans is limited to a third of the loans since May 2011. - Hungary imposed a ban on foreign currency denominated mortgage loans (August 2010–May 2011). ### Unintended consequences and design adjustments - Sectoral tools can create unintended consequences that require adjustments: - Tighter LTV limits may lead lenders to offer unsecured loans to compensate for lower credit availability against collateral value. - Sveriges Riksbank (2012) shows unsecured loan use increased after introduction of LTV limit (85 percent), although from low levels. - DSTI limits can increase prevalence of interest-only mortgage loans: - Responses include disallowing these loans (Singapore) or subjecting them to tighter regulation (Korea and Netherlands). - Example of circumvention: in Korea, tighter LTV limits for interest-only bullet loans with less than three years of maturity spurred a boom in same type of loans originated with maturity of three years and one day. - Longer amortization periods can be used to avoid tighter DSTI restrictions: - Canada reduced maximum amortization period for insured mortgage loans: from 40 to 35 years in 2008, 35 to 30 years in 2011, and 30 to 25 years in 2012 (equivalent to tightening DSTI caps). ### Sectoral tools for unsecured lending - Sectoral macroprudential tools can be imposed on unsecured household loans: - Unsecured lending is associated with higher interest rates and greater loss given default. - Proliferation of unsecured consumer loans has resulted in systemic financial risk historically. - Where risks are assessed as high, increases in unsecured lending can be contained by higher risk weights, DSTI limits, or exposure caps. ### Box 2 — Systemic Risk from FX Mortgage Lending: CESEE Experience (summary) - FX lending in CESEE and Latin America increased markedly ahead of the global financial crisis. - Interest rates on FX loans were much lower than domestic currency rates, incentivizing households to borrow in FX without factoring depreciation risks. - Examples and magnitudes: - Share of FX household loans in total household loans in Hungary reached around 60 percent in 2008 up from around five percent in 2004; Romania and Poland reached a similarly high share of FX mortgage loans. - Between 2008 and 2013 the Hungarian forint depreciated by 65 percent against the Swiss franc and 25 percent against the euro, increasing the cost of servicing FX loans. - NPLs on FX household loans (mostly in Swiss francs and euros) rose from less than 1 percent to around 21 percent and NPLs on domestic currency household loans went up from 1 percent to 13 percent through 2013. - Policy responses in CESEE: - Serbia (2008): 50 percent risk weight to local currency mortgage loans, 75 percent to FX mortgage loans to unhedged borrowers and 125 percent to other FX loans to unhedged borrowers. - Poland: higher risk-weights on FX mortgages in 2008, stricter caps on DSTI ratios on FX mortgage loans in 2010; measures tightened in late 2011 via amending “Recommendation S.” - Hungary: maximum limits on LTV and DSTI ratios on new FX mortgage loans in June 2010, banned FX mortgage lending in August 2010 (ban lifted mid-2011 under tight credit conditions). - Romania: tightened caps on DSTI ratios for households in 2008–09 and applied differentiated LTV limits by currency. ### Demand-side tools and housing supply considerations - Demand-side sectoral tools can be complemented with housing supply measures. - Places with elastic housing supply have fewer and shorter bubbles with smaller price increases. - Land supply is a major driver of long-run residential property price movements (example: Craig and Hua (2011) find land supply is the second most important factor in Hong Kong SAR after real GDP per capita). - Policymakers often favor demand-side instruments because supply-side measures operate with greater lags and are not easily reversed. - Where mismatches between housing supply and demand remain, demand-focused instruments face limitations and incentives for circumvention; staff should consider scope for measures to relieve supply constraints alongside macroprudential tools. - Housing supply can be increased by streamlining construction licensing procedures, changing tax policy on undeveloped land, and easing planning and zoning restrictions (for instance, removing constraints on brownfield developments). *Staff Guidance Note on Macroprudential Policy—Detailed Guidance on Instruments, INTERNATIONAL MONETARY FUND* ### Box 3. Macroprudential Instruments on Unsecured Household Loans ### Box 3. Macroprudential Instruments on Unsecured Household Loans ### Nature of unsecured household loans and systemic risk - Unsecured loans (e.g., personal signature loans and credit card loans) can be acquired by households without collateral. - Lenders face a greater loss given default on unsecured loans, so these loans are generally associated with higher interest rates than secured ones. - Historical episodes: credit card crises in Korea (2002–03) and Mexico (2008) illustrate systemic financial risk from proliferation of unsecured household loans. - When LTV limits apply only to mortgage loans, lenders may top up with additional unsecured lending above the regulated level, reducing the effectiveness of mortgage-focused measures. ### Monitoring indicators for unsecured lending - Core and additional indicators recommended for secured loans are applicable: - Growth rate of unsecured loans. - Share of unsecured loans to total household loans. - DSTI ratios on unsecured loans. ### Sectoral macroprudential instruments and country examples - Where risks are high, increases in unsecured lending can be contained by sectoral tools such as: - Higher risk weights. - DSTI limits. - Exposure caps. - Country examples and instrument applications: - Brazil (2010), Korea (2002), Mexico (2011), and Russia (2013): higher risk weights or loan loss provisioning applied to unsecured loans. - United Arab Emirates (2011) and Canada (2012): caps on DSTI ratios imposed on a borrower’s total outstanding household debt rather than on mortgage loans only. - Romania (August 2005): introduced a maximum DSTI ratio of 40 percent covering the sum of all household loans in addition to monthly maximum DSTI ratios of 30 and 35 percent on consumer credit and mortgage loans. - Turkey (recent measures): higher risk weights on longer-term installments of credit cards (risk weights on credit card loans with over 12 month installments were raised from 200 to 250 percent), higher monthly minimum payment requirements, and caps on credit limits for new credit card holders (200 percent of monthly income in the first year and 400 percent in the following years). ### Policy guidance on tightening sectoral instruments (relevant to unsecured and secured lending) - Gradual approach when tightening sectoral macroprudential instruments helps overcome uncertainty, reduce burden on lenders and borrowers, and strengthen expectation channels. - Sequence example: tighten less distortionary sectoral capital requirements first (e.g., risk weights on residential mortgage loans from 50 to a higher number, such as 100) before tightening LTV and/or DSTI limits. - LTV and DSTI ratio tightening example: if existing caps are 80 percent (LTV) and 40 percent (DSTI), they can be tightened further as necessary. - Application scope: - Limits on LTV and DSTI ratios should always be imposed on the flow of new household loans. - Sectoral capital requirements can be applied to the outstanding stock of exposures or to new lending only; applying to new lending reduces adjustment costs and sharpens incentives but complicates tracking. - Observations: - Under Basel II’s standard approach, risk weights for residential mortgage loans are 50 percent. - Observed maximum LTV ratios are below 80 percent in more than half of 51 sample countries. - A typical mortgage loan carries a LTV ratio of 71 percent across a global sample (Crowe and others, 2013). - Most countries with caps on DSTI ratios have imposed 40–45 percent as the limit (seven out of 13 countries), and four countries restrict it to be below 35 percent. ### Communication and implementation considerations - Policymakers should explain the source of systemic risk, chosen instruments, expected mitigation channels, and potential follow-up actions if effects fall short; clear communication enhances effectiveness via the expectation channel. - Ex-ante communication risks frontloading of activity and lobbying, particularly when instruments apply to the flow of new credit. - Sectoral capital requirements targeting the stock may require announcement well ahead of enforcement to allow adjustments. - Once tools are in place, monitor effects closely and adjust settings as needed; use additional analytical techniques such as stress tests to assess impact on financial system resilience. ### Loosening sectoral tools in downturns (relevance to unsecured and secured lending) - Rationale: housing busts often cause banking crises and severe recessions; feedback loops between falls in credit and house prices can exacerbate downturns. - How relaxation can break feedback loops: - Loosening sectoral capital requirements alleviates lenders’ balance sheet pressure (link 1). - Relaxing LTV limits can boost refinancing activity and transactions, reduce strategic default incentives, and make some potential new homebuyers eligible for loans (links 2 and 3). - Loosening DSTI caps can increase eligibility for new mortgage loans if caps had been tightened beyond prudential minima during the boom. - Limits of loosening: may be less effective during downturns (“pushing on a string”) because potential borrowers may be reluctant to buy while prices fall and lenders may remain risk-averse; extra buffers built in good times can make relaxation more effective. - Evidence: limited and based on few loosening events; IMF (2013a) finds tightening and loosening effects on credit similar in magnitude, though tightening LTV limits may have a stronger effect on house prices than loosening. - Indicators to inform decisions to relax: - House prices: declines can be early warning; analysis for 54 countries finds house prices started to decline about a year (sometimes three quarters) ahead of 60 percent of the banking crises in the sample. - Credit growth: a fall in house prices accompanied by sharp mortgage loan growth decline is a strong indication feedback mechanisms have started (median mortgage loan growth across eighteen crisis countries dropped from 15.4 percent to 10 percent at end-2007, and fell further to 3.7 percent by end-2008). - Other market prices: spreads on household loans, CDS spreads of financial institutions, and stock prices may signal the need for loosening. - Resilience of lenders: funding spreads and stock price behavior upon relaxation indicate whether loosening of sectoral capital requirements is appropriate. *Source: Staff Guidance Note on Macroprudential Policy—Detailed Guidance on Instruments, Box 3.* ### 81. There is merit in taking a sequential approach when loosening sectoral instruments, ### There is merit in taking a sequential approach when loosening sectoral instruments ### Sequential loosening and calibration - There is merit in taking a sequential approach when loosening sectoral instruments, but successive decisions may need to be taken more rapidly than ones in tightening phases. - Arguments for sequencing: - Loosen sectoral capital requirements first, to boost credit and help lenders absorb losses. - Loosen LTV and DSTI ratios only as needed and in steps, moving away gradually from the calibration adopted in the boom phase. - Exception: - In a severe downturn, authorities may need to loosen these instruments simultaneously to break the vicious feedback decisively, since relaxation of LTV and DSTI tools can have more powerful effects on credit growth and in supporting prices. ### Prudential minima and safe floors - Relaxation needs to respect prudential minima that guarantee an appropriate degree of resilience against future shocks. - If a large additional buffer was built up during tightening phases, it can be released safely to avoid a credit crunch without unduly jeopardizing lenders’ resilience. - Relaxation should not go beyond levels considered safe through downturn conditions, which serve as a permanent floor. ### Recommendations on LTV and DSTI - Staff should encourage authorities to define a maximum LTV and a maximum DSTI ratio that is considered safe in downturn conditions (perhaps not higher than 85 percent and 45 percent, respectively). - This provides space for tightening when risks build and for relaxation in periods of stress. - Policymakers should communicate that tightening can be followed by relaxation, to avoid market participants taking an adverse view of relaxation during a downturn (CGFS, 2012). ### Role of macroprudential tools vs aggregate demand policies - Sectoral macroprudential tools should not be used to manage aggregate demand (IMF, 2013d). - When negative shocks cause an economic downturn without adverse financial feedback effects, other countercyclical tools (monetary and/or fiscal policies) should manage aggregate demand. - Assigning macroprudential policies a primary role in managing aggregate demand risks overburdening them and creating distortions. ### Evidence from past relaxations (Box 4) - Cross-country experiences: loosening events tended to occur from 2008, amid financial stress from the global financial crisis. - Out of 35 instances of relaxation of macroprudential instruments on mortgage loans since 2001, more than half occurred after the recent crisis. - Examples of loosening: limits on LTV ratios were loosened in China, Denmark, Iceland, Korea, Latvia, Luxemburg, Serbia, and Thailand; caps on DSTI ratios were relaxed three times in Korea (2008, 2010, and 2012). - Number of Macroprudential Measures–Tightening or Loosening (2008–13) - Capital requirements: 19 (39) tightening, 7 (12) loosening - Limits on LTV ratios: 54 (76) tightening, 9 (19) loosening - Caps on DSTI ratios: 14 (26) tightening, 3 (4) loosening - Total: 87 (141) tightening, 19 (35) loosening - Note: Table shows tightening and loosening of three sectoral tools over 2008–13 and 2001–13 (in parenthesis). ### Addressing leakages - Policymakers need to vigilantly