Macroprudential regulation

Panel contribution by Luis de Guindos, Vice-President of the ECB, at the Banque de France / Sciences Po Financial Stability Review Conference 2021 “Is macroprudential policy resilient to the pandemic?”

1 March 2021

Introduction

• About one year ago, the euro area was hit by a major unexpected shock: the COVID-19 pandemic.
• While this health and economic crisis has had, and continues to have, a severe impact on European citizens and businesses, the euro area banking sector has so far weathered the crisis well.
• Rather than being part of the problem, it has been part of the solution.
• The banking sector has managed to support the economy through continued lending, including to the sectors most affected by the lockdown measures.
• Compared to past crisis episodes, there are two main reasons why banks have played a different role in this crisis.
• First, in terms of capital and liquidity, the euro area banking sector was much better prepared than it was before the great financial crisis.

Macroprudential space

• When the pandemic struck in early 2020, macroprudential authorities in the euro area had little room for manoeuvre to release macroprudential capital buffers.
• There seems to be a growing consensus on the need to reassess the current balance between structural and cyclical buffers and to create more macroprudential space that could be used in a system-wide crisis if needed.
• I strongly welcome this development and encourage further work and discussions on this important topic, including on specific ways to create macroprudential space.
• First, the creation of macroprudential space should be capital-neutral.
• Second, the additional macroprudential space created in this way needs to have strong governance in order to ensure that capital buffers are released in a consistent and predictable way across countries when facing severe, system-wide economic stress.
• Third, considerations to create macroprudential space should focus on options that ensure continued compliance with applicable international standards set by the Basel Committee.
• The capital conservation buffer would be a natural candidate for creating macroprudential space if it was made releasable in a context where these principles were adhered to.

Complementarities between macroprudential and monetary policy

• The second challenge relates to complementarities between macroprudential and monetary policy.
• [2] For instance, during phases of risk build-up, effective macroprudential policy can unburden monetary policy with respect to financial stability concerns.
• Similarly, during phases of risk materialisation, releasing macroprudential policy buffers can support monetary policy via the impact on banks credit supply.
• Exploiting the complementarities between monetary and macroprudential policy requires a structured approach to the interaction between the two policy areas.
• Under the current institutional architecture of the monetary and banking union, monetary policy and microprudential policy decisions for significant institutions are taken centrally in the euro area.
• A coordinated macroprudential policy response across the euro area is vital to strengthen the impact of policy actions and to support monetary policy, for instance through the release of macroprudential buffers in a system-wide crisis.

Conclusions

SPEECH

The euro area financial sector in the pandemic crisis

Keynote speech by Luis de Guindos, Vice-President of the ECB, at the 23rd EURO FINANCE WEEK

• Frankfurt am Main, 16 November 2020 [updated on 16 November 2020 at 10:50 CET] I am honoured to open the 23rd Euro Finance Week.
• My remarks today will focus on two main issues.
• First, I will provide an overview of the current economic situation in the euro area, and focus on how the pandemic has amplified existing vulnerabilities in the financial system.

An uneven recovery across sectors and countries increases the risks of fragmentation

• While the gradual relaxation of social distancing measures created a strong yet incomplete rebound in economic activity in the third quarter, that recovery started losing momentum.
• With the future path of the pandemic highly unclear, risks are clearly tilted to the downside.
• While its impact on the euro area economy should be contained, such an outcome could amplify the macro-financial risks to the euro area economic outlook.
• The severity of the pandemic shock has varied greatly across euro area countries and sectors, which is leading to uneven economic developments and recovery speeds.
• Output losses and the expected recovery will be significantly more uneven across sectors than in previous crises, as a result.

The pandemic has amplified existing vulnerabilities in the euro area financial system

• This would result in a credit crunch for non-financial corporations and translate into a sharp rise in company defaults.
• The pandemic has also weighed on the long-term profitability outlook for banks in the euro area, depressing their valuations.
• From around 6% in February of this year, the euro area median banks return on equity had declined to slightly above 2% by June.
• This profitability outlook is reflected in rock-bottom bank valuations, with the stock prices of euro area banks recovering less than the overall market over the summer.
• And despite these efforts, loan loss provisions of euro area banks, could still be below needs suggested by fundamentals.
• Under the baseline scenario, credit losses would continue increasing and the solvency position of the significant euro area banks would deteriorate by mid 2022.
• This again leaves the sector vulnerable to large redemptions in the event of any renewed stress in the financial markets.
• Moreover, financial vulnerabilities were aggravated by investment funds continuing to increase their exposure to credit risk.

