## _cr1370 — MACROPRUDENTIAL OVERSIGHT AND THE ROLE OF THE ESRB — TECHNICAL NOTE (MARCH 2013)

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### Executive Summary
- Purpose of macroprudential policy:
  - Identify and reduce risks to financial stability along a time dimension and a cross-sectional dimension.
  - Use prudential instruments to (i) limit the buildup of financial imbalances; (ii) address market failures related to risk externalities and interconnectedness between financial institutions; and (iii) dampen procyclicality of the financial system.
- Current EU arrangements and ESRB role:
  - National authorities are responsible for macroprudential oversight of their national financial systems; adequate frameworks are lacking in many EU countries.
  - Coordination and internalization of cross-border spillovers is achieved at the EU level by the European Systemic Risk Board (ESRB) through a non-binding “act or explain” mechanism.
  - In December 2011, the ESRB issued recommendations on the macroprudential mandates of national authorities; guidance for establishing common macroprudential toolkits is being developed.
- Key institutional messages:
  - Macroprudential policies at the national level must be effective, efficient, aligned with the internal market objective, and protect financial stability.
  - The instrument set should be comprehensive enough to address multifaceted macroprudential concerns at national and EU levels; efficient coordination is needed to limit negative externalities and unintended effects on the single market.
  - Coordination is especially important given highly integrated EU economic and financial markets; ESRB lacks formal modalities to coordinate macroprudential policy at the EU level.
- SSM implications:
  - Within EMU, assigning macroprudential policy to both the ECB and national authorities is advantageous; monetary and macroprudential policies can be mutually reinforcing and the ECB will internalize cross-border effects within the Banking Union (BU).
  - The independence of the ECB supports implementation of macroprudential instruments without undue political interference; national authorities should be provided similar operational independence and powers.
  - The ECB and national authorities should be responsible for a wider range of macroprudential instruments, beyond those included in the CRR/CRD IV.
- ESRB capacities and needs:
  - ESRB should be able to issue recommendations to the ECB as it does to national authorities.
  - ESRB needs legal powers, sufficient resources, improved capacity for identification, analysis and monitoring of EU-wide systemic risks, and access to timely information on financial markets and individual institutions.
  - ESRB’s coordinating role should be enhanced through closer cooperation with the ESAs.

### Review of the ESRB: Mandate, Organization, Outputs
- Mandate and accountability:
  - Responsible for macroprudential oversight within the EU to prevent or mitigate systemic risks, avoid widespread financial distress, contribute to smooth functioning of the Internal market, and ensure a sustainable contribution of the financial sector to economic growth.
  - Performs mandate under EU regulation and is accountable to the EU Parliament.
- Organization and constraints:
  - Complex organizational structure reflecting 27 member states; no legal personality; dependent on the ECB for administrative, logistical, statistical and analytical support.
  - Powers are non-binding; effectiveness depends on the “act or explain” mechanism.
  - Access to aggregate and disaggregated data from ESAs, ESCB, EC and national authorities; limited direct access to data on individual systemic institutions and supervisory data.
- Monitoring inputs and medium-term work:
  - Inputs: ECB risk surveillance note, risk analysis report, ECB white book, market intelligence reports (ECB and BoE), EC staff reports, ESAs dashboards, JC report on risks, ESRB Secretariat notes, and bottom-up questionnaires.
  - Topics covered in 2011–2012: bank funding and asset encumbrance, US dollar denominated bank funding, lending in foreign currencies, loan forbearance, sovereign exposures treatment, interconnectedness of CDS and interbank markets, stress testing, securities financing transactions, money market funds, high frequency trading, treatment of long-term guarantees in insurance.
- Main outputs and public recommendations:
  - Policy instruments: warnings and recommendations (confidential or public) addressed to EU, member states, EC, ESAs, or national supervisory authorities.
  - ESRB public recommendations issued (five), with issuance and publication details preserved as in source:
    - Recommendations on Foreign-Exchange Lending (issued 09/2011; published 11/2011; deadlines June and December 2012 and December 2013). Focus: improve resilience to currency risks, reduce asymmetric information, contain foreign currency lending countercyclically, improve incentives and risk pricing including supervisory actions.
    - Recommendation on US dollar funding (issued 12/2011; published 01/2012; deadline June 2012). Noted significant US dollar funding needs and maturity mismatches; recommended steps to mitigate US$ funding tensions and improve monitoring and data collection. (A non-public recommendation on US dollar funding was also issued.)
    - Recommendations on macroprudential mandates of national authorities (issued 12/2011; published 01/2012; deadline June 2013). Provided guiding principles for core elements: clear objectives, tasks and powers to overcome bias toward inaction; recommended giving a leading role to central banks.
    - Recommendation on funding of credit institutions (issued 12/20/2012; published 02/18/2013; specific timeline between 12/2013 and 12/2016). Addressed asset encumbrance, enhancement of institutions’ risk management and supervisory monitoring, deliberating on market transparency of asset encumbrance; touched on funding risks and aggregated feasibility of funding plans and identification of best practices for covered bonds.
    - Recommendation on money market funds (issued 12/2012; published 02/18/2013; deadline June 2014). Recommended MMFs move from constant to variable net asset value model, explicit liquidity requirements, enhanced public disclosure and reporting, and better information sharing between authorities.
  - Other outputs: ESRB Risk Dashboard (first publication 09/2012) to be updated quarterly; ASC reports and occasional papers on relevant topics.