monitor if credit provision moves toward nonbank or foreign entities, and expand the regulatory perimeter if necessary. - If sectoral tools apply only to the domestic banking sector, this can lead to increased provision of credit by foreign banks or domestic nonbanks, and incentives for domestic banks to move loan supply to affiliated nonbanks. - Cross-border and branch issues: - Sectoral capital requirements can be circumvented through a move to foreign banks providing credit across the border or through local branches (e.g., Bulgaria and Serbia). - Direct cross-border mortgage credit is less likely due to disadvantages in appraising local retail credits and collateral; subsidiaries are generally subject to local capital requirements. - The main issue is local branches outside the scope of domestic capital requirements; greater host control over foreign branches or reciprocity arrangements can be considered. - Domestic leakage: - LTV and DSTI limits can induce migration of credit provision to domestic nonbanks. - Borrower eligibility criteria can be applied to all products offered by any financial institution within a country and enforced on all regulated institutions by relevant supervisory agencies, including on foreign branches as necessary (BoE, 2011). - Regulatory cooperation and licensing: - Where separate regulators exist for nonbanks, cooperation is required; example: Korea applied LTV ratios to nonbank financial institutions under a single regulatory agency since 2009. - Extending tools to un-regulated entities may require expanding licensing regimes. - Securitization and public programs: - Arbitrage can occur where government-provided insurance and securitization programs co-exist with private label securitization (e.g., U.S. and Canada pre-crisis). - Staff should recommend the same standards for both private and public entities that securitize and/or guarantee mortgage backed securities. - Example cited: Canada in 2008 mandated private mortgage insurers to follow government eligibility rules for the government-owned mortgage insurer. ### Use and incidence of sectoral macroprudential instruments (Box 5 and figures) - Several countries used LTV and DSTI caps to discourage mortgage loan growth (examples: Hong Kong LTV since early 1990s and DSTI cap in 1997; Korea LTV in 2002, DSTI in 2005). - Since the global financial crisis, many AEs and EMEs, such as Hungary, Norway (LTI), and Singapore, have adopted these instruments. - Implementation counts: - Eleven AEs and 14 EMEs have implemented LTV ratio limits. - Seven AEs and eight EMEs adopted caps on DSTI ratios, which complemented LTV limits in all countries except two. - Number of Countries (Total = 46) — sectoral tool coverage (numbers and parentheses preserved exactly as in source): - Sectoral Capital Requirements: 23 (50 percent) - Limits on LTV ratio: 25 (54) - Caps on DSTI Ratio: 15 (33) - Limits on LTV and DSTI ratios: 13 (28) - At least One tool: 38 (83) - More than two tools: 20 (43) - All three tools: 5 (11) ### Corporate sector tools — when corporate exposures drive systemic risk - Staff should consider targeted macroprudential instruments when systemic risks stem from corporate exposures. - Broad instruments (CCB, provisioning) affect corporate exposures but targeted tools are recommended for heightened corporate risks. - Potential tools: - Increases in risk weights on corporate exposures. - Limits on growth of credit to the corporate sector. - LTVs and caps on the debt-service coverage (DSC) ratio for exposures to commercial real estate (CRE). - Tools affecting broad corporate credit: - Sectoral capital requirements can take the form of higher risk weights (or LGD floors) or additional capital requirements on corporate exposures. - Higher risk weights increase resilience and can raise funding costs, slowing corporate credit growth. - Caps on growth of new corporate credit or on the share of new corporate credit in total new credit can be considered if capital measures are insufficient; caps may increase lending standards as banks favor less risky borrowers. - Tools to address foreign exchange risks: - Targeted risk weights and exposure caps for FX corporate credit can build buffers and curtail supply of FX lending. - Risk weights can be combined with limits on credit growth. - Tools for commercial real estate (CRE): - CRE markets permit use of LTV and DSC ratios in addition to risk weights and speed limits. - Limits on LTV ratios cap loan size relative to appraised property value and enforce minimum down payments. - Caps on DSC require net operating income to exceed a fixed multiple of debt service, increasing borrower and bank resilience and containing property price booms financed by credit. ### Leakage risks for corporate-sector tools - Corporate borrowers can substitute domestic bank credit with borrowing from unregulated financial institutions, capital markets, or from abroad. - Containing leakages is particularly challenging where capital markets are well-developed. ### Historical corporate leverage in Asia (Box 6) - Corporate leverage before the crisis (1996) reported as: - Thailand close to 250 percent - Korea 350 percent - Indonesia close to 200 percent - Malaysia around 120 percent *Staff Guidance Note on Macroprudential Policy—Detailed Guidance on Instruments (extract).* ### 94. The effectiveness of these tools depends on a range of factors. While risk weights will ### _110614a - 94. The effectiveness of these tools depends on a range of factors. While risk weights will ### Effectiveness of tools and tightening corporate sector tools - Risk weights increase resilience of regulated financial institutions to corporate-sector shocks, but empirical evidence on the strength of effects of a variation of risk weights on credit growth is mixed. - Effects of risk-weight changes can be greater when issuing new shares and generating retained earnings is difficult and/or aggressive tightening forces intermediaries to cut lending. - Risk weights and caps on credit growth are prone to leakages. ### Indicators for activation and assessment - Core indicators - The share of corporate credit in total credit (flow and stock, level and growth rate) in combination with the growth rate of corporate credit. - Confirm that increases in the share are driven by increases in corporate credit and not by lower total credit growth. - Additional indicators - Leverage on new and old loans; - Debt service ratio (level of debt service as a share of operating surplus, distribution of the ratio and gap of the ratio); - Corporate credit/operating surplus (share and growth rate); - Corporate credit gap; - Lending standards. - Early-warning and firm-level analysis - Analyze growing leverage on new loans or for the sector as a whole, increases in the debt-service ratio, distribution and gap of these ratios to detect deteriorating lending standards and rising operating leverage. - Corporate credit/operating surplus and the corporate credit gap (defined as the difference between the corporate credit share and its trend) can serve as early warning indicators. - If granular firm data exist, analyze the Altman z-score and its components (working capital over total assets; retained earnings over total assets; earnings before interest and taxes over total assets; market value of equity over book value of total liabilities; sales over total assets) to predict default probability. - Use IMF early warning exercises and the Corporate Vulnerability Utility (Research Department) covering indicators (leverage, profits, growth opportunities, default risks) for more than 70 countries. - Signal evaluation and robustness - Staff encouraged to analyze historical dynamics and compare indicators across countries. - Empirical evaluation of signaling power at country/regional level is desirable but limited; selection depends on data availability. - For estimating the corporate credit gap, extract trend from the ratio using the HP filter with lambda equal to 400,000 instead of 1,600 for quarterly data; be cautious of the “end-point” problem and analyze signaling properties over different sample sizes, smoothing parameters, and with recursive forecasts. ### Judgment, calibration, and sequencing principles - Use judgment; do not apply indicators mechanically. Activate tools when different indicators convey a homogeneous picture and deviations or speed of growth across many indicators are large. - Adopt a gradual, step-wise approach to tightening given uncertainty about impacts and potential erroneous signals. - Calibrate risk weights using bank stress-test estimates of losses from corporate exposures so resulting buffer can absorb future unexpected losses related to corporate sector loans. - Principles when recommending tools: - Data requirements: encourage authorities to collect/improve corporate-sector data (complete and timely flow of funds accounts; composition of corporate assets/liabilities: foreign vs domestic, short-term vs long-term, liquid vs illiquid, bank vs nonbank, debt vs non-debt; distribution across sectors/firms). - Sequencing: use tools that build buffers and affect credit supply via higher lending rates first; caps on loan growth are more distortive and have little direct impact on banking-system resilience to corporate shocks—thus build resilience early. - Implementation: risk weights can be applied to the total stock of domestic corporate exposures or the flow of new exposures; applying to new exposures can be preferable when new loans are judged riskier and can be set at much higher levels than weights on the stock. - Notice period: for stock-applied risk weights, preannounce increases well before they take effect; measures targeting the flow of new credit generally need no notice period. - Calibration considerations: capital required by higher risk weights should reflect (i) potential capital shortfall and extra capital needed to maintain investor confidence during stress so loosening may be effective; (ii) uncertainty in estimating corporate credit losses; (iii) level of corporate indebtedness. - Additional guidance: set instruments higher for highly indebted economies; even with low corporate credit growth, high indebtedness amplifies vulnerability. ### Release phase of tools - Appropriate indicators for release depend on how imbalances materialize. - If imbalances recede gradually, use same tightening-phase indicators and release gradually. - If imbalances result in a crisis, sharp fall in growth rate of new corporate loans and market-based indicators (e.g., spikes in CDS spreads on corporate bonds and/or risk premia on corporate debt) signal need for prompt release. - If market indicators unavailable, monitor corporate losses, bankruptcy, nonperforming corporate loans, and tightening lending conditions. - Judgment is needed: credit indicators may be untimely; high-frequency indicators can be noisy with false positives. - Before reducing risk weights, assess effects on funding costs and investor confidence; advice to reduce should be informed by capital adequacy assessment (before and after release), including estimates of expected and unexpected losses under stress, and market-based indicators of banks’ resilience. - Do not loosen risk weights beyond micro-prudential limits. ### Addressing leakages (domestic and cross-border) - Leakage risks - Corporate borrowers may substitute domestic bank credit with borrowing from unregulated financial institutions or markets (domestic leakages) or borrow from abroad (cross-border leakages). - Leakages can allow build-up of corporate sector leverage via nonbank credit extension, increasing default risk including on banks’ existing exposures. - Sectoral tools (e.g., higher capital requirements) can increase banking system resilience but may not contain corporate-sector vulnerability build-up. - Mitigating domestic leakages - Expand regulatory perimeter to unregulated entities or require consolidation of such activity. - Market-based funding (e.g., corporate bond issuance) is difficult to curtail; may require greater emphasis on increasing risk weights to build resilience in banking sector and important nonbank intermediaries. - Mitigating cross-border leakages - Tools initially may not apply to foreign branches or direct cross-border credit. - Strategies: reciprocity arrangements; greater host control; targeted capital flow management measures (CFMs); fiscal policy. - Policymakers should obtain full information on how much companies borrow abroad and the nature of such funding to close information gaps. - Specific strategies: - Reciprocity: reciprocity for risk weights is not currently subject to international agreements; proposals referenced (Nordic Basel III/CRD, BoE FPC) consider expanding reciprocity to risk weights in addition to CCB. - Greater host control: encourage/require foreign affiliates to be subsidiaries rather than branches so they can be subject to capital regulation, higher risk weights, or caps on credit growth. - Targeted CFMs: when recommending CFMs, emphasize lengthening maturity of corporate debt issuance and reducing reliance on FX securities rather than focusing solely on inflow volumes. - Fiscal policy: increase taxation of corporate profits and correct tax bias in favor of corporate debt to reduce demand for corporate credit. ### Tools that target foreign exchange (FX) loans - Vulnerabilities of FX loans - FX or FX-linked loans often carry lower interest rates and induce FX borrowing by corporates, but un-hedged borrowers face significant credit risk if domestic currency sharply depreciates. - Depreciation can make un-hedged borrowers unable to service FX loans, increasing NPLs and reducing bank capital, thereby reducing lending capacity and aggravating the initial shock. - Risks are exacerbated by roll-over risk and maturity mismatch when FX loans are financed by short-term FX borrowing from abroad; deteriorating investor sentiment can increase credit and liquidity strains. - A build-up of FX credit impairs domestic monetary policy transmission because the central bank cannot influence cost of FX debt; exchange-rate channel of monetary policy poses risks since depreciation exposes corporate-sector vulnerability. - Empirical evidence - Capital inflows in some new EU member states fuelled corporate