Thursday, Apr 29, 2021

Integrating Microprudential Supervision with Macroprudential Policy

In this podcast, Barry Johnston discusses the TC Note Integrating Microprudential Supervision with Macroprudential Policy. He explains the reasons supervisory authorities should adopt a macroprudential approach and why the traditional approach to micro-prudential supervision has been ineffective in preventing financial crises.

Read the full transcript:

 

Demet Çanakçı:              

Hello, everyone. I am Demet Çanakçı, Program Director at Toronto Centre. This is the first podcast of Toronto Centre's Supervisory Guidance Note series, or TC Notes for short. TC Notes, are meant to provide practical guidance to financial sector supervisors, on key supervisory challenges.

My guest today is Barry Johnston, the author of the TC Note on, Integrating Microprudential Supervision with Macroprudential Policy, which was published last month. Barry, is a former assistant director of the International Monetary Fund, with more than 30 years experience in assisting countries with, financial sector policies, assessments and analysis. Among his many responsibilities during his career, Barry was chief of the IMF division that developed the IMF's Financial Sector Assessment Program.

Following the 2008 global financial crisis, he led the IMF, BIS, FSB team that developed the methodology, to assess systemically important financial institutions. Since retiring from the IMF, Barry has consulted for Toronto Centre, the IMF, the World Bank and national authorities on topics, including macroprudential policy, financial sector surveillance and assessments, financial crisis preparedness and resolution, financial crisis simulations, international regulatory codes and standards, and identification of systemically important financial institutions, and the bio goes on and on. Barry, thank you for taking the time to talk with us today.

Barry Johnston:              

Hello, Demet, it's a pleasure to participate in this Toronto Centre Podcast, and to speak to you on the topic of Integrating Microprudential Supervision with Macroprudential Policy. Now, one of the challenges in many of the companies that I worked in, is coordination among agencies... say between the Central bank and the supervisor, or between the supervisor and the resolution authority. There are of course, good reasons for this, as each agency operates under its own legal mandates and responsibilities. However, the financial stability challenges that authorities face are often highly complex, and difficult to compartmentalize, within a single agency, hence the need for collaboration across agencies. The title of Note, that we will discuss today... it uses one of the aspects of this collaboration. And that is how a, microprudential supervision and macroprudential policy, should be integrated for effective oversight of financial systems.

Demet Çanakçı:              

Thank you for authoring this important TC Note for us again, Barry. I wonder if you could start us of, by explaining what the macroprudential approach is, and how it differs from traditional microprudential supervision.

Barry Johnston:              

Demet, thank you for that question. Traditionally, microprudential supervision focused on the risks in individual financial institutions, markets or instruments. For example, bank supervision identifies a number of what are known as inherent risks confronting an individual bank, such as its credit risk exposures, liquidity risk, operational risk, and the arrangements to mitigate these risk such as is [capilatic 00:04:18] was beyond risk management practices.

Now, by contrast, macroprudential policy, focuses on the safety and soundness of the financial system as a whole, and the impact of the financial system on the real economy. This broader net risk is what is known as a systemic risk. The threat that financial sector failures will damage the real economy. And by this we mean people's income and their livelihoods, their employment prospects, their wealth, and their welfare. The microprudential approach, traditionally focused on one aspect, and that was preventing failures in individual institutions, markets or instruments.

But historical experience has shown, that is not sufficient to prevent broader failures in financial systems, or financial crisis, or systemic risks. In fact, the global financial crisis of 2008, was a dramatic illustration. Western countries were implementing a sophisticated system of microprudential supervision, but this did not prevent... and in some respects, it may even have contributed to the financial failures. So, a key lesson from the global financial crisis, was the need to develop a macroprudential approach, focusing on the identification and mitigation of systemic risk.

Demet Çanakçı:              

Thank you, Barry. Can you please elaborate on the reason why these two approaches, have to be integrated by the supervisory authorities, and what are the main elements of macroprudential's creation?

Barry Johnston:              

Well, as I mentioned at the beginning, one of the enduring challenges of oversight of financial systems, is collaboration among agencies. No single agency has the legal powers or the expertise, to address the complex challenges in financial systems. This is very much the case in the identification and mitigation of systemic risk. Because systemic risk involves elements of the inherent risks in individual institutions, markets or instruments, where the supervisors are in the lead, but it also involves risk elements, which are due to what are known as externalities.