### Effectiveness Assessment: Criteria, Findings, Communication, Implementation
- Assessment dimensions:
  - Prioritization and quality of risk warnings and recommendations.
  - Policy relevance, including through the publication of risk warnings.
  - Publication and implementation of recommendations by addressees.
  - Capacity to communicate its analysis of systemic risks.
- Effectiveness findings:
  - Risk warnings and recommendations were relevant and adequately prioritized.
  - Risk warnings were timely: issued when the crisis became systemic for the EU financial system.
  - Recommendations correctly identified emerging systemic risks and called for policy implementation, readiness to take action, and coordinated supervisory actions including recourse to backstop facilities.
  - The recommendation on US dollar funding pinpointed a key vulnerability that contributed to the seizure of wholesale funding markets at the end of 2011.
- Communication and public influence:
  - ESRB partly communicated warnings publicly; influence and timeliness of public statements difficult to assess.
  - Example: Press release of September 21, 2011 Board meeting referenced systemic nature of crisis and suggested recourse to “the possibility for the European Financial Stability Facility to lend to governments in order to recapitalize banks, including in non-program countries.”
  - Public position taken late through Sir Mervyn King’s introductory statement at December 22, 2011 General Board press conference, after EBA recapitalization exercise parameters were decided.
- Implementation status of the five recommendations:
  - All five recommendations were published within two months of issuance.
  - Foreign exchange lending: all EU member states, Norway and Iceland responded on the self-assessment part; some fixed exchange rate regime countries indicated measures should apply only to lending in foreign currencies other than their reserve currency.
  - US dollar funding: implementation “very good,” though further action may be needed in specific areas; some member states cited proportionality rule to not implement parts; implementation of non-public part linked to adoption of CRDIV/CRR legislative proposals.
  - National macroprudential mandates: extremely high responsiveness (all EU countries, plus Norway) in the first follow-up phase.
- Capacity and governance issues:
  - ESRB should develop capacity to communicate systemic risk analysis; risk dashboard is initial step and should be associated with publication of analysis as noted in ESRB regulation.
  - Determinants of effectiveness include ‘will to act’, enforceability of recommendations, policy impact of warnings, decision-making flexibility, and staff proposing work program in a bottom-up approach.
  - ESRB operates without legally-binding powers; the ‘act or explain’ mechanism has operated relatively well so far, but follow-up on risk warnings has been less evident.
  - Meeting frequency: quarterly may not be adequate in a crisis; consider simplified, more focused decision-making structure in emergencies.
- Role in crisis management:
  - ESRB has mandate to issue risk warnings during systemic crises but is excluded from crisis management.
  - Macroprudential tools for systemic crises (including exceptional liquidity provision) remain with central banks and other institutions.
  - ESRB should bring a macroprudential perspective to stress tests, in collaboration with ECB and EBA.

### Macroprudential Tool-Box: Principles, Instruments, Activation
- Design principles:
  - Instruments should mitigate channels of amplification, have built-in flexibility, and allow timing of activation/deactivation.
  - Some instruments target time dimension, others cross-sectional dimension; some both.
  - Consider diversity of countries and mortgage and financial structures across the EU.
- Basel III countercyclical capital buffer (CCB):
  - The CCB is necessary but not sufficient; should be complemented by more targeted instruments.
  - Limitations cited:
    - Long lags (up to one year) between announcement and implementation by banks, although under the draft CRD a short lag may be possible under extraordinary circumstances.
    - Releasing the buffer during downturns may conflict with microprudential principles.
    - The CCB may be a blunt tool when imbalances are sector-concentrated.
- Limits on LTV/DTI:
  - Contingent upper bounds on loan-to-value ratios, potentially complemented by an upper limit on debt-to-income ratios, can be useful to complement the CCB.
  - Implementation challenges: regulatory arbitrage and political economy considerations; evidence suggests LTV limits may be effective in mitigating house price appreciation and credit booms, with cross-country heterogeneity.
- Activation, triggers and governance:
  - Need ability to identify and measure systemic risks; clear activation criteria required.
  - Rules reduce uncertainty and anchor expectations, but discretion and judgment remain necessary.
  - Early warning indicators could include credit-to-GDP ratio or its deviation from trend (Gap measures), CDS spreads and other market-price default measures, non-core bank liabilities, and sectoral indebtedness measures.
  - Rule-based triggers should be transparent to avoid surprises; market-price-based triggers should minimize risk of downward spirals.
- Interaction with monetary policy:
  - Macroprudential instruments and monetary policy share transmission channels and may interact or conflict.
  - Where monetary policy is constrained (e.g., euro area), macroprudential instruments become relatively more important, particularly when financial cycles are not synchronized across countries.
  - Macroprudential instruments should not substitute for macroeconomic policies but can play a prominent role when monetary policy cannot ‘lean against the wind’ and fiscal policies are constrained.
- Complementary guidance for downturns:
  - Many instruments are better suited for upturns than downturns; tensions may prevent releasing capital buffers.
  - Structural or cyclical macroprudential instruments and liquidity provision by central banks remain essential during systemic crises.
- Proposal for a minimum set of instruments (all EU countries should have in place):
  - the CCB,
  - limits on LTV/DTI.
- Indicative complementary instruments:
  - Time varying exposures to specific sectors: time and sectoral contingent risk weights (examples: interbank lending, lending to sovereigns, corporates or households).
  - Funding of financial intermediaries: instruments limiting use of non-core funding to complement Basel III liquidity constraints.
  - Collateralized lending markets: contingent margins or valuation haircuts on securities used as collateral (e.g., repos); strong margining extended to OTC markets to incentivize central clearing of derivatives.