Policy considerations for the banking sector

• Starting in March 2020, European and national prudential authorities took swift and extraordinary policy measures to address the impact of the pandemic on the euro area banking sector.
• Over the medium term, a rebalancing between structural and cyclical capital requirements is desirable to create macroprudential policy space.
• But we must not lose sight of key structural weaknesses in the European banking sector that were evident even before the crisis hit.
• Consolidation via mergers and acquisitions is another potential avenue for reducing overcapacity in the sector.
• Finally, we also need to make progress on the banking union, which unfortunately remains unfinished.
• We also need to facilitate the flow of capital and liquidity within banking groups, subject to adequate financial stability safeguards and establish the third pillar of banking union the European deposit insurance scheme.

Policy considerations for the non-bank sector

• Only the decisive policy action by central banks helped stabilise financial markets and improve liquidity conditions across a broad range of markets and institutions.
• Policies should address system-wide risk and reflect the fact that the sector comprises a diverse set of entities and activities.
• This would ensure that the non-bank sector is better able to absorb shocks in the future.
• Authorities should be equipped with a range of policies to effectively mitigate the build-up of risks during periods of exuberance.
• At the same time, it contributed to amplify the liquidity pressures in the system for non-bank financial intermediaries in particular.

Conclusion

Let me conclude.

• Prepared by Markus Behn, Elena Rancoita, and Costanza Rodriguez dAcri [1] This article discusses the capital buffer framework under BaselIII, with particular focus on the issue of buffer usability.
• Capital buffers are a key element of the regulatory framework, inter alia aimed at enabling banks to absorb losses while maintaining the provision of key services to the economy.
• It also calls for a medium-term rebalancing between structural and cyclical capital requirements, as a greater share of capital buffers that can be released in a crisis would enhance macroprudential authorities ability to act countercyclically.

1 Objectives of the capital buffer framework

• The capital buffer framework for banks is one of the main new elements of the Basel III regulatory framework.
• Capital buffers play an important role in this respect, as they are inter alia meant to mitigate procyclicality by acting as shock absorbers in times of stress.
• In the European framework, these buffers include the capital conservation buffer (CCoB), the countercyclical capital buffer (CCyB), buffers for global and other systemically important institutions (G-SIIs and O-SIIs) and the systemic risk buffer (SyRB).
• [2] In recent years, banks in the euro area have increased their capital ratios considerably and built up capital buffers, in line with the timelines provided for in the framework.
• Starting in 2016, capital buffer requirements, such as the CCoB (in light green) and the buffers for G-SIIs and O-SIIs and the SyRB (in dark green), were phased in, increasing the total amount of required capital.
• Chart1 Evolution of bank capital ratios and their components in the euro area (percentages of risk-weighted assets)

2 Possible trade-offs between the objectives of the buffer framework

• While the various elements of the capital buffer framework are generally complementary, trade-offs and conflicts between them may exist in times of systemic stress.
• Over the medium term, the buffer framework aims to ensure a sound and stable banking system that is able to continuously provide key services to the economy.
• Following the materialisation of a systemic shock, however, when a number of banks may have to use the buffers as envisaged by the framework, conflicts between the objectives of the framework could arise.
• Maintaining lending at the onset of a crisis may help to reduce the amount of capital that will be needed to absorb losses further down the road.
• Thus, fewer losses would have to be absorbed in total, which mitigates the possible trade-off between the two objectives (see the article entitled Buffer use and lending impact in this issue of the Macroprudential Bulletin for a quantitative simulation of this effect).
• Importantly, for this benefit to materialise, it is necessary that the banking system collectively takes this positive externality into account in its lending behaviour.