FX lending ahead of the global financial crisis; Bulgaria and Slovakia had corporate firms more inclined to borrow in FX than households. - The share of FX corporate loans in total loans increased by around 20 percent in Slovakia and around 25 percent in Bulgaria over 2000 to 2007. - The share of FX household loans increased by less than 5 percent in Slovakia and by around 20 percent in Bulgaria over the same period. - Recommended tools for FX-credit risks - Risk weights and limits on FX exposures, ideally applied to FX exposures of un-hedged corporate borrowers only. - Where loan-by-loan enforcement is difficult, measures may apply to both hedged and un-hedged corporates; such measures can shift lending away from un-hedged borrowers by increasing FX lending costs for banks. - Tight calibration is critical: excessive tightening may prevent hedged borrowers from obtaining FX loans, causing efficiency losses. - Availability of data on firms’ natural hedges, open currency positions, and robustness of swap markets is important to assess trade-offs. *STAFF GUIDANCE NOTE ON MACROPRUDENTIAL POLICY—DETAILED GUIDANCE ON INSTRUMENTS, INTERNATIONAL MONETARY FUND* ### 107. The recommendation on the two tools should be combined with advice to strengthen ### 107. The recommendation on the two tools should be combined with advice to strengthen ### Combined recommendation and supervisory capacity - The recommendation on the two tools should be combined with advice to strengthen data availability and supervisory capacity. - Better data and supervisory capacity to restrict lending practices can enable the enforcement of better targeted tools, reducing efficiency losses. - There is a need for strong conduct of business requirements, such as requirements on financial institutions to provide borrowers with sufficient information to make well-informed and prudent decisions regarding the risks involved in foreign currency borrowing. ### Macroprudential instruments and dollarization - Macroprudential instruments should address systemic risks stemming from excessive FX credit growth, but will be insufficient to address widespread dollarization. - Objective of risk weights and speed limits applied to FX corporate exposures: - Address systemic risks arising from increases in FX loans. - Prevent FX loans from becoming prevalent and resulting in systemic risk. - These instruments may not suffice to reduce or eliminate a structurally high level of FX corporate loans. - Other structural tools beyond macroprudential tools might be recommended if dollarization is widespread: - De-dollarization is difficult and requires a multi-pronged and well-sequenced approach. - Sound macroeconomic policy frameworks, including sustainable fiscal and credible monetary policy, are key preconditions. - Financial markets in domestic currency should be built, for example by the public sector shifting from borrowing in FX to borrowing in the domestic currency. - Tightly calibrated macroprudential tools might be appropriate to de-dollarize the banking system, including: - Limits on net open positions; - Differentiated and/or marginal reserve requirement across currencies; - Requiring reserves in terms of foreign liquid assets. - A levy can be introduced on the interest paid on foreign loans to encourage a gradual substitution of foreign loans by domestic loans. - References cited in the source for further examples: Galac (2012) and ESRB (2011). ### Description and transmission mechanism: FX corporate borrowing - Higher risk weights are a key tool to address excessive growth in FX corporate borrowing: - Build a buffer for unexpected FX losses. - Likely reduce the share of FX corporate exposures by increasing the relative cost of funding of FX credit. - Calibration to unhedged borrowers only is preferable to achieve benefits at reduced cost to efficiency. - Exposure caps can complement risk weights: - Caps can be designed as a cap on the growth rate of FX credit or on the share of new FX credit to total new corporate credit. - A cap on the (stock of) FX credit in the (stock of) total corporate credit is an additional option. - Caps can enhance banking sector resilience indirectly by increasing lending standards if banks prioritize lending to better borrowers when lending caps bind (effect depends on banks’ risk aversion). ### Tightening phase — macroprudential tools targeting FX exposures - Indicators should be primarily focused on FX credit markets; core indicators should include measures of FX-based credit; additional indicators relate to financial conditions of corporate sector firms taking FX loans. - Core indicators: - Increases in the share of FX corporate credit in total corporate (and total) credit and the growth rate of this credit (flow and stock, level and growth rate), ideally broken down by companies that have and do not have a natural hedge. - Corporate FX credit/GDP (share and growth rate). - Corporate FX credit gap (difference between corporate credit and its trend). - Evaluation of the growth rate of FX corporate credit should complement the analysis of the share to gauge whether share dynamics are due to rapid FX credit growth or slower non-FX corporate exposure growth. - Additional indicators: - Growing leverage (on new and old loans) and debt-service ratios. - Deteriorating lending standards over time of firms involved in FX lending. - These can indicate that risks are building up. - An in-depth analysis drawing on indicators should inform staff’s advice on activating risk weights and exposure caps: - Make sure relevant information is available, importantly information on the fraction of hedged borrowers. - If possible, develop a mapping between the indicators and the activation of the speed limit and their calibration based on historical experience or cross-country comparisons. - Risk weights: - Can be applied to the total (stock of) FX corporate exposures, or on new loans only. - Risk weights on new exposures can be set at a much higher level and brought in immediately. - For measures applied to the stock, gradual, subsequent increases of risk weights are recommended. - Estimates of losses using stress tests of banks’ resilience to FX corporate losses could be used to calibrate risk weights—the tools should be set so that the resulting buffer is sufficient for absorbing future unexpected losses related to corporate sector FX loans. - Exposure caps: - Caps could be imposed on the growth rate of new FX loans or on the share of new FX corporate credit growth in new total corporate credit. - With appropriate sanctions for breaching the limit, these caps should have larger impact on FX lending than risk weights since they can more directly manage the growth rate of FX credit. ### Release phase: macroprudential tools targeting FX exposures - Decision to lower risk weights should depend on the extent of FX corporate loans and whether risks resulted in a crisis: - If risks have not materialized but vulnerabilities persist due to widespread dollarization (i.e., extent of FX loans), measures taken as part of an overall strategy to de-dollarize should not be released, as they are regarded as structural measures. - If a crisis materializes even in a dollarized banking system, risk weights could be released to cover FX loan losses. - Reducing risk weights can be used to soften a credit crunch but needs to ensure future resilience and respect microprudential standards. - Reducing exposure caps might not be necessary as they might not be binding during the stress period: - Keeping caps in place can be useful to deter currency speculation by local banks because growth rate of FX credit is a function of volume and value (value increases when domestic currency depreciates). - Keeping a cap during stress can deter banks from speculating against the domestic currency (Kraft and Galac, 2011). - Market-based financial and credit flow-based indicators can inform whether to lower risk weights: - A sharp depreciation of the domestic currency should be used as the main indicator for relaxation of increases in risk weights because depreciation can materialize credit risk on FX exposures. - Spikes in CDS spreads on bonds of corporate firms, and the risk premium on corporate debt might signal imminent systemic risk materialization. - A fall in measures of corporate earnings, increases in bankruptcy rates, nonperforming FX corporate loans and tightening lending standards could be taken into account when recommending the release of tools. ### Leakages - Cross-border leakages are acute for risk weights and caps imposed on FX corporate credit: - Firms might seek foreign sources of credit to circumvent higher costs or constraints from local macroprudential tools. - Banks may offer FX-linked loans when these are not subject to exposure caps even though they represent the same credit risk. - Banks might grant an FX loan and sell it to avoid it being counted towards the exposure cap. - Examples and experiences (summarized from source): - Croatia: - Macroprudential measures included higher risk weights on total FX loans (and domestic currency indexed to foreign currency) for un-hedged clients; FX liquidity minimum; credit growth (speed) limits linked to capital adequacy and core deposit growth; marginal reserve requirement on increases in banks’ foreign liabilities. - Measures strengthened banking resilience (higher capital and liquidity, slower credit growth, reduced reliance on foreign wholesale funding, lower leverage). - Leakages occurred: direct cross-border lending to nonfinancial firms accelerated as corporate firms borrowed directly from same foreign creditors; banks referred clients to parent banks abroad, and leakage was never fully closed. - Turkey: - Prohibition on local banks providing FX loans to households and un-hedged firms led to evasion: local banks lent in foreign currency via offshore branches or issued FX-indexed loans onshore. - The offshore lending increased external debt and contributed to an increase in the country risk premium; authorities permitted onshore FX lending to un-hedged firms in 2009 under conditions to reverse external debt dynamics. - Decree No. 32 and subsequent amendments are referenced for details. - India: - Active management of external borrowing by nonbank corporations: overall ceiling, individual limits, maturity limitations, and maturity-dependent all-in-cost ceilings. - All-in-cost ceilings on three-year to five-year loans varied between 150 and 300 basis points over six months LIBOR from 2004 through end-2008; ceilings were suspended in 2009 and re-introduced in January 2010. - Evidence on effectiveness in restraining credit growth is mixed; Singh (2007) finds the framework achieved a balanced maturity profile. - Strategies to deal with leakages could include: - Reciprocity arrangements for risk weights; - Greater host control; - Targeted CFMs; - Fiscal policy measures, for example changes in corporate tax code that penalize FX borrowing relative to domestic currency borrowing (with design options to exclude firms that can demonstrate a natural hedge). ### Tools that target Commercial Real Estate (CRE) exposure - CRE booms and busts have played an important role in many financial crises (U.S., U.K., Nordic countries, some East Asian crises, Irish and U.K. crises in 2008). Busts in CRE markets created larger losses due to higher default rates and higher volatility of commercial property prices. - Transmission mechanism and instruments: - In addition to risk weights and exposure caps, excessive CRE lending can be addressed by macroprudential tools that affect lending conditions: LTV and DSC ratio constraints. - LTVs and DSCs: - LTV limits impose a cap on the size of a commercial real estate loan relative to the appraised value of a property and enforce a minimum down payment. - Floors on DSC ratios require net operating income to be a fixed multiple (higher than one) of debt service payments, ensuring sufficient cash flow to cover loan payment. - Lower LTVs and higher DSCs directly reduce demand for credit by limiting market to borrowers that satisfy lending conditions, containing property price booms financed by credit. - Announcements of tightening, if credible and large enough, can affect expectations and reduce speculative incentives driving bubbles. - Secondary benefit: reduce riskiness of CRE loan market and enhance banking sector resilience indirectly by increasing quality of corporate credit. *Staff Guidance Note on Macroprudential Policy—Detailed Guidance on Instruments (excerpts).