### Need for a Supranational Approach, ESRB–SSM Interaction, and Cross-Border Coordination
- Rationale for supranational approach:
  - EU financial systems are integrated; supranational macroprudential oversight is necessary to overcome cross-country externalities, leakages and ring fencing tendencies and minimize regulatory capture risks.
  - Strong EU-level coordination is needed to avoid regulatory arbitrage by financial institutions located outside the country setting macroprudential policies.
- ESRB’s roles and calibration functions:
  - Provide guidance on macroprudential policy framework (mandate, institutional arrangement, instruments) to operationalize macroprudential policy in all member states.
  - May play a role in calibration of instruments across EU countries, collaborating closely with the ECB for SSM countries, ensuring flexibility and convergence of practices.
  - Ensure reciprocity across EU countries and harmonization of national macroprudential frameworks; issue recommendations to reciprocate when home and host countries are not part of the SSM.
  - Validate member state decisions to set or modify macroprudential instruments when these decisions interrelate with EU standards (e.g., CRD IV/CRR).
  - Potential mechanism: use of asset-class-based risk-weights applying to all financial institutions irrespective of location.
- Interaction with other EU bodies:
  - ESRB–ESAs interaction important to mesh macroprudential and microprudential instruments and risk assessments; current data access rules constrain ESRB effectiveness.
  - ESRB depends on ECB for analytical, statistical, logistical and administrative support but may need to strengthen independent analytical capacity, especially after creation of the SSM.
  - ESRB should warn Commission when legislative action unduly constrains macroprudential policy and recommend legislative action to ensure common macroprudential toolkits across the EU.
- Impact of Banking Union (BU) and SSM:
  - Draft Council Regulation (2012/0242) assigns macroprudential powers to the ECB over banks under the SSM and should also cover financial holding companies and mixed financial holding companies.
  - ECB will not have macroprudential powers over other financial institutions.
  - ECB to have binding powers to use macroprudential instruments in the CRD IV/CRR and its toolkit should include instruments not in CRD IV (such as limits on debt-to-income and loan-to-value ratios) when a common macroprudential framework for SSM countries is in place.
  - National authorities retain macroprudential powers under the SSM in close cooperation with the ECB; modalities require informing and consulting the other party ahead of action.
  - Need to clarify accountability lines between the ECB and national authorities to prevent ‘accountability gaps’; governance must protect ECB independence.
  - Complementarity: ESRB will continue coordinating macroprudential oversight between SSM participants and those outside SSM; ESRB could continue development of the macroprudential toolkit; macroprudential oversight at EU level remains important for non-banks and markets not covered by the SSM.
  - ECB should implement warnings and recommendations issued by the ESRB in close cooperation with national authorities.

### Lessons, Empirical Findings and Illustrative Evidence
- Box 1 — Emerging Europe lessons:
  - Central and Eastern European countries used a rich set of macroprudential instruments in response to capital inflows and credit booms; common features included heavy use of measures to limit foreign currency lending.
  - Examples of high prudential requirements: reserve requirements on short-term deposits and foreign reached at their peak, 30 percent in Romania and 45 percent in Serbia.
  - Empirical evidence: studies typically found modest impacts on overall credit growth and temporary effects on capital flows; effectiveness limited by circumvention through cross-border lending or lending by non-banks; measures during upturns helped build buffers valuable during downturns.
- Box 2 — Advanced EU countries and euro area lending standards:
  - Little historical experience with macroprudential policies; limited empirical evidence on instrument effectiveness.
  - Model simulations of Basel III instruments imply modest impact on credit growth or house prices:
    - MAG interim report (August 2010) result cited: long-term impact on credit of a 2.5 percent increase in capital requirements phased in over two years is estimated to be between 2 and 9 percent.
  - Panel data econometric analysis suggests limits on LTVs would have economically significant impact:
    - Estimated net tightening of LTV required to reduce mortgage credit growth by 10 percentage points: 8 percent.
    - Estimated net tightening of LTV required to reduce house price appreciation by 10 percentage points: 25 percent.
    - As a benchmark, net tightening of lending standards in the euro area in the year following the collapse of Lehman Brothers was a net 117 percent.
  - Historical national example: Spain relied on dynamic provisioning to build capital buffers, but measures were weakened after 2004.

### Recommendations and Conclusions (key policy prescriptions)
- Strengthen national macroprudential frameworks:
  - Ensure clear objectives, tasks, and powers for national macroprudential authorities to overcome bias toward inaction; consider leading role for central banks.
- Expand instrument coverage:
  - Grant both the ECB and national authorities responsibility for a wider range of macroprudential instruments beyond CRR/CRD IV.
- Enhance ESRB’s coordinating role and powers:
  - Provide the ESRB legal powers, sufficient resources, and improved data access (including supervisory data where justified) to effectively identify and mitigate EU-wide systemic risks.
  - Devise formal coordination modalities between the ESRB and the SSM; permit ESRB to issue recommendations to the ECB.
- Improve information and analytical capacity:
  - Enhance data exchange arrangements and internal capacity to deliver timely identification, analysis and monitoring of systemic risks across sectors and borders.
- Coordination and legal consistency:
  - Ensure national use of macroprudential instruments is consistent with internal market objectives while protecting financial stability; coordinate to limit negative externalities and unintended effects on the single market.

*Prepared by Thierry Tressel (EURER) and Jianping Zhou (MCMSR), INTERNATIONAL MONETARY FUND, MONETARY AND CAPITAL MARKETS DEPARTMENT (Technical Note, March 2013).*