3 The concept of buffer usability

• As evidenced by the crisis of 2007-09, a shortfall in credit supply (a credit crunch) can have material negative effects on GDP growth.
• Similarly, the economy may be negatively affected if banks withdraw from other activities that are economically relevant (e.g.market making, ownership of central counterparties, lending to other banks).
• Excessive deleveraging may occur in situations where banks want to avoid or mitigate deteriorations in their capital ratios, and usable capital buffers can help to prevent such undesirable behaviour.
• As noted above, such deleveraging can be harmful for the economy if it becomes excessive, which is why the buffer framework aims to ease the pressure to adjust.
• In addition, banks are explicitly allowed to operate below the remaining capital buffer requirements when needed, subject to automatic restrictions on distributions.
• Buffers are considered usable if banks are willing to operate within the CBR, while avoiding undesirable adjustment actions such as excessive deleveraging.
• First, the materialisation of losses reduces the amount of capital that is available to the bank, i.e.the numerator of the capital ratio.
• [4] In both of these cases, buffers are considered usable if banks do not take undesirable adjustment actions (such as excessive deleveraging) to avoid a breach of the buffer requirements or to shorten its duration.

4 Possible impediments to buffer usability

• Market-based factors that may undermine the usability of capital buffers include the following:
  • Higher funding costs: Banks’ funding costs could increase or the availability of funding could become restricted once capital ratios start to decline (owing to the increase in perceived default risk). This effect may be exacerbated by the potential stigma when a breach of the CBR becomes public knowledge. It could also be further aggravated if the decline in capital ratios is associated with an expansion in lending, as, in times of crisis, the latter may be associated with excessive risk-taking.
  • Possible rating downgrades: Banks’ capital positions are an important factor in their credit rating, which affects banks’ access to and cost of funding as well as their reputation more broadly.[5] As for the funding cost factor, rating downgrades may occur either because of the negative signal associated with a breach of the CBR or because of the decline in capital ratios (and the increase in default risk) more generally.
• Regulatory and prudential factors include the following:
  • Distribution restrictions: Banks would face automatic restrictions on distributions when operating below the CBR. These restrictions on dividend, bonus and AT1 coupon payments would have negative effects on investors and bank executives. To maintain a strong relationship with investors, and also to avoid triggering the market factors outlined above, banks may prefer to deleverage rather than face automatic restrictions. Concerns about distribution restrictions may be particularly relevant for certain instruments, such as AT1 bonds, since market intelligence suggests that a cancellation of a coupon payment could be seen as a particularly adverse signal – even if coupon payments are contractually set to be discretionary.
  • Existence of other regulatory/prudential requirements: Other regulatory and prudential requirements – such as the leverage ratio or the minimum requirement for own funds and eligible liabilities – may reduce the usability of the CBR if they become more binding than the risk-based requirement. The use of buffers may also be curtailed if banks wish to maintain a sufficient margin above the regulatory minimum requirement within the risk-based framework (i.e. the sum of Pillar 1 and Pillar 2 minimum requirements).
  • Concern and uncertainty about prudential authorities’ follow-up and their willingness to tolerate buffer use: Banks might want to avoid the increased supervisory scrutiny associated with a breach of the CBR, and such scrutiny is likely to increase the closer the bank comes to the minimum requirement, raising concerns regarding its viability. In addition, banks may face uncertainty with respect to the time they would have to restore their capital buffers after the initial breach of the CBR, unless this is clearly communicated by the supervisor. Finally, banks may be concerned about the speed of capital buffer increases once the crisis is over and conditions normalise. Such concerns may be more relevant at times when profitability is low or access to capital markets is constrained.
  • Many of these factors relate to some form of stigma, attached either to a breach of the CBR (potentially further strengthened by the associated restrictions on distributions) or to operating with capital ratios below market expectations.
  • Collective action problems may arise if individual banks fail to properly consider the social benefit of stabilising the economy and the banking sector through the use of the buffers.
  • Uncertainty over the future path of the crisis or existing vulnerabilities in the sector could also play a role.
  • In addition to the issue of stigma, which is about perception, there could also be difficulties relating to constraints stemming from other regulatory requirements and supervisory tolerance of buffer use.
  • Prudential and regulatory factors are one determinant of these target ratios, as banks may want to allow for sufficient (varying or constant) management buffers above the threshold of regulatory intervention.