Now these are risk factors, that are not evident on the balance sheet of an individual institution, but which can impact other financial institutions, and the stability of the financial system as a whole. Let me give you an example to illustrate... say if a financial firm A were to fail, the impact of that failure on another firm, financial firm B, the microprudential approach would traditionally focus on the risks on firm A's balance sheet, and would not take account of the potential knock-on effects to firm B.

Now the assessment of systemic risks requires that we understand both, the inherent risks, those are the risks on the firm A's balance sheet, and the risks from the knock-on effects, what we would call the externalities in this case, the implication of firm A's failure on the broader financial system. So in identifying these larger risks, the externalities is usually the responsibility of the macroprudential authority. So we need both the micro and the macroprudential approaches, and we need to integrate them to fully understand the risks, both to individual institutions, and to the financial system more broadly.

Demet, you also asked about the main elements of microprudential supervision. Now we probably don't have time in this podcast to go into all the details, but the central element is a microprudential or financial stability assessment. These are the type of assessments that I was involved in, as you mentioned introduction, in the IMF, as part of the financial sector assessment program. And there are also the types of assessments that are conducted regularly by national authorities. Now, these assessment teams, the teams that conduct the assessments are typically multidisciplinary, so they involve microprudential supervisors... and over the years, I worked very closely with many microprudential supervisors, but it also includes microfinancial experts.

These typically are economists or econometricians, used to modeling and assessing financial systems more broadly. So these financial stability assessments, examine both the risks and the individual institutions, individual markets, the instruments, and the arrangements to mitigate the risks in those individual institutions. And that's where the microprudential component comes in, but they also focus on the system-wide risks, the externalities, and that's the macroprudential component. And perhaps I could just add here that one of the important macroprudential considerations is, the examination of the interconnections between financial institutions, because these interconnections can amplify the impact of a flock on one financial institution, on the financial system more broadly.

And for example, an issue that our FSAPs identified quite early on was, the exposures and dependency of some financial systems on a few very large banks. And so these exposures were extreme that, if one of the large banks were to fail, the whole system would fail. As these banks were intimately involved in many aspects of financial intermediation, bonds, securities, money markets, as well as bank credit, deposit taking. And following the global financial crisis, these concerns with large institutions have been elaborated into the work on identifying... on mitigating the risk posed by what are known as systemically important financial institutions.

Another microprudential concern, are the potential feedback loops between the financial system and the real economy. And just to explain what I mean by the feedback loops... So in good times, when things are going well in the economy, asset prices tend to be rising and elevated, and credit in the banking system is expanding, and that's boosting economic activity, and it's also raising asset valuations, so it's giving a positive stimulus... the assets are giving a positive stimulus to the real economic activity.

However, the problem is, in bad times, the process goes into reverse. So as the economic activity and asset prices begin to decline, and loan delinquencies increase, the banks tend to withdraw credit from the financial system, at this acts to accelerate economic contraction. So these feedback loops contribute to what are known as the boom bust cycles in economies. So I will summarize [inaudible 00:13:06], all by way of saying that the macroprudential approach has to take a broader perspective than the risks in the financial system, than the microprudential approach.

Demet Çanakçı:              

Excellent. Thank you so much for this Barry. You mentioned systemic risk in your responses a couple of times, how can supervisors identify vulnerabilities to systemic risk? Can you briefly talk about the process?

Barry Johnston:              

Well, Demet, supervisors on their own, are not in a good position to identify all the exposures in the financial system. Because the supervisors tend to focus on... say a separate sect in the bank, so the insurance, or the securities market, so they're not looking across the financial system broadly.

And so to develop the systemic risk assessment, they will need to cooperate with the microprudential authority, which is conducting these broader assessments. I should mention here that when I talk about the microprudential authority, this might be assigned to the supervisor, the microprudential authority, or to another agency such as the Central bank or to a committee involving multiple agencies.

So when I speak of cooperation with the microprudential authority, this might be a separate department within the microprudential supervisor, or another agency, and different countries have developed different institutional frameworks, that really reflect their own national circumstances.

However, I think what is critical in all of these arrangements, regardless of how they've been set up institutionally is that, there is a need for collaboration between the micro and macroprudential authority. And this type of collaboration will involve, for example, information sharing and consultation, both in identifying the systemic risks, and how to respond to them.

Let me give you a couple of examples of what feedback, the microprudential supervisor might expect to receive. If the microprudential supervisor is designing some stress tests of some individual institutions, it should probably consult with the microprudential authority, to help identify the factors and the design of these stress tests.