### 2013. The views expressed in this document are those of the staff team and do not necessarily reflect

### MACROPRUDENTIAL OVERSIGHT AND THE ROLE OF THE ESRB — TECHNICAL NOTE (MARCH 2013)

### Executive Summary
- Purpose of macroprudential policy:
  - Identify and reduce risks to financial stability along a time dimension and a cross-sectional dimension.
  - Use prudential instruments to (i) limit the buildup of financial imbalances; (ii) address market failures related to risk externalities and interconnectedness between financial institutions; and (iii) dampen procyclicality of the financial system.
- Current EU arrangements:
  - National authorities are responsible for macroprudential oversight of their national financial systems; adequate frameworks are lacking in many EU countries.
  - Coordination and internalization of cross-border spillovers is achieved at the EU level by the European Systemic Risk Board (ESRB) through a non-binding “act or explain” mechanism.
  - In December 2011, the ESRB issued recommendations on the macroprudential mandates of national authorities; guidance for establishing common macroprudential toolkits is being developed.
- Key institutional messages:
  - Macroprudential policies at the national level must be effective, efficient, aligned with the internal market objective, and protect financial stability.
  - The instrument set should be comprehensive enough to address multifaceted macroprudential concerns at national and EU levels; efficient coordination is needed to limit negative externalities and unintended effects on the single market.
  - Coordination is especially important given highly integrated EU economic and financial markets; ESRB lacks formal modalities to coordinate macroprudential policy at the EU level.
- Implications of the Single Supervisory Mechanism (SSM):
  - Within EMU, assigning macroprudential policy to both the ECB and national authorities is advantageous because monetary and macroprudential policies can be mutually reinforcing and the ECB will internalize cross-border effects within the Banking Union (BU).
  - The independence of the ECB supports a strong institutional framework and capacity to implement macroprudential instruments without undue political interference; national authorities should be provided similar operational independence and powers.
  - The ECB and national authorities should be responsible for a wider range of macroprudential instruments, beyond those included in the CRR/CRD IV.
- Role and capacities for the ESRB:
  - Modalities for coordination between the ESRB (EU macroprudential oversight body) and the SSM need to be devised.
  - The ESRB should be able to issue recommendations to the ECB as it does to national authorities.
  - To be effective, the ESRB needs legal powers, sufficient resources, improved capacity for identification, analysis and monitoring of EU-wide systemic risks, and access to timely information on financial markets and individual institutions.
  - The ESRB’s coordinating role should be enhanced through closer cooperation with the ESAs given the ESRB’s scope across the whole financial system.

### I. Introduction — Context and Purpose
- Background:
  - The ESRB was set up in January 2011 following the 2009 De Larosiere Report and the establishment of the European System of Financial Supervision (ESFS).
  - Reorganization responded to weaknesses revealed by the 2008 financial crisis, notably fragmented supervision of cross-border banks and limited macroprudential oversight.
- Challenges:
  - The ESRB began operations shortly before a systemic euro-area crisis driven by bank and sovereign risks and architectural weaknesses.
  - The ESRB must balance systemic risk warnings, policy recommendations, and development of a macroprudential toolkit, while coordinating within a deeply interconnected EU financial system.
  - The ESRB operates under constraints: complex decision-making, lack of binding powers, dependence on ECB-provided resources, limited direct access to supervisory data.

### II. A Review of the ESRB
- Mandate and role:
  - Responsible for macroprudential oversight within the EU to prevent or mitigate systemic risks, avoid widespread financial distress, contribute to smooth functioning of the Internal market, and ensure a sustainable contribution of the financial sector to economic growth.
  - Performs mandate under EU regulation and is accountable to the EU Parliament.
- Organization and constraints:
  - Complex organizational structure to ensure high-level representation of 27 member states.
  - No legal personality; dependent on the ECB for administrative, logistical, statistical and analytical support.
  - Powers are non-binding; effectiveness depends on the “act or explain” mechanism.
  - ESRB has access to aggregate and disaggregated data from ESAs, ESCB, EC and national authorities, but access to data on individual systemic institutions is limited and usually requires justification.
- Approach to monitoring and assessing systemic risk:
  - Inputs used: ECB risk surveillance note, risk analysis report, ECB white book, market intelligence reports (ECB and BoE), EC staff reports on systemic risks, ESAs dashboards, JC report on risks, ESRB Secretariat notes, and bottom-up questionnaires.
  - Medium-term risk work involves working groups with ECB, EC, ESAs, national authorities, and academics producing analytical papers for policy recommendations.
  - Topics in 2011–2012: bank funding and asset encumbrance, US dollar denominated bank funding, lending in foreign currencies, loan forbearance, regulatory treatment of sovereign exposures, interconnectedness of credit default swaps and interbank markets, stress testing, securities financing transactions, money market funds, high frequency trading, treatment of long-term guarantees in insurance.
- Main outputs:
  - Policy instruments: warnings and recommendations (confidential or public), addressed to EU, member states, EC, ESAs, or national supervisory authorities.
  - Risk warnings: confidential messages in 2011; public chair communications hinted at concerns; press releases after General Board meetings contained warning elements. ESRB did not issue statements on the BU but ASC took positions (July 2012 report on forbearance, resolution and deposit insurance; September 2012 report on EC proposal for BU).
  - Public recommendations issued (five):
    - Recommendations on Foreign-Exchange Lending (issued 09/2011; published 11/2011; deadlines June and December 2012 and December 2013). Focus: improve resilience to currency risks, reduce asymmetric information, contain foreign currency lending countercyclically, improve incentives and risk pricing including supervisory actions.
    - Recommendation on US dollar funding (issued 12/2011; published 01/2012; deadline June 2012). Noted significant US dollar funding needs and maturity mismatches; recommended steps to mitigate US$ funding tensions and improve monitoring and data collection. (A non-public recommendation on US dollar funding was also issued.)
    - Recommendations on macroprudential mandates of national authorities (issued 12/2011; published 01/2012; deadline June 2013). Provided guiding principles for core elements: clear objectives, tasks and powers to overcome bias toward inaction; recommended giving a leading role to central banks.
    - Recommendation on funding of credit institutions (issued 12/20/2012; published 02/18/2013; specific timeline between 12/2013 and 12/2016). Addressed asset encumbrance, enhancement of institutions’ risk management and supervisory monitoring, deliberating on market transparency of asset encumbrance; touched on funding risks and aggregated feasibility of funding plans and identification of best practices for covered bonds.
    - Recommendation on money market funds (issued 12/2012; published 02/18/2013; deadline June 2014). Recommended MMFs move from constant to variable net asset value model, explicit liquidity requirements, enhanced public disclosure and reporting, and better information sharing between authorities.
  - Other outputs:
    - ESRB Risk Dashboard (first publication 09/2012) with quantitative and qualitative indicators, to be updated quarterly.
    - ASC reports and publications: ASC reports on BU proposal (09/2012) and forbearance, resolution and deposit insurance (07/2012); occasional paper on money market funds in Europe and financial stability (06/2012); commentaries on institutional set-up (02/2012), macroprudential mandate of national authorities (03/2012), systemic risk due to “retailization” (07/2012), lending in foreign currencies (12/2012); a Chair letter to EU legislators on macroprudential tools in the CRR/CRDIV (04/02/2012); and two advices to ESMA in EMIR context on eligible collateral for CCPs and OTC derivatives by non-financial corporations.
- Data constraints and implications:
  - Limited direct access to supervisory data and data on individual systemic institutions may hamper systemic risk analysis that requires real-time supervisory data.

