Aligning Macro- and Microprudential Supervision

Abstract

This chapter discusses how to align macro- and microprudential supervision. In essence, to be effective, macroprudential analysis needs to feed into supervision at the micro-level. By incorporating macro risks, microprudential supervision contributes to the stability of the system as a whole. Conversely, macroprudential analysis needs to assess information from microprudential supervision in order to capture risks in systemic institutions, common exposures and nascent risks stemming from financial innovations. The chapter depicts the rise in systemic risk in recent years, spells out the distinction between macroprudential and microprudential supervision, and discusses how these interact. From a macro perspective on the crisis, it then draws ten key lessons for microprudential supervision.

Appendices

Annex 1: Ambiguity in Risk Assessments: Initial Assessments of Lehman’s Collapse

On 15 September 2008, the U.S. investment bank Lehman Brothers filed for bankruptcy. This triggered a sharp deterioration in market sentiment and precipitated a global systemic crisis. However, at the time of the decision whether or not to provide public support, the assessments of Lehman’s systemic nature were ambiguous, if not mistaken. The then prevailing uncertainty and ambiguity, as illustrated by selected quotes from editorials and leading economists, contrasts sharply with the systemic relevance that became evident in retrospect.

FT Editorial “Decisive Inaction”, 11 September 2008

The U.S. government has bailed out Fannie Mae and Freddie Mac. The market now seems to view Lehman Brothers (…) as next in line, with possibly more to come. It is time for the authorities to step back. Further such rescues should be avoided like the plague. It is the job of a government to save the financial system, not individual institutions. What has been done so far should be enough. Yes, banks are going through tough times. (…) Yet a sudden failure, such as that of Bear Stearns in March, seems unlikely, since liquidity is assured by the Federal Reserve’s decision to open the discount window to investment banks. This is buying damaged institutions time needed to come up with a private sector solution. That is what they must seek. Apart from offering short-term liquidity, the Fed and the Treasury should remain on the sidelines.

Willem Buiter (ft.com/maverecom), 15 September 2008

We may have a test as early as tomorrow morning (Tuesday, 15 September 2005), of whether there are significant systemic externalities from the failure of a household-name investment bank. I am optimistic that investment banks will turn out to be more like normal businesses than like the negative-externalities-on-steroids painted by the Fed and the Treasury during the Bear Stearns rescue.

Martin Wolf, “The end of lightly regulated finance has come far closer”, 16 September 2008

(…) Today, however, the authorities must also ask themselves whether what they are doing will make the system safer after the crisis is over. By these standards, the decision not to bail out Lehman looked right. (…)

Willem Buiter (ft.com/maverecom), 18 September 2008

(…) From a long-run financial stability perspective, the decision not to put public money behind a bail-out of Lehman Brothers also would seem to be the correct one. While it may well have increased short-term volatility and uncertainty, the deleterious effect of tax payer support for a bank that was not systemically significant on incentives for future investment, lending and borrowing would have been horrendous – an open invitation for excessive risk taking. (…)

Annex 2: Warnings Prior to the Crisis

In the run-up to the crisis, financial stability reports by multilateral institutions and central banks noted many of the risks that subsequently emerged, including increasing risk tolerance, search for yield, leverage, complexity and inter-linkages, as well as specific shortcomings in risk modelling. While these risks were on the radar screens, their relevance was subject to considerable uncertainty and supervisors evidently did not translate them into adequate mitigating actions.

BIS (Annual Report), 2002

Recent years (…) have also seen very strong growth in markets for credit derivatives (…). These markets have contributed to resilience in a number of ways. (…) Against this generally positive background, recent developments give rise to a number of potential concerns. First, to some degree, the growth of credit risk transfer instruments has been driven by regulatory arbitrage.(…) Second, interdependencies within the financial system have increased (…). Third, the development of complex financial instruments can make it more difficult to assess the overall level of risk and its distribution within the financial system. And finally, (…) the development of instruments that allow credit risk to be easily transferred can facilitate the build-up of leverage in the corporate sector.

DNB (Overview of Financial Stability), December 2005

Spurred by the low risk-free interest rate, the search for yield has continued, resulting in a high risk propensity among market parties. Illustrating the point is the high net inflow into hedge funds (about USD 35 bn worldwide in the first half of this year with total assets under management estimated at about USD 1,000 bn) and the strong demand for credit derivatives and other complex financial products. The financial institutions engaging in such transactions may be exposed to new counterparty and reputation risks.

IMF (Global Financial Stability Report), April 2006

(…) rating agencies have played a significant role in the acceptance of new products by investors, (…) heavily reliant on sophisticated quantitative modelling. Not surprisingly, the development of structured credit markets has coincided with the increasing involvement of people with the advanced financial engineering skills (…). In fact, (…) the application of such skills may have become more important than fundamental credit analysis. Some questions remain as to whether all investors fully understand the risk profile of these instruments, and how it differs from that of similarly rated corporate bonds. In particular, structured credit products are likely to suffer more severe, multiple notch downgrades, relative to the typically smoother downgrade paths of corporate bonds. Many investors (and their senior management) may therefore be negatively surprised during the next rating downgrade cycle.

Bank of England (Financial Stability Report), July 2006

The market for CDOs has grown rapidly in recent years. (…) The very complexity of these instruments makes it difficult for investors to determine precisely how exposed they are to particular risk factors. (…) Modeling difficulties can also lead to errors in hedging, so traders can find themselves with residual exposures that they thought they had hedged. In such situations, they may wish to reduce the residual exposure if credit losses rise. But with the liquidity of CDO markets still developing, especially for some of the more complex instruments, a shortage of secondary market liquidity could potentially amplify price movements in the event of a shock.

VaR measures have not risen as much as the rise in trading income might suggest (…) This could mean that firms are diversifying their portfolios more efficiently. But it may also support the widely held view that VaR is an imperfect measure of risk in the trading book (…) Given the lack of data on more innovative and complex instruments, it is possible that the models used to price them and evaluate their risks will turn out to be inaccurate during times of stress.