For example, the feedback from the microprudential authority might include, the priorities on what institutions should the stress test be focused? How severe should they structure the stress test? For example, to take account of the types of feedback loops, that I've just mentioned, or the microprudential authority might give them advice on, what specific risks they want to include in the stress test.

For example, it might be on specific sectors, specific types of credit exposures, or maybe operational cyber risks, for example, if they considered they were of systemic concern.

And on the other hand, the microprudential authority, will have to be relying on the microprudential supervisors for detailed information on individual institutions, and that reflects the fact that the microprudential supervisors are, intimately knowledgeable of the institutions that they supervise, and there are also likely to be a confidentiality conditions, on sharing certain supervisory data with the microprudential authority.

So the microprudential, will be relying on the microprudential authority, for its assessment of individual institutions. I think this is all by saying that, the collaboration between the micro and macroprudential authority, is essential in systemic risk identification. And this will be true also, in designing the appropriate policy response to systemic risks.

Demet Çanakçı:              

Many thanks, Barry. We will get back to this collaboration issue in a couple of minutes, but before that, I have a follow-up question. How macroprudential approach helps supervisors mitigate the systemic risk? What kind of tools do they have at their disposal?

Barry Johnston:              

So, following the global financial crisis of 2008, there were several revisions to the international supervisory and regulatory architecture, to address systemic risks. I think we will probably discuss this a bit further, later in the podcast.

But among the revisions, was the attention to the identification and mitigation of risks, posed by systemically important financial institutions. Now, as you mentioned in your introductory remarks, I was deeply involved in the development of the approach, to identifying systemically important financial institutions. And the methodology that our team developed, was subsequently adopted with sector specific modifications, by the international supervisory standard setting bodies.

And as a result of this, the risks posed by the systemically important financial institutions, were incorporated into the microprudential supervisory frameworks. And a very specific example is the Basel III rules, that were developed in the wake of the global financial crisis, as these include additional capital charges, and more intensive supervision for systemically important... both globally systemically important banks, and domestically systemically important banks.

I might add that the Basel framework also includes what is known as, the countercyclical capital buffer, and that is designed to help address the risks from the feedback loops, that I mentioned earlier. I think these are two good examples of the specific tools, that supervisors have at their disposal to address systemic risks. Let me mention another area, where the macroprudential approach helps supervisors mitigate systemic risk, and that's in the targeting of their risk-based supervision. Now I think as our listeners probably know, risk-based supervision focuses on the most important risks, that's to say those risks that could cause maximum damage to users of financial services, or the financial system, and what we can characterize as systemic risk, which is exactly the object of our macroprudential assessments, which are assessing developing analysis of the most important systemic threats.

So the sources of systemic risks that could be identified might be the SIFIs that I've met... The systemic support institutions that I mentioned, or the microprudential assessments might be identifying the risk factors, such as there's excessive growth in the mortgage market, the housing market, or excessive leverage, or these two types of operational risks, or it might be the microprudential advisory might be identifying, say, risks posed by elevations in the financial system, the instruments or channels of intermediation. And so I think these macroprudential assessments provide information, that is extremely useful to the supervisors in prioritizing their risk-based supervision.

And I think the other advantage of the supervisors drawing on these macroprudential assessments is that, these assessments are normally prepared fairly frequently, annually or semi-annually. So they are a way for the risk-based supervisory agreements, to remain current and up to date, on the critical sources of systemic risks. I might also add that, supervisors are always... they're always confronting an evolving frontier of new risks. For example, on its clearly reflected in the Toronto Center's programs and it's podcast, and on its site, that supervisors are currently being asked to look at questions such as, sustainable development goals, and financial inclusion. They're been asked to examine the growth of Fintech and crypto assets.

There've being concerns about the cyber threats to the institutions that they regulate, and the risks posed by climate change, and certainly in the last year, they are being confronted with the COVID-19 pandemic risks. Now to supervisors, this is quite a daunting list of issues, and a focus on the systemic threats that these evolving channels pose to their national economies, can help them prioritize, to decide between these evolving frontier of risks, what's actually most critically important in their national context? And so they [inaudible 00:23:39] helps them, to decide between these competing demands, in allocating their very much scarce and sought after supervisory resources.

Demet Çanakçı:              

Thank you Barry. I couldn't agree more, it's quite a list for supervisors. Now back to the collaboration issue... as you mentioned in your responses and in the TC Note in more detail, systemic risk is a system-wide concept. So coordination among the authorities is the key to success. How can this be handled in practice, given different mandates of the national authorities?