### III. Macroprudential Tool-Box for EU Countries
- Design considerations:
  - National macroprudential frameworks need to be in place to ensure effective follow-up on ESRB warnings and recommendations.
  - Instruments and authorities should be designed to limit buildup of imbalances, internalize cross-border spillovers, and preserve integrity of the single market.
- Institutional allocation:
  - Within EMU/BU, macroprudential powers should be shared between the ECB and national authorities to internalize cross-border effects and reinforce policy credibility through institutional independence.
  - National authorities should be granted a degree of operational independence and powers comparable to the ECB.
- Instrument scope:
  - The ECB and national authorities should have responsibility for a wider range of macroprudential instruments beyond those in the CRR/CRD IV.
- Minimum set proposal:
  - Guidance for establishing a common macroprudential toolkit is being developed (proposal for a minimum set of macroprudential instruments described in the paper).

### IV. Effective Macroprudential Oversight for the EU
- Role of the ESRB:
  - Act as EU-level coordinator to identify correlated risk exposures of major EU financial institutions, minimize negative spillovers from national policies, reduce regulatory arbitrage, and foster effectiveness.
  - Need to strengthen formal modalities to coordinate macroprudential policy at the EU level.
  - Should interact closely with ESAs given ESRB’s coverage of the entire financial system (banks, insurance, pension funds, market infrastructures).
- Interaction with the SSM:
  - The implementation of the SSM will affect macroprudential institutional settings.
  - Within SSM-participating countries, the ECB will have macroprudential powers and will closely coordinate with national macroprudential authorities.
  - The ESRB should be able to issue recommendations to the ECB as it does to national authorities and engage on macroprudential toolkits when the ECB takes on responsibilities.
  - Modalities for coordination between the ESRB and the SSM need to be devised.
- Capacity needs:
  - The ESRB needs legal powers, sufficient resources, improved capabilities for identification, analysis and monitoring of EU-wide systemic risks, and access to timely information on financial markets and individual institutions.

### V. Recommendations and Conclusions
- Strengthen national macroprudential frameworks:
  - Ensure clear objectives, tasks, and powers for national macroprudential authorities to overcome bias toward inaction; consider leading role for central banks.
- Expand instrument coverage:
  - Grant both the ECB and national authorities responsibility for a wider range of macroprudential instruments beyond CRR/CRD IV.
- Enhance ESRB’s coordinating role and powers:
  - Provide the ESRB legal powers, sufficient resources, and improved data access (including supervisory data where justified) to effectively identify and mitigate EU-wide systemic risks.
  - Devise formal coordination modalities between the ESRB and the SSM; allow the ESRB to issue recommendations to the ECB.
- Improve information and analytical capacity:
  - Enhance data exchange arrangements and internal capacity to deliver timely identification, analysis and monitoring of systemic risks across sectors and borders.

*Prepared by Thierry Tressel (EURER) and Jianping Zhou (MCMSR), INTERNATIONAL MONETARY FUND, MONETARY AND CAPITAL MARKETS DEPARTMENT (Technical Note, March 2013).*

### 12.      Criteria. Assessing the effectiveness of the ESRB framework and instruments is a

### _cr1370 - 12.      Criteria. Assessing the effectiveness of the ESRB framework and instruments is a

### Assessment dimensions
- Prioritization and quality of risk warnings and recommendations.
- Policy relevance, including through the publication of risk warnings.
- Publication and implementation of recommendations by addressees.
- Capacity to communicate its analysis of systemic risks.

### Effectiveness findings
- Risk warnings and recommendations of the ESRB were relevant and adequately prioritized.
- Risk warnings were timely: issued when the crisis became systemic for the EU financial system.
- Recommendations correctly identified emerging systemic risks and called for:
  - policy implementation,
  - readiness to take action,
  - coordinated supervisory actions including recourse to backstop facilities.
- The recommendation on US dollar funding of EU financial institutions pinpointed a key vulnerability that contributed to the seizure of wholesale funding markets at the end of 2011.

### Communication and public influence
- The ESRB partly communicated warnings publicly, but the influence and timeliness of those public statements are difficult to assess.
- Example communications:
  - Press release of the September 21, 2011 Board meeting referenced systemic nature of the crisis and suggested recourse to “the possibility for the European Financial Stability Facility to lend to governments in order to recapitalize banks, including in non-program countries.”
  - A public position was taken late through the introductory statement of Sir Mervyn King at the press conference of the General Board meeting of December 22, 2011, when EBA recapitalization exercise parameters had already been decided.
- The ESRB did not take explicit positions or issue risk warnings in relation to the proposal for a BU, limited partly by its mandate and diversity of opinions among Board members.

