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Alfred Kammer's Remarks at the 6th ESRB Annual Conference
December 8, 2022
Thank you for inviting me to speak at this event.
The financial system is facing a challenging time. Russia’s war in Ukraine, the extreme rise in energy prices, high and persistent inflation, rapid monetary policy tightening, a slowdown in the US and China, the undoing of the peace dividend, and repricing of almost all financial assets – and the list goes on.
We can take comfort from the fact that the financial market functioned orderly and the European banking system remained strong in 2022. This is testimony to the quality of European regulators and supervisors. This is also a result of the reforms implemented since the global financial crisis, which included the introduction and widespread use of macroprudential policy tools.
But the next years may prove more difficult still. While we are only projecting a shallow recession for Europe for 2023, most risks are to the downside.
Against this background, it is appropriate to reflect on the role of macroprudential policy at the current juncture.
The “great moderation” exemplified a “divine coincidence”, where optimal monetary policy could simultaneously stabilize inflation and minimize unemployment. But it became apparent in the low-for-long interest rate environment that there was no divine coincidence between monetary policy and financial stability. The highly accommodative monetary policy that aimed to bring inflation up to target was at the same time encouraging risk taking and leverage and induced financial vulnerabilities.
Also today, there is no divine coincidence. Rapid monetary policy tightening that aims to bring inflation down to target is now boosting risk and term premia and it drains market liquidity. These financial stresses raise the specter of financial instability. Such instability would have historical precedents. For example, the Volcker disinflation of the early 1980s contributed to the Savings and Loan crisis in the US and to banking and sovereign debt crises in Latin America.
The first-line approach to resolving this conflict between monetary policy and financial stability is to let monetary policy focus on its inflation objective and use macroprudential policy to ensure financial stability. Macroprudential policy, however, may not be powerful enough, especially in high-pressure circumstances and when it comes to the less-regulated nonbank financial intermediation sector (NBFI).
Therefore, each policy – monetary and macroprudential – must be cognizant of its effects on the other. The ECB Monetary Policy Strategy Review recognized that monetary policy could affect the stability of the financial system and it viewed financial stability as a precondition for price stability.
With this, let me now outline our views on the desirable macroprudential policy stance in Europe.
Macroprudential policy in the EU should (1) lean towards maintaining its existing stance in the baseline, while (2) reflecting country-specific conditions and (3) being ready to accommodate should a downside macroeconomic scenario materialize.
Let me elaborate. I will start with the cyclical macroprudential tools, such as the countercyclical capital buffer (CCyB). These tools ensure that banks build up cushions in good times when the countercyclical capital buffer is “activated” and accumulated and use these cushions to continue lending during downturns when the buffer is “deactivated” and drawn down.
Unfortunately, most European countries could not accumulate countercyclical capital buffers quickly enough during the short post-pandemic recovery, and still have buffers at zero. But many countries have announced intentions to increase the countercyclical capital buffers later this or early next year, usually to around 1-2 percent. When these imminent increases are already incorporated into bank capital planning as is the case for France, Germany, or Sweden, they are almost as good as implemented.
For us, “maintaining the stance of macroprudential policy” means using current countercyclical capital buffer settings and announced plans as an anchor.
A loosening of buffers from these levels is premature, as financial excesses are still present and sometimes increasing. A marked tightening of buffers is not advisable either, as it may make macroprudential policy procyclical. If the credit cycle turns, the pressure on banks to comply with higher countercyclical capital buffer requirements may reduce credit supply and amplify a downturn.[1]
The other part of the macroprudential toolkit are structural borrower-based measures (BBMs), such as loan-to-assets (LTV), debt-to-income (DTI), and debt service-to-income (DSTI) limits in mortgage lending. Tighter borrower-based measures help build resilience during buoyant market conditions.
But we would urge caution on initiatives to loosen borrower-based measures to support financial conditions at the current stage of the cycle. Looser borrower- based measures may increase fragility and household financial risks in the still-imbalanced housing market. Additionally, empirical evidence confirms that the relaxations of borrower-based measures historically had little effect on financial conditions in downturns.[2]
In fact, given our clearer understanding of the spectrum of risks, countries could now augment loan-to asset and debt-to-income regulations by requiring banks to stress-test the debt service-to-income ratios on new mortgages to higher interest rates and lower disposable incomes – as is already done in some countries like Finland, Lithuania, Malta, Slovakia. The authorities could also issue recommendations or flow limits to avoid lending at high loan-to-asset and debt service-to-income ratios.
Countries can supplement the core macroprudential tools with “sectoral” measures, such as the systemic risk buffer (SyRB) to target specific risks, such as those in real estate. For example, Belgium, Germany, Lithuania, and Slovenia have recently imposed macroprudential capital charges on banks’ mortgage exposures, to better protect banks and the macroeconomy from adverse housing markets shocks. These sectoral measures are welcome, and the fact that they are targeted gives countries more flexibility in their implementation while limiting unintended consequences.
Our advice towards maintaining the existing macroprudential policy stance may, of course, change in a downside economic scenario. Then, the authorities can release (or, “deactivate”) the countercyclical capital buffer, consistent with its purpose of enabling bank lending in a severe downturn.
Let me make three further points.
First, it is critical to keep enhancing the macroprudential policy toolkit. If this toolkit is insufficient, a specter of a financial crisis may break down the separation between monetary and macroprudential policies, forcing a degree of “financial dominance” in policymaking.
In this context, we look forward to progress in the European Commission’s legislative review of the EU macroprudential framework, which started in 2021. This review could usefully include measures towards an earlier build-up of the countercyclical capital buffer to higher steady-state targets – a priority that has been underscored by recent events. Furthermore, the review could ensure that all member states should have access to basic borrower-based macroprudential tools to mitigate housing market risks and imbalances. The question of improving coordination and consistency of macroprudential policy across member states (while accounting for country-specific characteristics) also deserves analysis.
Second, not only monetary policy but also sound fiscal policy is important for the functioning of markets, as the recent British gilts market episode demonstrated. Markets can respond violently to unsustainable fiscal policies. There are other examples of fiscal policy that could impact financial stability, such as windfall taxes.
Finally, we should not lose sight of micro-prudential regulation. A timely and faithful implementation of internationally agreed Basel III bank capital standards would underpin global financial stability. Improving the regulation and supervision of non-bank financial intermediaries (NBFIs) is challenging, but critical. Given the global nature of this sector, coordination with the Financial Stability Board (FSB) and international standard-setting bodies is key. The current focus on liquidity risk management practices of non-bank financial intermediaries and on data gaps is the correct one.
With this, let me conclude.
The resilience of Europe’s financial system should not be taken for granted. The financial system withstood the pandemic and the war relatively well only thanks to hard, forward-looking work since the Global Financial Crisis by financial sector policymakers. Complacency is dangerous. Policymakers should see recent events as a wake-up call to prepare the financial system for whatever the future may hold.
[1] Indeed, while the cost of higher bank capital requirements may be modest in normal times, at about 0.1 percent of GDP for a 1 percentage point increase in bank capital, it can be substantially higher during tight financial conditions.
[2] According to the IMF MCM institutional view, BBMs could be relaxed when systemic risk dissipates. At present, systemic risk remains high, suggesting little scope to loosen BBMs.
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