* ### Box 8. Examples of Commercial Real Estate Booms and Busts ### Box 8. Examples of Commercial Real Estate Booms and Busts ### Historical examples of CRE booms and busts - Ireland (2003–06 boom, post-2008 bust) - CRE credit growth at the peak in 2006: growing by more than 60 percent (up from below ten percent in 2003). - CRE lending share: about 25 percent of total lending to the private sector (up from around 10 percent in 2003). - CRE lending share to private nonfinancial corporations: 60 percent (up from around 40 percent in 2003). - At least half of all CRE projects were pre-let or pre-sold. - Real commercial property prices have fallen more than 70 percent since their peak in 2007. - Nordic countries (1980s boom, early 1990s bust) - Office property prices in Sweden increased more than four fold in the 1980s. - Norway: NPLs on CRE assets doubled between 1988 and 1992. - Sweden: 75 percent of NPLs in 1991 were due to CRE exposures. - Finland: almost 50 percent of CRE loans had to be booked as NPLs or written off by 1993. - United States (early 1980s boom, late-1980s/early-1990s bust) - Total real estate loans increased from approximately 18 to over 27 percent of total assets in the 1980s. - Total consumer loans remained around 10 percent of total assets. - Total commercial and industrial loans declined from approximately 20 percent to 17 percent of total assets. - Banks that subsequently failed had higher ratios of CRE loans to total assets; in 1993, CRE loans of banks that subsequently failed constituted approximately 30 percent of total assets. - United Kingdom - Late-1980s/early-1990s: CRE price correction by 27 percent and residential home prices decline by 14 percent (peak to trough), accompanied by large losses at small banks; 25 banks failed during the crisis. - 2000–2007 period: CRE property prices increased by around 50 percent; CRE lending by banks tripled (from around 7 percent of GDP to around 20 percent of GDP). - By end-2007 CRE loans accounted for more than a third of the stock of lending to UK private nonfinancial companies by local banks. - CRE prices were almost halved from their 2007 peak by end-2012. - Around 6 percent of the U.K. banks’ stock of CRE debt written off between 2008 and 2012. ### Tightening phase — indicators to inform action - Core indicators (use as primary indicators of potential risks stemming from CRE lending): - The share of CRE loans in total credit (both stock and flow) and increases in those shares, complemented with the growth rate of CRE credit and price-based measures (commercial property price growth and commercial property price to operating surplus; CRE property prices relative to rental rates and vacancy rate, income yields; levels and gaps). - CRE credit/GDP (or CRE credit/operating surplus) and its growth rate. - CRE credit gap (defined as the difference between the share of CRE credit and its trend). - Additional indicators: - Average DSC ratios (net operating income over debt service payments). - Average LTV ratios (on updated commercial property prices and commercial property prices at origination). - Distributions of DSC and LTVs. - Underwriting standards for CRE. - Empirical guidance: - If a country has experienced a CRE bust in the past, empirical methods can be used to evaluate historical signaling performance of selected indicators and map them into the decision on when to tighten the limits. - The CRE credit/GDP ratio and its growth rate and the CRE credit gap might serve as potentially powerful early warning indicator. - Growth in credit for CRE often supports commercial property price inflation. ### Tightening phase — calibration of tools - General approach: - Risk weights and exposure caps on CRE exposures should follow the same principles as for other corporate exposures. - Risk weights can be applied to total CRE corporate exposures or to new CRE loans. - Exposure caps can be imposed on the share of new CRE credit in new total corporate credit or on the CRE credit growth rate. - Activate or tighten tools when different indicators convey a homogeneous picture and when the degree of deviations or speed of growth of many indicators is larger. - LTVs and DSCs: - Riskier properties (such as hotels) should typically have higher DSCs and lower LTVs than more stable operating properties such as apartment buildings. - Appraisal usually done by assessing potential income generated (income approach = discounted present value of potential net operating income, assuming rent, occupancy, operating expenses). - Given higher risks of CRE relative to residential market, more stringent loan covenants, guarantees and some pre-selling proportion of the project are often required. - Calibration guidance: - Calibration of LTVs and DSCs limits should be supported by data on the distribution of LTV and DSC ratios across borrowers based on updated commercial property prices and on commercial property prices at the loan origination date. - Limits on LTV and DSC ratios should only be imposed on the flow of new loans. - Staff should be guided by a gradual approach given uncertainty surrounding the impact of these tools on the banking sector and the real economy; a sharp change in LTV and DSC limits could interrupt the ability to refinance existing properties since CRE loans are usually non-amortizing. ### Using LTVs, DSCs, risk weights and exposure caps together - Design interactions: - Increased risk weights might be applied first as their impact will be less constraining. - Design of risk weights can take account of LTVs and DSCs (e.g., higher risk weights for exposures with higher LTVs and/or lower DSCs). - Exposure caps can be designed based on LTV and DSCs (e.g., caps on exposures with high LTVs and/or low DSCs). - Calibration caution: - A cautious approach to calibration is recommended because investors in CRE are usually highly leveraged, may have greater incentive to default if prices fall before project completion, monitoring/appraisal is difficult and costly, lenders’ only recourse is often the property, and CRE loans are usually non-amortizing, interest only loans. ### Loosening macroprudential tools for CRE - Indicators to assess stress and inform loosening: - Decline in CRE lending, falling CRE prices, market-based financial indicators (CDS spreads on corporate firms involved in CRE, risk premium on debt of firms involved in CRE, spreads on CRE loans, prices of securities backed by CRE loans). - If market indicators not available: increases in nonperforming commercial real estate loans, default rates of CRE loans, and slowing in commercial property transactions. - High-frequency indicators are noisy and judgment is required to avoid false crisis signals. - Advice on sequencing and prudence: - Assess indicators of future capital adequacy (expected and unexpected losses under stress), market-based indicators of banks’ resilience and credit conditions, outlook for growth and banks’ profitability. - If LTV and DSC limits are used in addition to risk weights, risk weights should be relaxed first. - In a downturn, risk weights could be reduced first, potentially followed by a relaxation of LTVs and DSCs; if investors’ confidence does not allow capital reduction, LTV and DSC limits might be gradually adjusted. - Loosening should generally be gradual because of uncertainty about effects of looser lending standards on credit losses and banking-sector capital; large increases/decreases in LTVs/DSCs might be procyclical and increase future credit losses. - In crisis, banks may endogenously tighten down payments (offsetting easing), reducing effectiveness of increased LTVs. ### Leakages and perimeter considerations - Domestic leakages: - CRE lending might migrate to domestic nonbank financial institutions (NBFIs); staff may recommend expanding the regulatory perimeter to include these institutions or enlarging a licensing regime to capture all financial institutions providing the targeted service. - Cross-border leakages: - Risk weights and exposure caps can be circumvented by foreign borrowing or borrowing from entities/markets not initially affected by macroprudential regulation. - Cross-border leakages from LTVs or DSCs can occur if borrowers have access to foreign credit or credit from local branches outside macroprudential scope. - Mitigation: harder for foreign banks without local operations to verify local CRE credit quality; use same strategies as for addressing cross-border leakages in corporate borrowing. ### Examples of country tool usage (selected observations from Table 7) - Colombia - Discretionary dynamic provisioning introduced in Jul 2007. - Rules based (from April 2010), institution specific, dynamic (individual) provisioning for commercial loan introduced based on 4 indicators (change in provisions, provisions over interest income, provisions over margin, credit growth) used for activation and depletion with thresholds set by the authorities; If the four indicators are met for 3 consecutive months, the entity will enter the depletion phase, it is institution specific. - Hong Kong - LTV ratio on commercial real estate mortgage loans assessed based on the net worth of a mortgage applicant reduced to 50 percent (Nov 2010), 40 percent (July 2011), 30 percent (Sept 2012). - India - Risk weights on exposures to commercial real estate tightened from 100 percent to 125 percent (Jul 2005) and further to 150 percent (April 2006) but reduced to 100 percent in Nov 2008. - Korea - Bank foreign-currency loans to non-financial corporates (for domestic use) were banned (July 2010). - Singapore - The LTV ratio was set to 50% on housing loans for property purchases who are not individuals (Jan 2011). - Buyer's stamp duty (10 percent) was imposed on corporate entities buying any residential property. - Turkey - LTV ratio on commercial real estate mortgage loans was limited to 50 percent (Jan 2011). - Foreign currency loans were banned (Jun 2009). Corporations were still allowed to borrow in foreign currency provided the maturity of the loan is more than a year and the amount financed is more than 5 million US dollars. *Source: Box 8, "Examples of Commercial Real Estate Booms and Busts", STAFF GUIDANCE NOTE ON MACROPRUDENTIAL POLICY—DETAILED GUIDANCE ON INSTRUMENTS* ### 133. Liquidity tools aim to mitigate systemic liquidity risks. As banks increase reliance on ### _110614a - 133. Liquidity tools aim to mitigate systemic liquidity risks. As banks increase reliance on ### Overview - Liquidity tools mitigate systemic liquidity risks arising when banks rely more on noncore funding (short-term, wholesale, or foreign currency funding) to fund illiquid assets. - Vulnerabilities can impair banks’ ability to obtain funding and refinancing in stressed times, triggering abrupt deleveraging and fire sales (IMF, 2010b; Covitz and others, 2009; Kapadia and others, 2012). - Tightening liquidity tools can also have the side-effect of slowing credit growth. ### Basel III Liquidity Tools (Box 9) - Liquidity Coverage Ratio (LCR): - Objective: promote short-term resilience by ensuring sufficient High Quality Liquid Assets (HQLA) to survive a significant stress scenario for one month. - Definition: stock of unencumbered HQLA divided by total net cash outflows over the next 30 calender days (with draw-downs on liabilities assumed to mimic those over a stressed period). - Total net cash outflow: total expected cash outflow (from outstanding balances of liabilities and off-balance sheet commitments with run-off and draw-down assumptions) minus total expected cash inflow (from outstanding balances of contractual receivables). - Minimum requirement timeline: starts from 60 percent in January 2015, and rises by 10 percentage points each year to reach 100 percent from January 2019 onwards. - Net Stable Funding Ratio (NSFR): - Objective: reduce funding risk over a longer time horizon by requiring banks to fund activities with sufficiently stable sources. - Definition: amount of available stable funding (ASF) divided by amount of required stable funding (RSF). ASF is a weighted sum of capital and liabilities with maturity over one year; RSF is a weighted sum of assets and off-balance sheet activity based on liquidity characteristics and residual maturities. - Minimum requirement timeline: BCBS intends to set the minimum requirement of 100 percent on an ongoing basis from January 2018. ### Types of Liquidity Tools and Design Features - Instruments can be price-based (levies, charges, fees, taxes) or quantity-based (limits on balance sheet ratios). - Tools can be tailored by liability type (currency, maturity), applied to stocks or flows, and adjusted over financial cycles. - Main examples and designs: - Liquidity buffer requirements: - Ensure banks hold liquid assets to cover outflows during a stressed period for a few weeks (e.g., LCR or a liquid asset ratio). - Banks respond by increasing liquid assets or decreasing short-term liabilities. - Stable funding requirements: - Examples: NSFR, core funding ratio (CFR), cap on loan-to-deposit (LTD) ratio, cap on loan-to-stable funding (LTSF) ratio, limits on maturity mismatches. - Practical experience often confined to simpler measures like LTD ratios due to NSFR complexity. - Liquidity charges: - Levies on non-core funding (differentiated by maturity or currency); proceeds to general budget or contingency fund for liquidity support. - Example cited: levy on banks’ non-core foreign currency liabilities in Korea in 2011. - Reserve requirements: - Banks hold reserves with the central bank; can be differentiated by liability type, applied on stock or flows, remunerated below policy rate or unremunerated. - Can be adjusted for financial stability purposes (example: Brazil expanded deductibles in 2004). - Constraints on open FX positions: - Limits on net open FX positions (aggregate and by currency) to reduce exchange rate vulnerability. - Constraints on FX funding: - Caps on FX borrowing, limits on FX swaps/derivatives, differentiated reserve requirements on FX liabilities, taxes/levies on cross-border flows. - May include CFMs in certain circumstances in line with principles (IMF, 2012b). - Toolkit for nonbanks: - Liquidity requirements tailored to nonbank activities (collective investment schemes), redemption restrictions, margins regulation in securities lending. - FSB has proposed a policy framework and recommendations for nonbank entities. ### Effects on Resilience and Credit - Liquidity tools enhance financial system resilience to liquidity shocks (MAG, 2010; IMF 2013c; CGFS, 2012). - By constraining liabilities (stable funding requirements, liquidity charges) and requiring liquid assets, reliance on volatile funding sources is reduced. - Banks may (i) increase HQLA holdings; (ii) reduce illiquid assets; or (iii) shorten loan maturities to improve liquidability. - Improved individual bank resilience reduces system-wide contagion risk and potential negative real-economy repercussions. - Impact on credit growth: - Tightening liquidity tools can slow credit growth though empirical evidence varies by tool. - Liability-side constraints (core funding ratio) and asset-side constraints (liquid asset ratio) increase funding costs during booms. - To meet tighter requirements, banks may (i) increase core funding (raise retail deposits, lengthen funding terms, transform unsecured to secured funding) or (ii) reduce credit growth. Core funding grows slowly, making the first option costly in booms—hence liquidity tools can act as brakes on loan growth. - Holding a higher share of liquid assets (usually lower-yielding) can prompt banks to raise lending spreads to recover profits, also slowing credit. ### Evidence on Reserve Requirements - Increases in reserve requirements can affect broader credit conditions (IMF, 2013a). - When reserves are remunerated below policy rate or unremunerated, lending spreads increase, discouraging credit growth. - Time-varying reserve requirements can curb excessive credit growth and reduce procyclicality. - Studies show raising reserve requirements moderated