### Implementation of recommendations
- All five recommendations were published within two months of their issuance.
- Implementation status noted as satisfying so far:
  - On foreign exchange lending:
    - All EU member states, Norway and Iceland responded on the self-assessment part.
    - Some member states with fixed exchange rate regimes indicated measures should apply only to lending in foreign currencies other than their reserve currency.
  - On US dollar funding: implementation has been very good, while further action may be needed in some specific areas.
    - Some member states referred to a proportionality rule as a reason not to implement the recommendation.
    - Implementation of the non-public part has been linked to adoption of the CRDIV/CRR legislative proposals.
  - On national macroprudential mandates: extremely high responsiveness (all EU countries, plus Norway) in the first follow-up phase.

### Capacity and governance issues
- The ESRB should further develop its capacity to communicate systemic risk analysis:
  - Publication of a risk dashboard is an initial step; it should be associated with publication of an analysis of systemic risks as noted in the ESRB regulation.
  - Surveillance notes produced by the ECB complement the dashboard.
- Effectiveness may need strengthening; key determinants include:
  - ‘Will to act’ and enforceability of recommendations.
  - Policy impact of warnings.
  - Decision-making flexibility to facilitate timely communication and recommendations.
  - Staff proposing work program and systemic risk analysis to the Steering Committee to promote a ‘bottom-up’ approach, with ATC playing a technical role.
  - The ESRB operates without legally-binding powers; assess whether this constraint could impede future effectiveness.
  - The ‘act or explain’ mechanism has operated relatively well so far, but follow-up on risk warnings has been less evident.
  - Meeting frequency: a quarterly frequency may not be adequate in a crisis; consider a simplified, more focused decision-making structure in emergencies.

### Role in crisis management
- The ESRB has a clear mandate to issue risk warnings during systemic crises but is excluded from crisis management.
- Application of macroprudential tools is likely to remain asymmetric; tools for systemic crisis (including exceptional liquidity provision) remain with central banks and other institutions.
- The ESRB should bring a macroprudential perspective to stress tests, in collaboration with the ECB and the EBA, including when used for crisis management purposes.

### Macroprudential tool-box: principles and features
- Toolkit design principles:
  - Include a carefully selected set of instruments sufficient to address foreseeable systemic risks.
  - Instruments should mitigate channels of amplification, have built-in flexibility, and allow timing of activation/deactivation.
  - Some instruments target time dimension, others cross-sectional dimension; some both.
  - Consider diversity of countries and circumstances within the EU.
- Basel III countercyclical capital buffer (CCB):
  - The CCB is a necessary but not sufficient element; should be complemented by more targeted instruments for cross-sectional and time dimensions.
  - Limitations:
    - Long lags (up to one year) between announcement and implementation by banks, although under the draft CRD a short lag may be possible under extraordinary circumstances.
    - During downturns, releasing the buffer may conflict with microprudential principles (banks should not deplete capital when nonperforming assets are building up).
    - The CCB may be a blunt tool when imbalances are sector-concentrated.
- Limits on LTV/DTI:
  - Contingent upper bounds on loan-to-value ratios, potentially complemented by an upper limit on debt-to-income ratios, can be useful to complement the CCB.
  - Implementation challenges include regulatory arbitrage and political economy considerations.
  - Evidence from emerging markets and euro area countries suggests LTV limits may be effective in mitigating house price appreciation and credit booms, with benefits differing across countries by mortgage market characteristics.
  - Relaxing LTV limits in a downturn may create conflicts between macroprudential and microprudential perspectives.

### Activation, triggers and governance for macroprudential instruments
- A set of principles should ensure the ‘will-to-act’ and trigger use during upswings:
  - Ability to identify and measure systemic risks is key; clear activation criteria are required.
  - Rules reduce uncertainty and anchor expectations, but discretion and judgment remain necessary.
  - Decision to trigger activation is complex; costs of mistimed activation are asymmetric.
- Early warning indicators could include:
  - credit to GDP ratio or its deviation from a trend level (the Gap measures), at aggregated or sectoral level;
  - indicators for market volatility (CDS spread) or other price-based measures of default or distress;
  - indicators measuring bank vulnerability and potential funding stress, such as non-core bank liabilities;
  - sectoral measures (household or corporate indebtedness) to identify sectoral vulnerabilities.
- Rule-based triggers should be transparent to avoid surprises; market-price-based triggers should be designed to minimize risk of triggering downward spirals.

### Interaction with monetary policy
- Macroprudential instruments and monetary policy share transmission channels and may interact or conflict:
  - Monetary policy may need to respond to build-up of systemic risks, especially when macroprudential instruments are constrained.
  - In downturns, monetary policy decisions (including unconventional ones) may need to internalize financial stability considerations.
  - Uncertainty about effectiveness and side effects of macroprudential instruments motivates consideration of complementarities with monetary policy instruments.
- Principles for a monetary union:
  - Where monetary policy is constrained (e.g., euro area), macroprudential instruments become relatively more important, particularly when financial cycles are not synchronized across countries.
  - Macroprudential instruments should not substitute for macroeconomic policies but can play a prominent role when monetary policy cannot ‘lean against the wind’ and fiscal policies are constrained.
  - In the euro area, macroprudential instruments gain importance given lack of a fiscal union and transfers to cushion crisis impacts.

### Complementary guidance for downturns
- Many instruments are better suited for upturns than downturns.
- In downturns, tension between microprudential and macroprudential objectives and market pressures may prevent releasing capital buffers or relaxing other tools.
- Consideration of structural or cyclical macroprudential instruments may help correct fire sale externalities and dampen contagion effects; liquidity provision by central banks and unconventional measures remain essential during systemic crises.

