How do we regulate to reduce systemic risk?

How can we avoid another financial crisis? The answer depends on when you’re asking. Before the global financial crisis, regulatory supervision assessed the risk potential of banks and other financial services companies primarily on a stand-alone basis. Post-crisis supervision seeks to also identify common vulnerabilities across the largest financial institutions in the system. Supervisors do so, mostly, because from 2008 they learned the hard way that such “macroprudential” perspective is necessary.

Today, those doing the supervising know they are no longer alone with this perspective. On Monday, May 18, 15 CEOs, Chairmen and senior executives of large financial institutions in Europe and North America endorsed a Statement in support of macroprudential policies, designed to reduce systemic risk. The statement was developed and published by the World Economic Forum in collaboration with Oliver Wyman as part of the Role of Financial Services in Society initiative, and elaborated in detail with financial leaders from the private and public sectors at the World Economic Forum Annual Meeting in Davos last January.

The signatories include leaders from HSBC, UBS, Zurich Insurance Group, BlackRock, Deutsche Bank and Swiss Re, as well as representatives from academia and civil society. They believe that macroprudential policies could contribute to reducing the risk of another financial crisis, and thereby benefit society and the economy. In the opinion of Douglas Flint, Group Chairman, HSBC, “One of the most significant features of the post-crisis retrospective was recognition of the potential role of macroprudential policy in identifying and addressing systemic risk, and providing a coherent framework for the prudential initiatives required to balance financial stability with sustainable economic growth”.

The type of policies the finance executives endorse can be grouped into two primary categories: structural policies that are in effect at all times, and time-varying policies intended to constrain excessive credit build-up in moments of exuberance of the cycle. The detection and mitigation of systemic risk lie at the crux of effective macroprudential policy-making.

With short-term interest rates in advanced economies hovering around zero, the addition of macroprudential tools to the regulator toolkit could become critical in reducing systemic imbalances. While low inflation and high unemployment foretell a continuation of accommodative monetary policy by central banks, risks emerging from the potential formation of asset bubbles in select asset classes are a growing concern that could be addressed through macroprudential regulation.

Macroprudential policies enable policy-makers to use a more calibrated approach to addressing excesses in specific asset classes or sectors of the economy. For example, time-varying tools, such as adjusting loan-to-value and debt-to income caps on real estate lending could help constrain excessive credit build-up and reduce the amplitude of a boom-and-bust cycle while allowing policy-makers to maintain low interest rates.

Policy-makers in emerging markets have used such policies frequently since the 1990s (e.g. Mexico, Singapore, Korea), while macroprudential policies have re-emerged in advanced economies since the financial crisis (in the UK, Sweden, New Zealand) as a way to address potential financial imbalances. “Macroprudential policies could support financial market stability and thus long-term investors’ ability to provide risk capital to the real economy,” said Michel Liès, CEO of Swiss Re. He added that “applying a one-size-fits-all approach, however, should be avoided and unintended consequences monitored.”

It is therefore essential, say the executives in their statement, to proceed with caution as such policies present a number of risks. As highlighted in the statement, current knowledge of the impact of macroprudential policies is still limited, especially as it relates to their effectiveness in complex financial systems such as the United States and Europe.

In addition, society at large will face significant trade-offs as monetary and macroprudential policies can have a dramatic distributional impact. All the while, regulators may lack the necessary political mandate to legitimize their policy decisions. As highlighted by Axel Weber, Chairman of UBS and former President of the German Bundesbank, who also endorsed the statement, the governance of macroprudential policies will be essential to the successful use of such tools.

While significant progress has been made to date, more needs to be done, according to the signatories of the statement. In particular, additional research is required to ensure that macroprudential tools are effective and do not generate unanticipated risks. An incremental approach involving prudent experimentation is suggested.

The statement is meant to contribute to the ongoing dialogue between policy-makers, industry leaders, academics and society at large on how to strike the right balance between financial stability and economic growth.

The Role of Financial Services in Society initiative, and more broadly the World Economic Forum, will continue to reinforce the contribution of the financial system to sustained economic growth and social development through a deeper process of public-private cooperation.

The statement to which this article refers is part of the broader “Role of Financial Services in Society” initiative of the World Economic Forum, run in collaboration with Oliver Wyman.  

Author: Matthew Blake is Head of Banking and Capital Markets, World Economic Forum. Anthony Charrie is Project Manager, Role of Financial Services in Society Initiative, World Economic Forum.  

Image: Silhouetted workers walk in front of office towers in the Canary Wharf financial district in London February 16, 2011. REUTERS/Luke MacGregor