credit growth and procyclicality (IMF, 2011a and 2013a; Lim and others, 2011). - Open market operation volumes can be adjusted to sterilize liquidity impact and keep interbank rates close to policy rate when changing reserve requirements. ### Structural Risks and Regulatory Perimeter - Liquidity tools can contain structural risks by reducing domestic or cross-border exposures among financial institutions tied to wholesale market funding. - Regulatory arbitrage can undermine effectiveness by building liquidity risks outside the regulatory perimeter; monitoring and extending the perimeter when necessary is required. ### Indicators for Monitoring Liquidity Risks - Advice should be based on continuous monitoring using bank balance sheets, macroeconomic conditions, and funding market developments. - If indicators do not exist, authorities should be encouraged to collect relevant data. - Core indicators: - Loan-to-deposit ratio; - Non-core-to-core funding ratio. - Note: the LTD denominator can be expanded to include non-deposit stable funding (LTSF ratio) where appropriate. - Additional balance sheet indicators: - Share of HQLA in total assets; - Asset-liability maturity mismatches; - Gross open currency positions; - LCR and NSFR developments (once implemented) reported to supervisors can be analyzed to gauge liquidity conditions, but once binding quantitative limits are imposed they no longer serve as signaling indicators. - Indicators of general credit conditions such as credit-to-GDP ratio are useful for guiding liquidity tools. - Market-based and macroeconomic indicators: - Interbank market turnover; - Issuance of securities; - Volume of unsecured borrowing; - Trends in short-term capital inflows (positions and flows of other investments and portfolio investments intermediated by banks) for small open economies; - Market surveys on funding composition. - Table of Core and Additional Indicators (as listed): - Core indicators: - Loan-to-deposit ratio; - Non-core-to-core funding ratio. - Additional indicators: - Liquid asset ratio; - Maturity mismatch indicators, including NSFR once finalized; - Gross open FX positions; - Volume of short-term capital inflows (especially those intermediated by banks); - Volume of securities issuance; - Volume of unsecured funding. ### Monitoring FX and Maturity Risks (Box 10) - Indicators can be defined by currency to monitor currency-specific risks; Basel III proposes LCR by significant currency as a key monitoring tool. - Net open position limits and currency swaps can address currency mismatches, but maturity mismatches can persist in a specific currency even when aggregate limits are met. - Example: Singapore — consolidated LTDs below 90 percent, but U.S. dollar loans grew more rapidly than U.S. dollar deposits, creating USD liquidity risks; swap roll-over risks can expose banks to swap premium spikes or counterparty risk. - Policy design examples: - Different reserve requirements by currency and maturity; - Macroprudential Stability Levy in Korea targeting nondeposit FX liabilities with maturities up to a year; - LCR and NSFR can be enforced separately for major funding currencies (example: Sweden initially applied LCR to foreign currency only). - ESRB recommended monitoring U.S. dollar funding and liquidity risks, and limiting excessive FX exposures. ### Calibration — When to Tighten - Steep increases in core indicators (e.g., rapid increases in LTD ratio) can justify tightening liquidity tools. - No established universal thresholds exist; assessment should consider structural financial market features. - Cross-country observation: - High-income countries often have LTD ratios exceeding 100 percent, higher than the average of 80 percent for low and middle-income countries. - With systemic liquidity risk buildup, policy choices include: - Building liquidity buffers to improve resilience to funding shocks; - Improving funding structure by encouraging long-term and stable funding; - Introducing liquidity charges that penalize noncore, short-term and FX funding when those funding sources are a major concern; - Using LTD ratios or tightening funding constraints (core funding ratios) to act as brakes on rapid credit growth and help maintain stable funding. *Prepared by Chikako Baba (MCM) — STAFF GUIDANCE NOTE ON MACROPRUDENTIAL POLICY—DETAILED GUIDANCE ON INSTRUMENTS* ### 147. The selection and scope of tools should depend on country circumstances and data ### 147. The selection and scope of tools should depend on country circumstances and data ### Country-specific selection and scope of liquidity tools - For financially developed economies: major concerns likely lie in wholesale funding, the quality and amount of liquid assets, and interconnectedness among institutions through funding linkages. - For home countries of systemically-important financial institutions (SIFIs): additional attention to systemic liquidity risks of the SIFIs that can cause fire sales of global assets. - For small open economies reliant on foreign funding: FX open position limits and tools that address systemic risks from short-term and FX funding are important. - For financially less developed and closed economies: reserve requirements will likely be a primary tool to control aggregate liquidity in the domestic banking system since the availability of high quality liquid assets is often limited. - Calibration of liquidity tools should consider the strength of deposit insurance arrangements and more generally the ability of the government or central bank to back-stop the system in case of liquidity stress. ### Empirical examples and cross-country heterogeneity (Box 11 highlights) - LTD ratios increased dramatically in some countries prior to the global financial crisis: - Iceland: LTD ratio jumped from 220 percent in 2003 to 385 percent in 2006. - Ireland: LTD ratio rose from 150 percent to 220 percent over five years. - Korea and New Zealand activated liquidity tools after their LTD ratios rose by about 25 percentage points over three years. - Cross-country heterogeneity in LTD ratios complicates defining a comfortable level: e.g., U.S. LTD ratio remained below 85 percent even before the global financial crisis because securities markets are a large component of US financial markets and the LTD ratio does not capture off-balance sheet funding and nonbank credit provision. ### Stress testing and data requirements - Stress testing can help calibrate liquidity tools: - Encourage stress testing the banking system for various macro scenarios to identify vulnerabilities and gauge need for tightening. - Scenario analysis based on historical experiences of the country or peers should be applied to assess if the system has enough liquidity in stressed times. - Such scenarios can be used to assess specific risks from funding in FX. - Repeating stress tests after tightening liquidity tools helps assess measures’ effects in strengthening resilience. ### Gradual tightening and implementation sequencing - Merit in gradual tightening given limited experience with liquidity tools; adopt learning-by-doing to observe market reactions and unintended consequences. - Example: New Zealand set minimum CFR initially at 65 percent of total loans and advances in 2010, raised in two steps in 2011 and 2013 to reach 75 percent. - When requirements are imposed on stocks on banks’ balance sheets, allow a preparation period for banks to meet new requirements: - Korea announced a ceiling on the LTD ratio in December 2009; Korean banks were expected to meet the ceiling by the end of 2013 (subsequently brought forward to June 2012).106 - If measures target new funding or new lending (e.g., a marginal reserve requirement), implementation should take effect immediately. ### Calibration considerations and central bank backstops - When the central bank is committed to provide liquidity support, banks’ buffers can be smaller (example: U.K. FPC recommended relaxation given availability of central bank liquidity facilities). - Where sovereign debt markets are thin, committed central bank lines can serve as macroprudential liquidity tools and may count towards liquidity buffers (e.g., LCR) (Australia FSAP). - If foreign bank branches have a large presence, tailor measures to their activities (example: cap on FX derivatives positions of foreign bank branches in Korea). ### Potential side effects of liquidity tools - Liquidity tools can excessively restrict banks’ maturity transformation, reducing efficiency of financial intermediation or limit interbank money markets’ buffering role. - Overly restrictive calibration could encourage migration of banking activities into less-regulated sectors (shadow banks), potentially accentuating systemic risk. - Because yields on high quality liquid assets are usually low, liquidity requirements may lead to increased risk taking by banks searching for returns; higher reserve requirements can push banks into higher risk segments without curbing credit growth (see Turkey FSAP). - In countries with shallow domestic debt markets, requiring greater term funding may force banks to take on exchange rate risks. ### Addressing systemic liquidity risks in the nonbank financial sector - Staff should monitor build-up of systemic liquidity risks outside banking sector: short-term funding of long-term and illiquid securities can produce procyclical feedback between market and funding liquidity, causing fire-sales and balance sheet stress. - Global financial crisis examples: - U.S. money market funds suffered redemption requests in 2008 causing large-scale liquidity freeze that spilled into European markets. - Margin calls and rollover freezes on short-term repo funding contributed to fire-sales and failures of Bear Stearns and Lehman. - Structural changes since the crisis may have exacerbated systemic liquidity risk: - Banks reduced corporate bond inventories, weakening secondary corporate bond market liquidity, while repo financing involving corporate bonds grew. - Growing presence of collective investment vehicles and off-balance sheet products redeemable at short maturities but holding hard-to-sell assets increases redemption-driven fire sale risks. ### Data collection, monitoring, and oversight of nonbanks - First steps: collect broader data and assess flow of funds to identify potential concerns; then focus on nonbanks engaging in credit intermediation involving leverage or maturity transformation or interlinkages with banks. - Encourage authorities to establish monitoring frameworks with regular data reporting by systemic nonbank institutions. ### Macroprudential measures extended to nonbanks - Extend prudential regulations to nonbank credit institutions that perform bank-like activities to mitigate liquidity and fire sale risks. - Basic tools for nonbanks include: - liquidity buffer requirements; - limits on investments in illiquid assets as a proportion of assets; - limits on asset concentration in particular market segments; - limits on leverage; - limits on maturity of portfolio assets to reduce maturity mismatches. - Design and calibration should reflect specific nonbank risk-return profiles while promoting a level playing field. ### Securities lending markets and margin requirements - Regulation of margin requirements can mitigate fire sale risk and margin spirals: - Margin is collateral (cash or securities) that a borrower deposits to cover credit risk; arises in securities lending and repo markets. - Margins are typically very low when markets are calm but increase sharply in stress, requiring additional collateral and potentially forcing liquidation of securities—this can trigger a “margin spiral” (Brunnermeier and Pedersen, 2009). - Regulatory minimum requirements on margins (e.g., minimum floor on dollar amount of collateral, possibly depending on type of security) increase buffers and can dampen margin spirals.107 - FSB policy framework establishes standard calculation methodologies and minimum numerical floors for collateral haircuts in bank-to-nonbank securities financing transactions: - Minimum haircuts range from 0.5 to 4 percent for corporate bonds and 1 to 7 percent for securitized products, depending on maturities; 6 percent for main index equities; and 10 percent for other assets. - The framework will be implemented by end-2017.108 - Some argue for broad application of margin requirements to any party using short-term collateralized funding to finance securities holdings (universal margin requirements). FSB (2014a) also proposes expanding minimum margin requirements to nonbank-to-nonbank securities financing transactions. ### Additional and emerging tools for intermediaries - Proposed tools for broker-dealers and intermediaries (experience limited): - capital and liquidity requirements; - restrictions on use of clients’ assets (e.g., limits on re-hypothecation); - liquidity-linked capital surcharges. ### Tools for collective investment vehicles (CIVs) to manage redemption pressures - FSB policy framework offers two sets of tools: extension of liquidity requirements to CIVs and tools to manage redemption pressures. - Examples of redemption-management tools (Table 9): - Redemption gates: constrain redemption amounts by CIVs to a specific proportion on any one redemption day. - Suspension of redemptions: exceptional measure to buy time for fund manager assessment. - Imposition of redemption fees or other redemption restrictions: make investors bear liquidity costs in stress and restrain redemptions; fees may be applied continuously or be contingent on market conditions. - Side pockets: legally separate impaired or illiquid portfolio portions so the CIV can continue normal operations with higher quality portion. - Recent adoption: liquidity fees and redemption gates were recently adopted in the U.S., alongside liquidity requirements, as tools to address destabilizing runs on money market funds (SEC, 2014). ### Caution in activating CIV tools and legal/operational prerequisites - Caution needed: trigger-based or regulator-imposed redemption fees/gates may send negative market signals and lead to pre-emptive runs; conversely, a run may trigger the tool and “self-correct” the run. - Scope to impose redemption restrictions may require prior supervisory action affecting the fund’s legal structure and