### Proposal for a minimum set of macroprudential instruments
- All EU countries should have in place:
  - the CCB,
  - limits on LTV/DTI.
- Indicative complementary instruments could include:
  - Time varying exposures to specific sectors:
    - Time and sectoral contingent risk weights to target sectors where systemic risk is developing and allow cross-sectional differentiation.
    - Examples: contingent risk weights on interbank lending, lending to sovereigns, corporates or households.
  - Funding of financial intermediaries:
    - Instruments limiting use of non-core funding to address time and cross-sectional dimensions of systemic risk and complement Basel III liquidity constraints.
  - Collateralized lending markets:
    - Contingent margins or valuation haircuts on securities used as collateral (e.g., repos) to regulate secured funding and reduce fire sale risks.
    - Strong margining should be extended to OTC markets to incentivize central clearing of derivatives.

*Source: _cr1370 - 12.      Criteria. Assessing the effectiveness of the ESRB framework and instruments is a*

### 27.      Because EU financial systems are integrated, a supranational approach to

### _cr1370 - 27.      Because EU financial systems are integrated, a supranational approach to

### Need for a supranational macroprudential approach
- EU financial systems are integrated; a supranational approach to macroprudential oversight is necessary to overcome cross-country externalities, leakages and ring fencing tendencies and minimize the risks of regulatory capture at the national levels.
- Strong coordination of policy actions at the EU level is needed to avoid regulatory arbitrage by financial institutions located outside the country setting macroprudential policies.
- The establishment of the SSM, whereby the ECB is given macroprudential powers, requires designing modalities for coordination between the ECB and the ESRB.
- Asset class example: “sovereign bonds of country A or mortgages on properties of country B.” (text excerpt defining an asset class).

### Role of the ESRB
- The ESRB has a role in ensuring effective macroprudential oversight for the EU financial system as a whole, with close cooperation with the ECB.
- Core functions and recommendations:
  - Continue to provide guidance on macroprudential policy framework (including mandate, institutional arrangement, and instruments) to ensure macroprudential policy is operational in all member states.
  - May play a role in calibration of individual macroprudential instruments across all EU countries, collaborating closely with the ECB for SSM countries.
  - Calibration should ensure identified risk is adequately addressed, allow flexibility at the national level, and ensure convergence of practices across countries.
  - Instruments should be calibrated to mitigate risks effectively—without imposing undue costs on the financial sector—and aim for similar quantitative responses to systemic risks across national authorities.
- Cross-border coordination:
  - ESRB should play a forceful role in ensuring reciprocity across EU countries and in harmonization of national macroprudential frameworks.
  - National authorities may lack power over all lending within their territory, including lending by foreign bank branches; a mechanism is needed whereby home country authorities reciprocate host country macroprudential measures based on exposures of consolidated national financial institutions to the asset class of the host country considered.
  - Reciprocity is not required by legislation; if the ESRB is satisfied that host authority action is justified, it should issue a recommendation to other macroprudential authorities to reciprocate, when home and host countries are not part of the SSM.
- Validation and approval:
  - ESRB could validate member state decisions to set or modify macroprudential instruments when these decisions interrelate with EU standards (for example under CRD IV/CRR).
  - A potential solution to prevent arbitrage, leakages and negative externalities: use of risk-weights based on asset classes that apply to all financial institutions irrespective of location.
  - Use of macroprudential instruments over a particular activity could be referred by national authorities to the ESRB for approval so that all EU banks regardless of origin are covered.
- Institutional constraints and capacity:
  - Notwithstanding resource constraints, ESRB may also play a role in calibration but may need to strengthen analytical resources independently of the ECB.
  - ESRB has announced intention to establish coordination procedures when considered appropriate.

### Interaction with other EU bodies and the SSM
- Interaction with the ESAs:
  - Continued ESRB–ESAs interaction is important to ensure proper meshing of macroprudential and microprudential instruments and risk assessments.
  - Strong cooperation is needed in exchange of data and information; current regulations stipulate requests for detailed data from the ESAs must be ad hoc and motivated, and the ESRB (or the EBA) has no direct access to data—this constraint may hamper ESRB effectiveness.
- Dependence on the ECB and analytical capacity:
  - ESRB depends on the ECB for analytical, statistical, logistical and administrative support; close collaboration may remain important.
  - Because ESRB covers non-euro area countries and non-banks, it may need to strengthen its own analytical resources and acquire independent analytical capacity, especially after creation of the SSM.
- Interaction with the EU Commission:
  - ESRB needs to warn when legislative action by the Commission unduly constrains macroprudential policy action.
  - ESRB should recommend that the Commission take positive legislative action to ensure common macroprudential toolkits are available across the EU, potentially beyond instruments included in CRD IV/CRR.
- Impact of creation of a Banking Union (BU) covering at least euro area countries:
  - ECB macroprudential powers:
    - Draft Council Regulation (2012/0242) assigns macroprudential powers to the ECB over banks under the SSM and should also cover financial holding companies and mixed financial holding companies.
    - ECB will not have macroprudential powers over other financial institutions.
    - ECB is given binding powers to use macroprudential instruments in the CRD IV/CRR and its toolkit should include instruments not in CRD IV (such as limits on debt-to-income and loan-to-value ratios) when a common macroprudential framework for SSM countries is in place.
    - ECB independence and financial stability expertise would help implement macroprudential instruments against national political pressure while considering interactions with monetary policy; however, ECB could be subject to political pressures and disagreements with national authorities and needs ability to have a final say and act if needed.
  - Interaction between national authorities and the ECB within the SSM:
    - National authorities will be allowed to retain macroprudential powers under the SSM, in close cooperation with the ECB.
    - Either party that takes action needs to inform and consult the other ahead of time under modalities described in the EU Council draft regulation of the SSM.
    - Cooperation is critical to ensure flexibility to macro-financial developments, coherence and effectiveness of measures; mechanisms must ensure effective decision making and ‘will to act’.
    - Accountability lines between the ECB and national authorities need clarification to prevent ‘accountability gaps’; mechanisms to resolve conflicts of interest and overcome inaction bias must be designed; governance mechanisms must protect ECB independence.
  - Complementarity of ESRB and SSM:
    - Overlap between ESRB and ECB tasks in banking and euro area coverage should reinforce macroprudential oversight.
    - ESRB will continue coordinating macroprudential oversight between SSM participants and those outside SSM.
    - ESRB could continue to be tasked with development of the macroprudential toolkit.
    - Macroprudential oversight at the EU level remains important for non-banks and markets not covered by the SSM.
    - ECB should coordinate closely with the ESRB, and implement warnings and recommendations issued by the ESRB in close cooperation with national authorities.

