Macroprudential Policy and Financial Vulnerabilities
IMF News, September 22, 2017
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- Authors: Tobias Adrian
- Published: September 22, 2017
Overview
- Speech by Tobias Adrian, IMF Financial Counsellor, delivered at the European Systemic Risk Board Annual Conference, European Central Bank, Frankfurt; "As Prepared for Delivery."
- Date: September 22, 2017.
- Central proposition: policymakers should care about sharp movements in financial conditions even when those movements do not crystallize into systemic disruptions of financial intermediation, because such movements can amplify economic volatility and adversely affect GDP growth.
Definitions and Goals of Cyclical Macroprudential Policy
- Financial stability:
- One definition: absence of systemic risk (disruption to financial system’s capacity to perform functions, especially to provide credit).
- Alternative: absence of sharp movements in financial conditions.
- Financial conditions: ease of financing across funding markets (credit, equity, money, foreign currency), reflecting pricing of risk and underwriting standards.
- Financial vulnerabilities: dimensions include leverage and maturity transformation across sectors (households, nonfinancial corporates, banking sector, shadow banking).
- Two-fold tasks of cyclical macroprudential policy:
- To lean against the buildup of financial vulnerabilities to reduce macro-financial amplification mechanisms.
- To build temporary buffers when financial conditions are overly easy and financial vulnerabilities are growing.
- Rationale: increasing resilience when conditions are easy is like taking out insurance; it is cheaper in booms.
Key Economic Frictions Driving Excess Variation in Financial Conditions
- Extrapolative expectations:
- Market participants (analysts, CFOs, housing professionals) extrapolate past returns into the future, expecting highest returns at peaks and lowest returns at troughs.
- Evidence cited: Greenwood and Shleifer 2014; Cheng, Raina, and Xiong 2014; Baron and Xiong 2017.
- Competition leading to excessive risk taking:
- Firms compete on return on equity (ROE); high ROE across firms forecasts high equity market returns in short run but forecasts equity returns negatively in the longer run.
- Incentives to increase ROE can produce excessive risk taking in aggregate (Adrian, Friedman, and Muir 2015).
- Leverage cycle and risk management practices:
- Heterogeneous beliefs: optimists dominate pricing in booms, pessimists in busts (Geanakoplos 2010).
- Agency frictions: managers’ limited liability creates temptation to invest in risky assets; investors impose leverage constraints that depend on measured risk (Adrian and Shin 2010, 2014).
- Prudent micro risk management can amplify leverage cyclicality in the aggregate.
Empirical Links Between Financial Conditions, Vulnerabilities, and GDP Risks
- Cyclicality:
- Pricing-of-risk cycles tend to be shorter than cycles in leverage or maturity transformation.
- Easy financial conditions often precede tightening; timing and durability vary across cycles.
- Volatility paradox (cited concept):
- At short horizons (up to 5 quarters), easier financial conditions forecast lower GDP volatility.
- At longer horizons, easier financial conditions signal higher GDP volatility as shocks are amplified by larger vulnerabilities.
- Note on index: the financial conditions index used is higher when conditions are worse (e.g., a credit spread, or market volatility).
- Transmission channels to output:
- Higher borrower defaults and weakening lending standards → intermediaries sustain losses → reduced credit supply (credit crunch).
- Credit crunch effects documented both in crises and outside full-blown banking crises (Nier and Zicchino, 2008; Claessens, Kose and Terrones, 2009).
- Tightening conditions can force deleveraging by borrowers (households, corporates), reducing investment and consumption (Guerrieri and Lorenzoni, 2017; Eggertsson and Krugman, 2012).
- Micro evidence:
- U.S. counties with larger household leverage increases from 2002 to 2006 showed sharper declines in durable goods consumption starting as early as the end of 2006 (Mian and Sufi 2009, 2014).
- Cross-country evidence: higher household debt-to-income ratios in 2007 associated with larger consumption drops between 2007 and 2012 (Riksbank Financial Stability Report, 2015).
- Historical relationship:
- Long-run historical data find a close relationship between build-up of credit during expansions and severity of subsequent recessions (Jorda, Schularick, Taylor, 2013).
Interaction with Monetary Policy
- Monetary policy impacts financial conditions and can offset changes in financial conditions, but has limitations relative to macroprudential policy:
- Monetary policy cannot induce changes in resilience (e.g., increasing buffers via CCyB).
- Monetary policy is less targeted across sectors; macroprudential tools can be sector-specific (e.g., residential or commercial real estate).
- Monetary policy’s primary mandate is price stability; tradeoffs with inflation objective may limit its ability to offset build-up of financial risks.
- At the lower bound, monetary policy may be constrained; relaxing macroprudential buffers can complement monetary easing and help preserve transmission (example: CCyB lowered after Brexit referendum; leverage ratio eased after September 11, 2001; Nier and Kang, 2016).
Timing, Indicators, and Implementation Considerations
- Forecast horizons of indicators:
- Leverage-type indicators (credit-to-GDP, household leverage, corporate sector leverage) tend to forecast downside risks at medium-term horizons such as 2 to 5 years.
- Household debt service ratio dominates at shorter horizons (Drehmann and Juselius, 2014).
- Market indicators (asset prices, financial conditions indices) tend to have shorter forecasting power, though they may contain information about medium-term imbalances.
- Term structure of financial stability risks:
- Different indicators span risks at different horizons; a term structure can guide which tools to deploy and when.
- Upcoming analytical chapters of the GFSR referenced as presenting tentative results on term structure (household leverage and financial conditions as predictors).
- Implementation lags:
- Prudential policy tools often take many months or up to a full year to change; not well suited to address rapidly changing risks in tightening phases.
- In response to adverse shocks, prudential tools can be released quickly (e.g., U.K. CCyB lowered after Brexit referendum; leverage ratio easing after September 11, 2001).
Policy Implications and Way Forward
- Objective refinement:
- Cyclical macroprudential policy may aim to mitigate sharp movements in financial conditions and the associated amplification of GDP downside risks even absent systemic intermediation failures.
- Monitoring:
- Monitoring financial conditions and vulnerabilities provides information on downside risks to GDP in the short and medium run and can guide policy stance.
- Tradeoffs and open questions:
- There are tradeoffs between mitigating medium-term risks and short-run activity distortions; quantifying these tradeoffs is an important research and policy agenda item.
- Not a call to target financial conditions directly:
- Policymakers should not target financial conditions per se; rather, use monitoring of financial conditions and vulnerabilities to guide the use of macroprudential tools and complement monetary policy.
Source: Tobias Adrian, "Macroprudential Policy and Financial Vulnerabilities," speech delivered at the European Systemic Risk Board Annual Conference, September 22, 2017.