5 Policy implications of the COVID-19 crisis

Initial policy reaction in response to the crisis

• European and national authorities took swift measures to address the impact on the financial sector of the coronavirus pandemic.
• Several euro area macroprudential authorities (including central banks and banking supervisors) reduced macroprudential buffer requirements, releasing more than 20billion of CET1 capital held by euro area banks.
• [6] Specifically, in several of the countries where the CCyB was positive or was in the course of being activated, authorities reduced the requirement or halted its activation.
• In some countries, the SyRB was also fully released or lowered, while buffers on selected O-SIIs were reduced.
• Starting on 12March 2020, ECB Banking Supervision announced a number of temporary capital and operational relief measures in response to the COVID-19 shock.
• In addition, banks were encouraged to avoid excessive procyclical effects when applying International Financial Reporting Standard (IFRS)9.

Reflections on the way forward

• Clear and convincing communication can help overcome supervisory impediments to buffer usability and, possibly, also market-based impediments.
• In their communications, prudential authorities have repeatedly stated that using buffers today would be in line with the expectations set out in the regulatory framework.
• This message clarifies authorities expectations and can help overcome impediments to buffer usability stemming from uncertainty about supervisory follow-up action.
• Moreover, clear and credible communication on the use of buffers also helps inform the expectations of financial market participants, thereby limiting the possible stigma associated with banks use of buffers.
• Shaping agents expectations on the path towards replenishing used buffers will also help to enhance their usability.

Implications for future policy design

• A possible way to address this issue would be to enhance the role of releasable capital buffers within the capital framework.
• Following the release of a specific buffer requirement, banks can operate with lower capital ratios without breaching the CBR and without being subject to automatic restrictions on distributions.
• The limited availability of releasable capital buffers in the COVID-19 crisis constrained macroprudential authorities ability to act countercyclically.
• Moreover, unless accompanied by clear communication, the release of structural buffers could impair the credibility of the macroprudential framework and generate uncertainty over the future application of the buffers.
• Any adjustments to the framework would have to ensure that all of the buffer frameworks current objectives continue to be met.
• For this reason, a clear framework for the timely restoration of releasable elements in the capital stack would be needed.

6 Conclusion

• It explains the concept of buffer usability and examines a number of impediments that may limit the use of buffers.
• Buffers are considered usable if banks are willing to operate with capital ratios below the CBR while avoiding undesirable adjustment actions such as excessive deleveraging.
• Regulatory, prudential and market-based impediments may, however, limit banks willingness to use available buffers and allow capital ratios to decline.
• To ensure that the prudential policy measures already implemented remain appropriate, the issue of buffer usability needs continuous monitoring.
• Moreover, a better balance between structural and cyclical elements of the capital stack would increase the macroprudential policy space in a stress situation.

References

• Prepared by Matthieu Darracq Paris, Christoffer Kok and Matthias Rottner The availability of larger releasable buffers before the pandemic would have provided an important complement to the monetary policy mix.
• Had authorities built up larger countercyclical buffers (CCyB) before the pandemic, it would have been easier to release usable capital in response to the crisis.
• This article shows that the usefulness of creating macroprudential space by enhancing countercyclical capacity (via proactive use of the CCyB) can effectively complement monetary policy actions during a crisis particularly when constrained by the effective lower bound on interest rates and thereby improve the policy mix available to achieve better macro-financial stabilisation.

1 The importance of a well-capitalised banking sector

• The strengthening of banking sector solvency after the global financial crisis meant that euro area banks entered the coronavirus (COVID-19) crisis in a solid position.
• The unexpected emergence of the COVID-19 pandemic and the sheer scale of the real economic impact illustrate the usefulness of a well-capitalised banking sector.
• So far, thanks to their much improved solvency positions, euro area banks have been able to weather the current storm better than other recent crises (i.e.
• ECBs recent vulnerability analysis showed that under the central, and most likely, scenario the banking sector is currently sufficiently capitalised to withstand a short-lived deep recession.
• This policy complementarity, it is argued, is especially important in the current context of very low interest rates.