documentation; ex ante documentation describing possibility of redemption restrictions is typically required. - Activation typically requires active role of securities and conduct regulators and close collaboration with macroprudential authorities. ### Liquidity backstops and moral hazard considerations - Authorities should assess ability to provide emergency liquidity to break vicious feedback loops between funding and market liquidity. - Providing liquidity support to nonbanks requires strengthened supervision to avoid moral hazard from investor perceptions of insurance.109 ### International spillovers and complementary policies - Appropriate supervision and prudential regulation in nonbank home countries can have positive international spillovers: - Growing presence of foreign nonbank investors in emerging market primary markets while secondary market liquidity declined can create systemic liquidity mismatch if foreign investors sell holdings. - Complementary policies in recipient countries: - Deepen secondary markets for securities or promote larger local investor base to increase resilience to fire sales and sudden stops. - Local institutional investors less subject to run risk (insurance companies, pension funds) can provide long-term financing and act as shock absorbers. - Limits on portfolio investments by foreign nonbank investors can be considered; when such measures are CFMs, ensure objectives are explicitly associated with systemic liquidity risks, not substitutes for macroeconomic adjustment, and that measures are effective and least distortive in addressing risks (IMF, 2012b). *Source: STAFF GUIDANCE NOTE ON MACROPRUDENTIAL POLICY—DETAILED GUIDANCE ON INSTRUMENTS, INTERNATIONAL MONETARY FUND* ### Box 12. Money Market Mutual Funds in the U.S. ### Box 12. Money Market Mutual Funds in the U.S. ### Origins and structural features - MMMFs in the U.S. originated in the 1970s from a desire to escape Regulation Q, which did not allow interest to be paid by deposit-taking institutions on demand deposits. - As nonbanks, MMMFs could avoid the reserve requirements and FDIC contributions imposed on depository institutions. - Two key regulatory/features supported their growth: - “Hold to maturity” accounting conventions that allowed them to use stable net asset values (NAVs) for reporting and redemptions, giving investors a deposit-like claim. (Footnote: MMMFs could, under normal circumstances, use the penny rounding method to maintain a price of US$1.00 per share without pricing to the third decimal point like other mutual funds, and the amortized cost method so that they need not strike a daily market-based NAV.) - The right to take on some credit, market, and maturity risk without being subject to the full set of prudential regulations. ### Size and market role (pre-crisis) - At their peak, the U.S. MMMFs’ total holdings of financial assets at end 2008 amounted to about US$3.8 trillion, equivalent to 27 percent of GDP. - MMMFs also accounted for a significant share of the triparty repo market. ### Vulnerabilities and the 2007–09 financial crisis - MMMFs became vulnerable in the early stages of the financial crisis, particularly due to their outright purchases of asset-backed commercial paper (ABCP). - During 2007–08, MMMFs were exposed to substantial losses: - losses on the debt securities underpinning ABCP, and - losses from default of debt securities issued by Lehman Brothers Holdings Inc. - Market participants had become accustomed to constant NAVs of US$1.00 per share; one large MMMF “broke the buck” following the Lehman default in September 2008, causing a run and redemptions across a large number of MMMFs. - Sponsors provided substantial support to avoid forced liquidation of funds and to limit reputational damage. - The key role played by MMMFs increased the vulnerability of bank funding markets to sudden withdrawal of liquidity by MMMFs. When this occurred, short-term funding to corporate borrowers via commercial paper and ABCP threatened to dry up. - Unprecedented emergency facilities established by the Treasury and Federal Reserve were ultimately needed to contain the run on money market funds and provide additional liquidity. - Footnote: The Treasury Department introduced the Temporary Guarantee Program, which temporarily guaranteed certain investments in money market funds that decided to participate in the program. The Federal Reserve Board created its ABCP MMMF Liquidity Facility, through which it extended credit to U.S. banks and bank holding companies to finance their purchases of high-quality asset backed commercial paper from money market mutual funds. The programs expired in September 2009 and February 2010, respectively. ### Regulatory response and reforms - SEC rule changes effective in May 2010 were intended to increase resilience by reducing interest rate, credit and liquidity risks in MMMFs’ portfolios. - In response to recommendations by FSOC, in July 2014 the SEC adopted a reform that: - requires a floating NAV for prime institutional money market funds, and - allows all money market funds the use of liquidity fees and redemption gates (i.e., a temporary suspension of redemptions) in times of stress. - The 2014 reform also includes additional diversification, disclosure and stress testing requirements. - Footnote clarifications: - The adoption of market-based NAV requires funds to value their portfolio securities using market-based factors. - Prime institutional MMMFs are geared toward institutional investors and primarily invest in corporate debt. ### Financial stability implications and supervisory follow-up - The run on MMMFs demonstrated how instability in a major nonbank short-term funding provider can amplify funding stress across the financial system, threatening commercial paper and ABCP markets. - The Financial Stability Oversight Council (FSOC) remains vocal on MMF reform and will weigh the sufficiency of the SEC's new reforms; FSOC will consider whether the rule will impact its next steps for designating certain asset managers as systemically important. ### Cross-border and leakage considerations (contextual link to broader liquidity policy) - Regulatory arbitrage can undermine liquidity tools by building up liquidity risks outside the regulatory perimeter (for example, via off-balance-sheet maturity transformation such as ABCP or migration to nonbank financial sector activities). - To avoid leakage, regulators should monitor activities not subject to liquidity requirements and extend the regulatory perimeter when necessary; liquidity requirements can be extended to foreign bank branches and NBFIs with tailored calibration. - The U.S. experience: liquidity requirements were tightened on MMMFs since the crisis (in 2010 and further in 2014). - Examples of country measures to close reserve-requirement loopholes cited in the text: - Turkey recently extended regulations on reserve requirements to financing companies; - Brazil (in 2008) and Serbia (in 2005) introduced reserve requirements on commercial leasing operations in their effort to contain credit growth. *Source: Box 12. Money Market Mutual Funds in the U.S., Staff Guidance Note on Macroprudential Policy—Detailed Guidance on Instruments (excerpt).* ### 181. This chapter provides practical guidance on risk monitoring and macroprudential ### This chapter provides practical guidance on risk monitoring and macroprudential policy to address risks in the structural dimension. ### Three Step Approach - Recommends a three step approach for surveillance of risks in the structural dimension (paragraphs 182–183): - Step 1: Analyze composition of the financial system using aggregate information by financial sector and subsectors and sectoral flow of funds if available. - Step 2: Focus on structural risks in the banking sector, identify systemically important banks and tools to improve resilience (improved supervision, resolvability, loss absorbency). - Step 3: Depending on country characteristics, expand analysis to further structural risks and/or relevant financial activities and NBFIs that may pose systemic risk. - Purpose: tailor staff analysis and advice to the degree of complexity and specific features of the financial system in a given country; address introduction and calibration issues and cover unexpected consequences, including cross-border, of macroprudential policy. ### Step 1: Financial system overview (paragraphs 183) - Key objectives: - Characterize composition of the financial system, including size and interconnectedness of different financial sectors at the aggregate level. - Measure size of each financial sector relative to the entire financial system and relative to a measure of the real economy (e.g., GDP). - Use flow of funds to expand characterization of interconnectedness across sectors when available. - Guidance when flow of funds are unavailable: - At minimum, characterize channels and degree of interconnectedness between the banking sector and other financial sectors (funding exposures, common exposures, counterparty credit risk). - Illustrative empirical material (Chile FSAP Update (2011)): - Table 10. Chile: Financial System Structure — raw table entries as presented: - Banks2650.592.72549.4102.8 - Domestic banks1322.641.51121.745.2 - Foreign banks1219.235.21319.139.7 - Subsidiaries616.530.3818.839.1 - Branches62.74.950.30.7 - State-owned18.716.018.617.9 - Insurance companies 1/5111.020.1579.720.1 - Property and casualty220.61.0260.81.6 - Life2910.419.1318.918.5 - Pension fund administrators 1/ 2/631.758.1630.663.7 - Other fund administrators 1/ 2/ 3/ 436.912.64310.321.4 - Total126100.0183.5131100.0208.1 - Footnotes: 1/ 2010 figure as of September. 2/ Assets under management. 3/ Includes mutual funds, investment funds, investment funds for foreign capital. (Column heading indicators include "2005" and "2010".) - Figure 10. Chile: Major Gross Cross-Sectoral Financial Exposures (In percent of GDP, 2009) — matrix entries as presented: - Row/column summary line: 23%99%30%3%20%67%16%318%38%102%717% - Selected matrix elements (Panel B values as shown): - Central Bank: 0% 5% 1% 0% 0% 0% 0% 0% 0% 14% 20% - Banks & Coop.: 13% 6% 1% 0% 0% 0% 2% 42% 30% 7% 102% - Pension funds: 4% 13% 3% 0% 0% 0% 4% 16% 0% 27% 66% - Non-fin. Corp.: 0% 22% 12% 2% 2% 1% 4% 115% 0% 31% 188% - Households: 2% 16% 8% 0% 17% 66% 0% 23% 0% 7% 141% - Rest of World: 1% 11% 2% 0% 1% 0% 2% 96% 0% 0% 114% - Notes: Exposures exclude net derivative positions. Preliminary BCCh estimates of long-term securities positions (item AF.32) are included. World Bank staff estimates of Shares and Other Equity (excluding mutual funds) (item AF.51) and Other Accounts (item AF.7) are based on maximum entropy methods. ### Step 2: Systemically important banks — Identification (paragraphs 184–188) - Key point: size alone is not the only consideration; three main criteria from IMF-FSB (2009) are size, interconnectedness, and lack of substitutability; complementary indicators can include vulnerability measures (leverage, maturity mismatch). - Indicator-based measurement approach (paragraph 185): - For each selected indicator: score = (individual institution amount) / (aggregate amount across sample). - Scores are weighted by indicator weighting for and within each category; weighted scores summed to obtain overall systemic importance score. - Complement indicator-based approach with supervisory judgment and validation. - BCBS guidelines for GSIBs and DSIBs (paragraph 186): - GSIB identification captures five dimensions: size, interconnectedness, lack of substitutability, complexity, global scope. - DSIB criteria similar to GSIBs but exclude global scope; reference system for DSIB failure is the domestic economy; framework provides national discretion and recommendation to publish outline of methodology. - Example applications: - FSB publishes GSIB list annually; 2013 list included a total of 29 global banks (paragraph 187). - Adaptations for DSIBs noted in Braemer and Gischer (2012) and Australia FSAP Update (2012). ### Complementary analytical tools (paragraphs 188 and Box 14) - Two model-based toolsets commonly used: - Network analysis: - Identifies core elements of architecture of financial interconnectedness; requires measurement of exposures among financial institutions. - Main tools: centrality analysis, cluster analysis, balance sheet simulation methods. - Data limitations: derivatives, cross-border exposures, confidentiality of bilateral exposures. - Market-based indicators: - Rely on asset prices (stocks, bonds, derivatives) to estimate distress dependence among institutions. - Examples of IMF-used market-based tools: CoVaR, CoRisk, return spillovers, distress spillovers, JPod/CoPoD, systemic CCA. - Limitations when sector not publicly traded or markets thin. - Role: model-based tools can be incorporated within indicator-based approaches to capture specific dimensions (e.g., interconnectedness), but indicator-based approaches are relatively simple and robust. ### Tools and policy responses for systemically important banks (paragraphs 189–193) - FSB/BCBS three-pillar approach for systemic banks: - Intensified supervision - Improved resolvability - Enhanced loss absorbency - Intensified supervision (paragraph 190): - Microprudential supervisors should apply intensified supervision with special attention to risk management practices. - Authorities need mandate, resources, operating independence, and full set of powers. - Recommendations: adopt higher supervisory standards for SIFIs; international coordination among supervisors; strengthen internal controls (governance, incentives, remuneration); allocate more supervisory resources and continuous supervision (communication channels, shorter supervisory cycles); greater information disclosure and transparency. - Improved resolvability (paragraph 191): - FSB “Key Attributes for Effective Resolution Regimes for Financial Institutions” (2011) aims to reduce moral hazard and enable resolution without severe systemic distress or taxpayer bail-outs. - Key Attributes cover any institution of systemic importance (banks, NBFIs, market infrastructures such as CCPs) and comprise 12 key principles implying three broad powers: - (i) powers to intervene quickly (prior to insolvency) and assume control from owners/managers; - (ii) powers to effect a resolution; - (iii) powers to support the resolution (e.g., suspend third party actions). - Recommendation: effective recovery and resolution plans (RRPs), tailor-made RRPs for SIFIs to reduce bailout costs and uncertainties. - International coordination and arrangements for mutual cooperation in resolving GSIFIs are essential to prevent regulatory arbitrage and enable cross-border resolution. - Enhanced loss absorbency (paragraphs 192–193): - BCBS GSIB framework introduces capital surcharges ranging from 1 to 3.5 percent, required to be met by common equity tier one capital; banks ranked and placed in five buckets with graduated surcharges. - DSIB guidelines give national discretion in calibrating systemic capital surcharges. - Calibration principles: - Higher loss absorbency should be commensurate with degree of systemic importance. - Calibration should be informed by quantitative methodologies, country-specific factors (e.g., concentration in banking sector or size of banking sector relative to GDP), and supervisory judgment. - Principle of “equal expected impact”: set higher surcharges to reduce probability of failure of systemic institutions relative to nonsystemic institutions, keeping expected impact of failure the same. - Empirical and policy developments: - Australia, Canada, Singapore require major banks to maintain a common equity ratio one percent higher (two percent for Singapore) than Basel III proposals. - Austria, Denmark, Sweden have set supplementary capital requirements of up to three percent (five percent for Sweden) for domestically important institutions. - Switzerland has a progressive systemic surcharge of six percent for its two large banks that can be fulfilled by “low trigger” contingent capital (CoCos). - IMF survey: 35 additional countries reported plans to introduce capital surcharges on SIFIs within the next two years. *Source: STAFF GUIDANCE NOTE ON MACROPRUDENTIAL POLICY—DETAILED GUIDANCE ON INSTRUMENTS, International Monetary Fund.