Barry Johnston:              

Demet, this is a very good question. In my experience, it's not simply a question of mandates, but these are obviously important. Coordination and cooperation among agencies involves people, that has great strengths, but also in some circumstances, can create weaknesses. For example, I have observed situations where there were limited formal arrangements for coordination, but informal cooperation among agencies was excellent, but unfortunately I have also observed the reverse.

So, the practical question you raised is, I think very important. Well, some of the elements that I have observed in my experience, that can help smooth the collaboration and coordination... The way I do, and again, emphasize those involve people, about some of the factors are, the composition of the governing boards of the different collaborating organizations. Do they have representation from the other cooperating agencies? Also, the culture that is established by the senior management, in the organizations, in their own communications and consultations.

And, what can also help is this secondment or transfer of staff, from one agency to another, so they can understand the internal culture of the cooperating organizations, and how best to communicate and coordinate effectively with it. ,In fact, in my own career, when I started work at the bank of England, they seconded me first to the bank for international settlements, and later in my career with the bank, they seconded me to a British treasury, so I can speak to the benefits of having secondments, to strengthen your knowledge of how other organizations work, and to help you collaborate with them.

But I mentioned another important aspect is, for the institution to appreciate and practice, the critical importance of coordination and collaboration. This often requires actual experience, you have to be really in the front line and experience why you need to cooperate, and what are the pitfalls of not doing it? But one way of bringing this practical experience, is through simulations, and the Toronto Centre does this as part of its crisis management simulations, because these simulations help to highlight the importance of coordination and cooperation.

And indeed in the simulations that I've been involved in with the Toronto Centre... one of the key learning notes that participants nearly... I would say always identify at the end of our simulations is, this idea of coordination and cooperation, how important this is, how critical it was to come to the solutions that were needed, to deal with the challenges that we had created during the simulation.

Demet Çanakçı:              

Thank you very much for sharing your experiences, Barry. That was very useful. Now, moving on to the regulations, following the global financial crisis, the international standards setters also modified the supervisory core principles. In your opinion, what are the most important revisions in terms of improving microprudential supervision?

Barry Johnston:              

Demet, I think I would mention two revisions that I consider most important. The first would be the revisions to the supervisory core principles, and by those, I mean, the ones developed by the Basel committee for banking, the international association of insurance supervisors, for insurance and the international organization of securities commissions for securities. And the revisions to their core principles, post global financial crisis, was to recognize the mitigation of systemic risks, as a core objective of microprudential regulation.

Prior to the revisions, the regulatory frame was focused on mitigation of the inherent risks that we discussed, those are the risks on the balance sheets of the individual institutions, or individual markets or instruments, but the revisions following the global financial crisis significantly modified this approach, and incorporated new elements to take account of the sources of systemic risks, and to adopt policies to mitigate them. So this would be the first, I think the major that I had emphasize. The second one was, I think the development by the financial stability board of... what are known as the key attributes of effective resolution regimes for financial institutions, and their adoption as a new international standard.

Now these key attributes provide a framework to resolve failing financial institutions, without creating systemic risk, and avoiding moral hazard, and the fiscal costs of government bailouts. And by allowing for orderly resolution of financial institutions, the key attributes provide a framework for disciplining financial institutions, even large ones. And this provides an important additional degree of freedom for microprudential supervisors, and it has helped to reduce the moral hazard in the financial system. And I would say, the more supervisors can rely on market discipline to price and manage inherent risks, the more they will be able to turn their attention and supervisory resources, to mitigation of systemic risk.

Demet Çanakçı:              

Thank you very much Barry, I think this is a good place to conclude the conversation. It's fascinating, I have learned a lot about the co-dependency of micro and macroprudential supervision. Do you have any final comments?

Barry Johnston:              

No, I have no final comments Demet, I would just only wish to thank you, the Toronto Centre, for hosting this podcast. And I look forward to collaborating further with the Toronto Centre, in the future.

Demet Çanakçı:              

Thank you Barry. And many thanks for being such a strong supporter of Toronto Centre, much appreciate it. I encourage participants to read the TC Note, which can be found in the resource center on our website.

I'm here today with Barry Johnston, and you have been listening to Toronto Centre's first episode of TC Notes Podcast series. Thank you for joining us today, and stay tuned for the next episodes.