GovernanceRegulationThe Reality of Macro-prudential Regulations

The Reality of Macro-prudential Regulations

Macro-prudential regulation will become a reality that all financial firms will have to actively address. Elements of a macro-prudential regime are already in place in many jurisdictions. Coming up in 2016 we have the counter-cyclical buffer followed by the introduction of the leverage ratio in 2017; both tools of macro-prudential regulation. In the UK the interim Financial Policy Committee (FPC), situated within the Bank of England (BoE), has been active since February 2011. On 1 April 2013 the Financial Services Bill is due to establish formally the new UK regulatory structure which includes the FPC. In Europe we have the European Systemic Risk Board (ESRB) currently monitoring EU wide macro-prudential issues. These efforts stem from the Basel III capital adequacy initiative and are encouraged by the Financial Stability Board (FSB), International Monetary Fund (IMF) and, of course, the Basel Committee on Banking Supervision (BCBS).

There has been a marked increase in the amount of papers published on this subject by the regulatory authorities in 2012. The three that have been the most attention grabbing are the BCBS’s working paper 21, published in May, the European Systemic Risk Board’s (ESRB) risk dashboard paper published in September, and the UK HM Treasury consultation paper, which is part of the Financial Services Bill entitled ‘The Financial Policy Committee’s Macro-prudential Tools’, also published in September.

In this month’s post I will be asking: ‘What lessons can firms learn from what has been published so far, and how will some of these issues change a firm’s stress testing and risk oversight?

In order to address these questions, it is important to clarify what the three main sources of systemic risk are. These are given in the HM Treasury paper as:

  • Cyclical risks: The tendency for firms and households to underestimate risks when conditions are favourable and over-estimate when they are adverse.
  • Cross-sectional risk related to financial market structure: This includes poor information transmission; externalities, such as the impact of fire sales; market illiquidity; contagion; systemically important firms or groups; and financial market structural inadequacies.
  • Cross-sectional risk related to distribution of risk within the financial sector: Risks posed by activities or markets being highly concentrated in a small number of firms.

In order to achieve its purpose, the macro-prudential regulations can insist upon various means of control or requirements, which include:

  • Controlling the national counter-cyclical buffer.
  • Varying sectorial risk weights.
  • Imposing minimum leverage ratios.
  • Restricting distributions of profits and bonuses.
  • Time varying liquidity requirements.
  • Imposing and manipulating loan-to-value (LTV) and loan-to-income (LTI) criteria for financial firms.
  • Ability to impose higher margining requirement.
  • Forcing classes of trades through central counterparties (CCPs).
  • Changing the disclosure requirements of reporting firms.

For risk managers, business managers, treasurers, finance directors and others, which are primarily concerned with the safety and soundness of their firms, these expectations will clearly suggest new stress tests that firms will need to employ. As the triggers of the implementation of these measures are systemic, by definition firms will not normally be able to predict the implementation of any of these measures using internal metrics alone.

The key concern will be regarding what conditions a macro-prudential regulator will decide to use which measures, and what will be the impact on a firm in the short-to-medium term as a result of one or more of these policy tools being used. These points then lead to further considerations regarding how much and how fast changes to capital, liquidity, leverage and margins will be implemented.

The BCBS working paper 21 gives some interesting ideas regarding the detailed issues of macro-prudential modelling that have some direct implications for financial firms and their corporate treasury clients. It is difficult for the regulatory bodies to accurately understand how the different financial and economic factors interact with each other. Furthermore, the intervention of the macro-prudential measures will itself change the way these factors interact. As a result regulators will have to use their judgement, along with a wide range of quantitative modelling tools.

Issues that a macro-prudential regulator may look at include:

  • Estimates of the business/credit cycle.
  • Level ownership of overvalued assets.
  • Profitability, solvency and liquidity of firms/system under shock scenarios.
  • Impact of unexpected losses while the system is under stress.
  • Effects of credit migration on the system.
  • Impact of long term stress scenarios lasting up to five years and specific liquidity stress scenarios.

One of the findings of the BCBS paper was that the impact of some stress scenarios was underestimated as they did not properly consider the effect on interest margin, commission and fees, and trading income simultaneously. It should be noted that it has generally been found that the higher the granularity of data, the better results the model can achieve.

Liquidity stresses bring their own special concern. Generally firms and financial systems with higher leverage and maturity mismatches are far more sensitive to liquidity risk events. It was also found that for these firms the impact on short-term liabilities was more important than capital. Additionally, the raising of countercyclical capital on a highly leveraged system that was impacted, a liquidity shock can make matters worse.

Finally there will be reporting requirements levied on firms as a result of macro-prudential regulation. The ESRB risk dashboard gives the industry an idea of the kind of metrics that are being looked at. Credit risk, funding and liquidity risk, market risk, as well as traditional financial health indicators all feature. Not only may some of the information used not be within the current reporting framework, but macro-prudential regulators will inevitably have more requirements over time. As such this is yet another reason for firms to ensure that their information systems are as comprehensive and flexible as they can be, and built in a way that eliminates reconciliation as much as possible.

Overall there is a lot for firms to look at and consider. It is becoming increasingly important that firms not only cater for the impact of micro-prudential regulation but are able – on a firm-wide basis – to analyse the impact of any macro-prudential actions by the regulators. One always has to remember that financial regulators will be acting on this. The firms that are the least prepared are likely to have the worse outcomes in the future.

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