* ### 194. Additional requirements can be put in place to increase the resilience of systemic ### _110614a - 194. Additional requirements can be put in place to increase the resilience of systemic ### Resilience measures for systemic banks - Higher leverage ratio requirement: U.S. has established (effective in 2018) a higher leverage ratio requirement for systemic banks. - U.S. leverage buffer calibration: - Systemic banks will be required a leverage buffer of two percentage points above the minimum supplementary leverage ratio requirement of three percent, for a total of five percent. - The rule applies to U.S. top-tier bank holding companies with more than US$700 billion in consolidated total assets or more then US$10 trillion in assets under custody (covered BHCs) and their insured depository institution subsidiaries. - Insured depository institution subsidiaries of covered BHCs must maintain at least a six percent supplementary leverage ratio to be considered “well capitalized” under the agencies’ prompt corrective actions framework. - Other jurisdictions and tools: - BoE has issued a consultation paper considering the introduction of a supplementary leverage ratio to systemically important banks and its interaction with capital (risk-weighted) surcharges. - Tighter liquidity requirements for systemic banks could complement capital surcharges. - Liquidity surcharges can be applied to SIFIs and made proportional to the banks’ contribution to systemic liquidity risks. - Capital composition guidance: - Guidelines establish that the higher loss absorbency requirements be met with common equity tier one capital and recommend imposing the higher of either the DSIB or GSIB capital requirements in the case where the bank has been identified as a DSIB in the home jurisdiction as well as a GSIB. ### Box 15 — Higher Loss Absorbency for Systemically Important Banks in Australia (2012 FSAP calibration) - Methodology: - A CCA approach was used in the 2012 FSAP for Australia (IMF, 2012) to estimate the additional capital required for the four largest DSIBs. - Expected default frequency obtained from Moody’s CreditEdge was used as an estimate of default probabilities. - A power function relationship between estimated default probability and market-capitalization-to-assets ratio was found to be a relatively robust fit for the top four Australian banks based on daily data from June 2011 to June 2012. - Assumptions: market value of assets and regulatory risk-weighted assets closely coincide if supervisor’s view of risk weights coincides with the market’s view; additional capital can be raised at the current market value of equity. - Comparative ratios reported for Australia in 2011: - Reported Tier 1 capital ratio: 10.1 percent - Market-capitalization-to-assets ratio: 9.4 percent - Calibration results (additional Tier 1 capital required as percent of RWA): - Maintaining a one-year-ahead probability of 99.9 percent of not defaulting on any payment would require the four major banks to hold additional Tier 1 capital ranging from 0.9 to 2.8 percent of RWA at the end of 2011. - If the goal were to achieve a 99.95 percent probability of no default, additional Tier 1 capital ranging from 1.4 to 5.2 percent of RWA would be necessary. - Policy implication: - The actual amount of loss absorbency required would be determined by the regulator’s risk tolerance. ### Step 3: Advanced analysis — extending perimeter and tools - Purpose: - Expand analysis to consider further tools to address structural risks and/or to cover relevant financial activities and NBFIs that may pose systemic risk. - More developed and complex financial systems require higher staff coverage in this step. - Additional activities and institutional coverage: - Systemic risk monitoring should include all institutions performing critical functions: credit intermediation, maturity transformation, risk management, payments and settlement of securities transactions, and support of primary and secondary funding markets. - Special attention to shadow banking activities operating outside the regulatory perimeter. - Where detailed data are limited, studies may characterize aggregate exposures across different sectors. - Systemic importance assessment—beyond individual entities: - Clusters of institutions can be collectively significant even if individually small. - Systemic risks may arise from products offered by a class of institutions or from activities across a diverse range of nonbank institutions. - Considerations specific to insurance: - Assessment should include asset correlations, leverage and maturity mismatch. - Insurance underwriting risks are generally not correlated with the economic cycle; traditional insurers are less likely to suffer runs, while insurers engaged in non-traditional or non-insurance activities can be more vulnerable and contribute to systemic risk. - IAIS guidance stresses interconnectedness and non-traditional activities; size receives a lower weight for insurers. - Examples and precedents: - U.S. FSOC (section 113 of the Dodd Frank act) can determine that a non-bank financial company be supervised by the Federal Reserve if it could pose a threat to U.S. financial stability; FSOC’s methodology is an indicators-based approach. - FSOC designated three nonbank financial firms as systemically important in 2013: AIG, GE Capital and Prudential Financial (designation applies to individual entities and financial market utilities). - Shadow banking monitoring and policy: - Shadow banking defined as parts of the financial system that carry out bank-like intermediation but are typically less regulated and lack safety net guarantees. - Systemic risks arise when credit intermediation is funded short-term, leading to credit risks and maturity mismatches outside banking, vulnerability to runs, fire sales, and contagion through ownership linkages or opaque intermediation chains. - Monitoring principles: - Cast the net wide to cover all non-bank credit intermediation for data gathering and surveillance. - Narrow focus to subset giving rise to regulatory arbitrage or systemic risks (maturity/liquidity transformation, flawed credit risk transfer, leverage). - Data requirements: - Access to granular data is a prerequisite; close data gaps, encourage authorities to collect and share information; complement with market intelligence. - Regulatory approach: - Intervention should be proportionate and tailored; authorities should be able to regulate activities/entities posing systemic risks, define activities and subject them to licensing, then apply proportionate regulation. - Equivalent prudential intervention should be extended to intermediaries facing “bank-like” sources of risk. - Additional tools to contain interconnectivity and contagion: - Exposure limits: - Prudential exposure limits aim to reduce network complexity, concentration and connectivity, producing a less contagious network of exposures. - Limits have been broadly accepted internationally; Basel Committee reviewing framework to establish an internationally agreed-upon standard. - Common practice: limits to single counterparties or connected groups; interbank exposures are often exempted. - To address contagion risks, limits on a bank’s exposure to other financial institutions should be included; tighter limits for exposures between SIFIs and for exposures of smaller banks to SIFIs could be useful. - Typical large exposure thresholds mentioned in practice: - Exposures representing ten percent or more of a bank’s capital are defined as a large exposure. - Twenty-five percent of a bank’s capital is the limit for an individual large exposure to a private sector nonbank counterparty or a group of connected counterparties. - Deviations from these limits are frequent and exceptions abound; exposures arising from off-balance sheet as well as on-balance sheet items and contingent liabilities should be captured. - Recent Basel Committee proposal principle: apply the large exposure limit to interbank exposures as applied to other exposures to third parties, with scope for certain limited exemptions; includes proposed tighter limits for exposures between GSIBs, and encourages consideration of stricter limits for DSIBs and for exposures of smaller banks to GSIBs. *Staff Guidance Note on Macroprudential Policy—Detailed Guidance on Instruments, selected excerpts.* ### 206. Risk weights. Tighter risk weights for intra-financial system exposures may be used to ### _110614a - 206. Risk weights. Tighter risk weights for intra-financial system exposures may be used to ### Risk weights - Tighter risk weights for intra-financial system exposures may be used to reduce network connectivity. - Risk weights on exposures to other banks are generally low, though some tightening has been brought with the implementation of Basel III.140 - The U.K. FPC has the power to set increased sectoral capital requirements for exposures within the financial system, such as specific types of exposures that are growing rapidly. - The FPC proposes that sectoral capital requirements on banks’ exposures to other parts of the financial system may be applied in two main ways: - for exposures to specific types of financial institution; or - for specific types of intra-financial system activity or instrument. - Policy rationale and priorities: - Introduction of higher risk weights on exposures to SIFIs could be particularly useful. - Increases in risk-weights for types of exposures that grow rapidly could contain increases in systemic risk from innovative products whose risks are poorly understood. ### Liquidity requirements - Objective: increase banks’ liquidity buffers and reduce maturity mismatches at individual banks to mitigate systemic liquidity and contagion risk. - Liquidity requirements that penalize reliance on short-term wholesale funding, particularly from other financial institutions (for example the Net Stable Funding Ratio), provide an incentive to reduce funding interconnectedness by reducing noncore funding obtained in wholesale financial markets. - Evidence and references: IMF 2013c; Shin, 2010a and 2010b. - Complementarity: tighter liquidity requirements for systemic banks that take into account funding linkages among these banks could complement capital surcharges in increasing resilience. ### Margin requirements - Regulation of margins in securities lending and repo markets, and margin requirements in derivatives markets, can help avoid margin spirals that contribute to excess leverage and procyclicality (Geanakoplos, 2010; Longworth, 2010; Hanson and others, 2011; FSB, 2012b). - Possible regulatory approaches: - Establish a minimum floor on the dollar amount of collateral to be posted, with the minimum potentially depending on the type of security offered as collateral. - Market-wide minimum requirements could harmonize regulation across organizational forms and reduce migration of lending activity into the shadow banking sector. - Haircut regulation for assets used in funding the shadow banking system can dampen destabilizing dynamics. - Role in derivatives markets: - Example: a proposed U.S. rule to establish minimum margin requirements for initial and variation margin between covered swap entities and counterparties to non-cleared swaps and non-cleared security-based swaps; the amount would vary based on the relative risk of the counterparty and of the non-cleared swap or non-cleared security-based swap. - Historical/legal note: The 1934 Securities and Exchange Act gave the Federal Reserve broad authority to regulate margins in securities lending markets, except for government securities; between 1934 and 1974 the Federal Reserve actively managed margin requirements for stock market investors (Regulation T).141 ### Changes to market infrastructures - Market infrastructure changes (payment, settlement, clearing) can reduce buildup of credit exposures within the financial system. - Real time gross settlement encourages broader security against payment system failures. - Post-crisis push to strengthen clearing of derivatives transactions; G20 (September 2009) commitment to mandate central clearing of all standardized OTC derivatives contracts. - Benefits of CCPs over bilateral clearing: - Reduce potential contagion because impact