2 The usefulness of a more proactive countercyclical capital buffer

• A model-based assessment illustrates the usefulness of releasable capital against the backdrop of the COVID-19 pandemic.
• Had banks held larger releasable CCyBs could have given them more leeway to mitigate the impact of the crisis on their balance sheet.
• The economic downturn exerts pressure on banks balance sheets and solvency position through higher losses and lower demand for financial services.
• In response, to shield their solvency position, individual banks may have a natural inclination to deleverage their balance sheets.
• [6] Counterfactual simulations indicate that higher CCyB accumulation before the crisis could have provided important support to bank intermediation capacity during the crisis.
• [8] Chart1 Bank credit growth for different levels of countercyclical capacity (bank asset growth as percentage deviation from baseline projection with actual pre-crisis CCyB; end of 2022)
• A more aggressive build-up of the CCyB before the crisis would have shielded the economy better.
• Chart2 shows the projected path of euro area real GDP (expressed in percentage deviation from the 2019 level) reflecting the demand and supply-side shock following the lockdowns triggered by the COVID-19 pandemic.
• The blue bars are consistent with the central forecast of the June 2020 Eurosystem staff macroeconomic projections and thus reflect the actual build-up of CCyB in the euro area banking sector of about 0.2% at the end of 2019.
• The yellow and red bars indicate the projected path of economic activity if authorities had built up larger CCyBs before the crisis (at the end of 2019).
• This would have freed up capital for banks to continue servicing the economy (as shown in Chart1) and would consequently have supported the resilience of the corporate sector during the recession, leading to a less severe contraction in 2020.
• Chart2 Real GDP for different levels of countercyclical capacity (percentage deviation of real GDP level from baseline projection with actual pre-crisis CCyB)

3 Enhancing banks’ countercyclical capacity can reinforce the monetary policy transmission mechanism

• A banking sector with more releasable capital enhances the effectiveness of the bank lending channel of monetary policy transmission.
• Specifically, we find that if banks pre-crisis countercyclical capacity had been higher, the likelihood of monetary policy being constrained by the effective lower bound would have been reduced (see Chart3).
• It is important to highlight that this does not imply that monetary policy accommodation is constrained in these circumstances, but simply that its transmission may be somewhat less efficient.
• Chart3 Likelihood of hitting the zero lower bound for different levels of countercyclical capacity (percentage of quarters over the period 2020-22 where the policy rate could be constrained by the zero lower bound)
• While a proactive CCyB setting helps to restore the monetary policy transmission mechanism in the event of large contractionary shocks, it also affects it in normal times.
• First, banks are assumed to be capital constrained, giving rise to financial accelerator effects as in Gertler and Karadi (2011).
• However, while banks market power is strong in good times, it weakens if the policy rate approaches a negative environment, as in Brunnermeier and Koby (2018).
• [12] As a consequence, monetary policy affects the deposit rate less if interest rates are low.
• Both effects reduce the net worth and weaken the balance sheets of banks, which amplifies the shock via the financial accelerator mechanism.
• However, the impact of such a policy is non-linear, owing to the imperfect deposit rate pass-through and the lower return on government asset holdings.
• ChartA Real GDP for different sized shocks to risk premia (x-axis: quarters; y-axis: Percentage deviations to the steady state)
• At very low or negative interest rate levels, monetary policy becomes less effective and can even enter reversal interest rate territory in which marginal monetary policy accommodation produces contractionary effects.
• If the risk premium shock is negative or around zero, which can be interpreted as an expansion or tranquil times respectively, monetary policy is very effective.
• In contrast to this, as the bank lending channel of monetary policy transmission becomes less effective, policy rate reductions are less powerful in recessions than in booms, when interest rates are close to the lower bound.
• ChartB Real GDP impact of a policy rate reduction for different sized risk premium shocks, with and without active macroprudential policy (x-axis: size of risk premium shock; y-axis: real GDP impact of monetary policy rate reduction in percentage deviation to baseline)

4 Conclusion