### Recommendations and conclusions
- General principles:
  - Macroprudential policy toolkit should be applicable for both upturns and downturns of economic cycles:
    - During upturns: instruments need to prevent build-up of aggregate or correlated risks over time (e.g., aggregate or sectoral credit imbalances).
    - During downturns: instruments need to mitigate amplification and contagion effects arising from interconnectedness and procyclicality, most importantly to prevent fire sales of bank assets.
- Role of the ECB within the BU:
  - Within the BU, the ECB should have macroprudential powers because strong monetary policy and macroprudential policy frameworks can be mutually reinforcing and ECB is well placed for integrated systemic risk identification.
  - ECB should be responsible for a wider range of macroprudential instruments, going beyond those included in the CRR/CRD IV, as envisaged under the EC proposal for SSM.
  - Accountability and governance mechanisms must be in place to limit conflicts of interest and protect monetary policy objectives.
- Role and powers of the ESRB:
  - ESRB should remain responsible for macroprudential oversight at EU level and must have a clear mandate and legal powers to be effective.
  - Cross-border externalities and EU-wide financial stability concerns provide rationale for a supranational macroprudential supervisor.
  - ESRB is responsible for macroprudential oversight of non-banks.
  - Establishment of ESRB in January 2011 was a crucial step, but ESRB faces institutional constraints: complex Board decision-making (with 27 member states and EU/euro area institutions involved), no direct access to supervisory data, and no binding powers.
  - Considerations may be given to granting ESRB binding powers and providing more resources independent from the ECB.
- Coordination and legal consistency:
  - ESRB’s coordinating role should be enhanced through closer cooperation with the ESAs and the ECB as single supervisor for the BU.
  - ESRB–ESAs interaction remains important to mesh macroprudential and microprudential instruments and risk assessments.
  - ECB should implement warnings and recommendations issued by ESRB, or impose on national authorities to ‘act or explain’ when ESRB issues a warning directed to them; ECB should continue to provide support to the ESRB.
  - National use of macroprudential instruments must be consistent with internal market objectives (free movement of services and capital) while protecting financial stability; coordination is needed to limit negative externalities or unintended effects on financial stability and sustainability of the single market.

### Lessons from experience and empirical findings (Boxes)
- Box 1 — Emerging Europe lessons:
  - Many Central and Eastern European countries used a rich set of macroprudential instruments in response to capital inflows and credit booms.
  - Common features:
    - Credit and housing booms often fueled by foreign-exchange denominated or indexed loans.
    - Instruments included reserve or liquidity requirements, capital requirements, loan classification and provisioning rules, and measures to limit foreign currency lending or restrict credit eligibility.
    - Timing and intensity of instruments varied across countries; some tightened late, others relaxed during expansion.
    - Examples of high prudential requirements: reserve requirements on short-term deposits and foreign reached at their peak, 30 percent in Romania and 45 percent in Serbia.
  - Empirical evidence:
    - Studies typically found some modest impacts on overall credit growth and temporary effects on capital flows.
    - Limited effectiveness in some cases due to circumvention through cross-border lending or lending by non-banks (subsidiaries booking loans with parent or non-bank subsidiary to avoid host restrictions).
    - Some studies found domestic credit growth was significantly affected; others found dampening effects on house price appreciation.
    - Measures taken during upturns helped build buffers valuable during downturns.
- Box 2 — Advanced EU countries and euro area lending standards:
  - Most advanced economies have little experience with macroprudential policies; limited empirical evidence on instrument effectiveness.
  - Model simulations of Basel III instruments (e.g., countercyclical capital buffer) imply modest impact on credit growth or house prices.
    - MAG interim report (August 2010) result cited: long-term impact on credit of a 2.5 percent increase in capital requirements phased in over two years is estimated to be between 2 and 9 percent.
  - ECB Bank Lending Survey (BLS) insights:
    - Banks typically rely on non-price measures to contain credit supply or screen borrowers.
    - BLS reports net proportion of banks reporting net tightening of loan-to-value ratio (LTV) and contribution of cost of capital to tightening or loosening of lending standards.
    - These indicators provide indirect information to gauge potential impact of macroprudential measures on credit growth and house prices in the euro area.
  - Panel data econometric analysis:
    - Suggests limits on LTVs would have an economically significant impact on credit growth and house prices in EMU countries.
    - An instrument variable approach with controls for endogeneity of lending standards implies large impacts from net changes in LTVs.
    - Illustration: estimated net tightening of lending standards required to reduce mortgage credit growth or house price appreciation by 10 percentage points:
      - Required net tightening of LTV would be 8 percent to reduce mortgage credit growth by 10 percentage points.
      - Required net tightening of LTV would be 25 percent to reduce house price appreciation by 10 percentage points.
    - As a benchmark, net tightening of lending standards in the euro area in the year following the collapse of Lehman Brothers was a net 117 percent.
  - Historical national example:
    - Spain relied on dynamic provisioning as a measure to build capital buffers, but the measures were weakened after 2004.

*Italic: IMF staff report content as provided in the source document.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr1370.pdf_