of a major counterparty failure is absorbed by the CCP and mutualized among clearing members. - Mutualize counterparty failure risk using prefunded default funds and other risk management mechanisms. - Manage counterparty credit risk centrally via margin requirements (initial and variation) on both sides of trades. - Reduce exposures through multilateral netting and collateralization of initial and potential future exposures. - Increase transparency of the amount and distribution of risk exposures. - Caution: CCPs reduce interconnectedness but concentrate systemic risk; they need prudent design and close supervision.142 - All CCPs (and Central Securities Depositories) are considered systemically important according to CPSS-IOSCO Principles for Financial Market Infrastructures. - Some central banks in Europe and Asia provide intraday and sometimes overnight liquidity to CCPs (examples: Singapore, France and Korea). ### Structural limits on activities - Policies restricting the size and scope of financial institutions can reduce interconnectedness, complexity, and the number of systemic institutions. - Rationale: useful for managing risks that are difficult to measure and address through other tools; complement other macroprudential tools. - Possible measures: - Move businesses identified as too risky and complex into stand-alone subsidiaries. - Prohibit banks from engaging in certain activities altogether. - Trade-offs and costs: - Empirical evidence supports (albeit weakly) the existence of economies of scale and scope in banking. - Curtailing banks’ activities may reduce market liquidity, efficiency, and risk management capacity. - Risks may migrate to less-regulated activities.143 ### Calibration and phase-in - Structural macroprudential tools are not intended to be tightened and loosened in response to the credit cycle; objective is to strengthen system resilience to aggregate or idiosyncratic shocks and reduce contagion. - Capital surcharges could be eased following structural changes (for example, improvements in resolvability or policies restricting scope). - Implementation considerations: - These measures affect leverage levels, asset prices, and the price/supply of credit even if not their main objective. - To meet higher capital requirements, banks may reduce balance sheets or raise lending rates instead of raising new capital or retaining profits, potentially lowering credit. - Introducing systemic surcharges during credit expansion—when raising new capital is relatively cheap—would reduce deleveraging pressures in a downturn. - A sufficiently long phase-in period for surcharges can help avoid unintended deleveraging pressures. ### Unintended consequences and international dimension - Domestic unintended consequences: - Regulated entities may shift activities to related-party institutions (different financial sector or across borders) in response to tighter requirements. - This can reduce systemic importance of tightly regulated entities but shift risks to less-regulated activities. - Low degree of separation between targeted institutions and related parties may mean systemic importance of the financial group has not effectively decreased. - Consolidated supervision, transparency of intra-group exposures, and appropriate firewalls between related parties are crucial to monitor and manage these risks. - Cross-border effects: - Tighter requirements in one country may lead to: - (i) reallocation of certain activities to related parties across the border; - (ii) deleveraging by subsidiaries and branches of foreign parent banks; - (iii) repatriation by parent banks of voluntary capital buffers from subsidiaries and branches abroad; - (iv) increased risk taking by locally established institutions across the border. - Need for coordination: - International agreements and guidance (such as the BCBS framework for globally and domestically systemic important banks) are important to counter risks of inaction and a potential race to the bottom in application of prudential controls.144 - International surveillance of macroprudential action should complement such agreements. - Bilateral and multilateral coordination and consultation are necessary. - Mechanisms that can facilitate coordination and information exchange: - Supervisory colleges to capture risks across groups, foster understanding of home-host interdependencies, and develop strategies to contain adverse consequences of regulatory actions. - Regional initiatives (for example, the ESRB and the Nordic-Baltic Macroprudential Forum) to help internalize adverse cross-border effects. - Ad hoc structures for specific problems (example: the “Vienna Initiative” to encourage cooperative solutions that helped avoid excessive deleveraging in central and eastern European countries after the crisis). *Staff Guidance Note on Macroprudential Policy—Detailed Guidance on Instruments (excerpts).* ### References ### References ### Macroprudential policy instruments and frameworks - Aiyar, Shekar, Charles Calomiris, and Tomasz Wieladek, 2012, “Does Macropru Leak? Evidence from a U.K. Policy Experiment,” Bank of England Working Paper, No. 445. - Aiyar, Shekhar, Charles W Calomiris and Tomasz Wieladek, 2014, “How Does Credit Supply Respond to Monetary Policy and Bank Minimum Capital Requirements?” Bank of England Working Paper No. 508. - Arregui, Nicolas, Jaromír Beneš, Ivo Krznar, Srobona Mitra, and Andrew Oliveira Santos, 2013, “Evaluating the Net Benefits of Macroprudential Policy: A Cookbook,” IMF Working Paper, WP/13/167. - Bank of England, 2011, “Instruments of Macroprudential Policy,” Discussion Paper (December). - Bank of England, 2014a, “Implementing the Financial Policy Committee’s Recommendation on Loan to Income Ratios in Mortgage Lending,” Consultation Paper, CP11/14. - Bank of England, 2014b, “The Financial Policy Committee’s Review of the Leverage Ratio,” Consultation Paper, July 2014. - Bank of England, 2014c, “The Financial Policy Committee’s Power to Supplement Capital Requirements,” Policy Statement (January). - Basel Committee on Banking Supervision, 2010, “Guidance for National Authorities Operating the Countercyclical Capital Buffer” (December). - Committee on the Global Financial System (CGFS), 2012, “Operationalising the Selection and Application of Macroprudential Instruments,” CGFS Papers, No. 48. - European Systemic Risk Board (ESRB), 2014, The ESRB Handbook on Operationalising Macro-prudential Policy in the Banking Sector. - Lim, Cheng Hoon, et al., 2011, “Macroprudential Policy: What Instruments and How Are They Used? Lessons from Country Experiences,” IMF Working Paper, WP/11/238. - Lim, Cheng Hoon, Ivo Krznar, Fabian Lipinsky, Akira Otani, and Xiaoyong Wu, 2013, “The Macroprudential Framework: Policy Responsiveness and Institutional Arrangements,” IMF Working Paper, WP/13/166. - Viñals, José and Erlend W. Nier, 2014, “Collective Action Problems in Macroprudential Policy and the Need for International Coordination,” Banque de France Financial Stability Review, April, No. 18. ### Capital, leverage, liquidity and funding - Adrian, Tobias and Hyun Song Shin, 2010, "Liquidity and Leverage," Journal of Financial Intermediation, Vol. 19–3 (July), pp. 418–437. - Borio, Claudio and Mathias Drehmann, 2009, “Assessing the Risk of Banking Crises—Revisited,” BIS Quarterly Review (March), pp. 29–46. - Brunnermeier, Markus, and Lasse Heje Pedersen, 2009, "Market Liquidity and Funding Liquidity," Review of Financial Studies, Vol. 22 (6), pp. 2201–2238. - Drehmann, Mathias, Claudio Borio and K. Tsatsaronis, 2011, “Anchoring Countercyclical Capital Buffers: the Role of Credit Aggregates,” International Journal of Central Banking, Vol. 7 (December), No. 4. - Drehmann, Mathias, and Kleopatra Nikolaou, 2013, “Funding Liquidity Risk: Definition and Measurement,” Journal of Banking and Finance, Vol. 37 (July), No. 7, pp. 2173–2182. - Bridges, Jonathan, et al., 2014, “The Impact of Capital Requirements on Bank Lending,” Bank of England Working Paper No. 486. - Macroeconomic Assessment Group (MAG), 2010, "Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements—Final Report," December. ### Real estate, housing markets, and LTV/DTI measures - Ahuja, Ashvin and Malhar Nabar, 2011, “Safeguarding Banks and Containing Property Booms: Cross-Country Evidence on Macroprudential Policies and Lessons from Hong Kong SAR,” IMF Working Paper, WP/11/284. - Aizenman, Joshua and Yothin Jinjarak, 2009, “Current Account Patterns and National Real Estate Markets,” Journal of Urban Economics, Vol. 66 (September), Issue 2, pp. 75–89. - Benford, James and Oliver Burrows, 2013, “Commercial Property and Financial Stability,” Bank of England Quarterly Bulletin, 2013 Q1. - Crowe, Christopher, Giovanni Dell’Ariccia, Deniz Igan, and Pau Rabanal, 2013, “How to Deal with Real Estate Booms: Lessons from Country Experiences,” Journal of Financial Stability, No. 9, pp. 300–319. - Duca, John V., John Muellbauer, and Anthony Murphy, 2011, “House Prices and Credit Constraints: Making Sense of the U.S. Experience,” The Economic Journal, Vol. 121, pp. 533–551. - Igan, Deniz and Heedon Kang, 2011, “Do Loan-to-Value and Debt-to-Income Limits Work? Evidence from Korea,” IMF Working Paper, WP/11/297. - Wong, Eric, Tom Fong, Ka-fai Li and Henry Choi, 2011, “Loan-to-Value Ratio as a Macroprudential Tools—Hong-Kong’s Experience and Cross-Country Evidence,” HKMA Working Paper, No. 01/2011. - Reserve Bank of New Zealand, 2014, “C30 New Residential Mortgage Lending: Loan-to-Valuation Ratio (LVR),” Statistics. ### Systemic risk measurement, monitoring, and indicators - Arregui, Nicolas, Jodi Scarlata, Mohamed Norat, and Antonio Pancorbo with Eija Holttinen, Jay Surti, Chris Wilson, Rodolfo Wehrhahn, and Mamoru Yanase, 2013, “Addressing Interconnectedness: Concepts and Prudential Tools,” IMF Working Paper, WP/13/199. - Arsov, Ivailo, Elie Canetti, Laura Kodres, and Srobona Mitra, 2013, “Near-Coincident Indicators of Systemic Stress,” IMF Working Paper, WP/13/115. - Blancher, Nicolas, Srobona Mitra, Hanan Morsy, Akira Otani, Tiago Severo, and Laura Valderrama, 2013, “Systemic Risk Monitoring (“SysMo”) Toolkit—A User Guide,” IMF Working Paper, WP/13/168. - Borio, Claudio and Philip Lowe, 2002, “Assessing the Risk of Banking Crises,” BIS Quarterly Review (December), pp. 43–54. - Drehmann, Mathias and Mikael Juselius, 2012, “Do Debt Service Costs Affect Macroeconomic and Financial Stability?” BIS Quarterly Review (September). - Drehmann, Mathias and Mikael Juselius, 2013, “Evaluating Early Warning Indicators of Banking Crises: Satisfying Policy Requirements,” BIS Working Paper Series, No. 421. - Oet, Mikhail V., Timothy Bianco, Dieter Gramlich, and Stephen Ong, 2012, “Financial Stress Index: A Lens for Supervising the Financial System,” Federal Reserve Bank of Cleveland Working Paper, No. 12–37. - Wolken, Tony, 2013, “Measuring Systemic Risk: The Role of Macro-prudential Indicators,” Reserve Bank of New Zealand Bulletin, Vol. 76, No. 4. ### Resolution, supervision of SIFIs, and cross-border issues - Basel Committee on Banking Supervision, 2012, “A Framework for Dealing with Domestic Systemically Important Banks,” October. - Basel Committee on Banking Supervision, 2013, "Global Systemically Important Banks: Assessment Methodology and the Additional Loss Absorbency Requirement," November. - Financial Stability Board (FSB), 2010–2014, multiple outputs on SIFI supervision, resolution regimes, shadow banking, and G-SIB updates (selected entries: 2010; 2011a; 2011b; 2011c; 2012a; 2013a; 2013b; 2013c; 2013d; 2014a; 2014b). - International Monetary Fund, Financial Stability Board and Bank for International Settlements, 2009, “Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations,” mimeo. - Fiechter, Jonathan, Inci Ötker, Anna Ilyina, Michael Hsu, Andre Santos, Jay Surti, 2011, “Subsidiaries or Branches: Does One Size Fit All?” IMF Staff Discussion Notes, No. 11/4. - Viñals, José, Ceyla Pazarbasioglu, Jay Surti, Aditya Narain, Michaela Erbenova, and Julian Chow, 2013, “Creating a Safer Financial System: Will the Volcker, Vickers, and Liikanen Structural Measures Help?” IMF Staff Discussion Note, No. 13/4. ### Empirical studies, country experiences and case studies - Benes, Jaromir, Kevin Clinton, Roberto Garcia-Saltos, Marianne Johnson, Douglas Laxton, Petar Manchev and Troy Matheson, 2010, “Estimating Potential Output with a Multivariate Filter,” IMF Working Paper, WP/10/285. - Galac, Tomislav, 2010, “The Central Bank as Crisis-Manager in Croatia—A Counterfactual Analysis,” Croatian National Bank Working Paper, W-27. - Galac, Tomislav, 2012, “Global Crisis and Credit Euroisation in Croatia,” Croatian National Bank Working Paper, W-33. - Kraft, Evan and Tomislav Galac, 2011, “Macroprudential Regulation of Credit Booms and Busts-The Case of Croatia”, World Bank Policy Research Working Paper, No. 5572. - Krznar, Ivo and James Morsink, 2014, “With Great Power Comes Great Responsibility: Macroprudential Tools at Work in Canada,” IMF Working Paper, WP/14/83. - Hallissey, Niamh, Robert Kelly, and Terry O’Malley, 2014, “Macro-prudential Tools and Credit Risk of Property Lending at Irish Banks,” Economic Letter Series, Vol. 2014, No. 10. - Lee, Jong Kyu, 2012, “The Operation of Macroprudential Policy Measures: The Case of Korea,” mimeo. ### Complementary topics: shadow banking, securitization, taxes, and macro-financial interactions - Financial Stability Board, 2011c, “Shadow Banking: Strengthening Oversight and Regulation: Recommendations of the Financial Stability Board,” October. - KPMG, 2011, “Securitization Vehicles—Is IFRS the End of the Road?” Insights into Canadian Banking, Issue 2, Spring 2011 Edition. - Perottia, Enrico, and Javier Suarez, 2011, “A Pigovian Approach to Liquidity Regulation,” International Journal of Central Banking, Vol. 7, No. 4, pp. 3–41. - Shin, Hyun Song, 2010a, “Non-Core Liabilities Tax as a Tool for Prudential Regulation,” Policy memo. - Shin, Hyun Song, 2010b, “Macroprudential Policies Beyond Basel III,” Policy memo. - Gobat, Jeanne, Mamoru Yanase, and Joseph Maloney, 2014, “The Net Stable Funding Ratio: Impact and Issues for Consideration,” IMF Working Paper, WP/14/106. *Source: _110614a - References (PDF chapter).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2014/_110614a.pdf_