BIS macro-prudential approach

With the global financial crisis that burst in 2008, the Bank for International Settlements (BIS) is receiving more and more attention for its analysis of financial stability issues. Typical for the BIS is a broad approach to financial stability, "marrying" its micro- and macro-prudential dimensions.

The BIS was set up in 1930 as a forum for central bank cooperation. It provided central bankers with three main services (Toniolo, 2005): research on issues relevant to interna- tional payments and prudential supervision, a venue for regular and discreet meetings, and a financial arm (particularly important in the gold market).

The BIS macro-prudential approach to financial stability had its origin in the late 1970s, when central bankers worried about the strong growth of external debt in develop- ing countries. In this context, the BIS, and especially Alexandre Lamfalussy, its economic advisor, emphasized that a borrowers' market had been developing, mainly because of loose US monetary policies. So, a distinguishing characteristic of the BIS approach is to place debt problems in a broader macroeconomic framework, paying particular attention to the interaction of global imbalances and debt dynamics. The BIS macro-prudential approach referred further to prudential policies that promote the safety and soundness of the broad financial system - and not of individual financial institutions alone.

The macro-prudential concept was first publicly presented in the Cross Report on innovations in international banking (BIS, 1986). In that way, the macro-prudential approach became very closely associated with financial innovations. However, even before the Cross Report, Lamfalussy (1985, p. 411) had emphasized the accelerating speed of financial innovation and raised the issue of systemic stability: "You may argue that when risk-averse market participants shift risks [. . .] onto willing risk takers, every- body is going to be better off. This may well be the case, but increased collective happi- ness does not necessarily mean greater systemic stability. Or does it?". Later, Lamfalussy (1986), then the BIS General Manager, gave a negative answer to this question. His argu- ment was strongly influenced by his analysis of the Latin American debt crisis (Maes, 2010). In his view, the shift to a generalized use of floating interest rates in medium-term bank loans, during the petrodollar recycling in the 1970s, allowed banks to protect them- selves against the erosion of their intermediation margins. However, it also had the effect of passing on short-term market interest rate movements to borrowers. With negative real interest rates, credit demand was stimulated, leading to a period of over-expansion. The return to positive real interest rates in 1979 placed a crippling burden on many debtors. The ensuing debt crisis threatened the world financial system. It was in Lamfalussy's view a clear argument for a macro-prudential approach, complementing the micro-prudential supervision of financial institutions.

Later, in the early 2000s, the BIS macro-prudential approach gained prominence. Crockett (2000, p. 2) defined it as "limiting the costs to the economy from financial distress, including those that arise from any moral hazard induced by the policies pursued". As such, it is very much concerned with systemic risk. It contrasts with the micro-prudential objective, which focuses on limiting the failure of individual institu- tions (idiosyncratic risk). The macro-prudential approach focuses on the financial system as a whole, paying special attention to the risk of correlated failures and to institutions that have a systemic significance for the economy. It also emphasizes that systemic risk arises primarily through common exposures to macroeconomic risk factors. Further, White (2006) noted some interesting similarities with Austrian business cycle theories: a focus on imbalances in the economy, the assumption of systemic errors of judgment by economic agents, and an inherent tendency towards periodic crises. There are, further, also similarities with the work of Hyman Minsky, who was well appreciated at the BIS (see Borio et al., 2001). An additional characteristic of the macro-prudential approach is the view that aggregate risk depends on the collective behaviour of individual institu- tions, the so-called endogeneity of risk. A crucial implication is that actions that might be appropriate for individual financial institutions may not result in desirable aggregate outcomes (for instance, sales of assets in bad times).

The macro-prudential approach also has clear policy implications. These have been taken up in the Basel III regulatory framework (Borio, 2012), both the time dimension (how to address pro-cyclicality) and the cross-sectional dimension (the calibration of regulatory and supervisory arrangements depending on the systemic importance of the institutions concerned).

Another implication of the macro-prudential approach is that central banks should not only focus on price stability but also take financial stability as an objective. This is an object of serious debate. For instance, Issing (2012, p. 14) argues that the "line in the sand" should be drawn where maintaining price stability is endangered.

Compared with the late 1970s, the macro-prudential concept has gained in depth and dimension (Clement, 2010). It now commonly refers to a prudential framework that focuses on the financial system as a whole, and which through the application of specific tools seeks to limit risks deriving from the pro-cyclicality of the financial system (namely, how risk evolves over time, during the financial cycle) as well as from the distribution of risks within the financial system at any point in time (the so-called cross-sectional dimen- sion of risk; for instance, the "too big to fail" problem). Ultimately, however, the goal of a macro-prudential approach remains what it has been since the term was first used in the late 1970s and that is to limit the risks and costs of systemic financial crises.

See also:

Basel Agreements; Financial crisis; Financial innovation; Financial instability; Lamfalussy, Alexandre; Macro-prudential policies; Macro-prudential tools; Minsky, Hyman Philip; Negative rate of interest; Systemically important financial institutions.

With the global financial crisis that burst in 2008, the Bank for International Settlements (BIS) is receiving more and more attention for its analysis of financial stability issues. Typical for the BIS is a broad approach to financial stability, "marrying" its micro- and macro-prudential dimensions.

The BIS was set up in 1930 as a forum for central bank cooperation. It provided central bankers with three main services (Toniolo, 2005): research on issues relevant to interna- tional payments and prudential supervision, a venue for regular and discreet meetings, and a financial arm (particularly important in the gold market).

The BIS macro-prudential approach to financial stability had its origin in the late 1970s, when central bankers worried about the strong growth of external debt in develop- ing countries. In this context, the BIS, and especially Alexandre Lamfalussy, its economic advisor, emphasized that a borrowers' market had been developing, mainly because of loose US monetary policies. So, a distinguishing characteristic of the BIS approach is to place debt problems in a broader macroeconomic framework, paying particular attention to the interaction of global imbalances and debt dynamics. The BIS macro-prudential approach referred further to prudential policies that promote the safety and soundness of the broad financial system - and not of individual financial institutions alone.

The macro-prudential concept was first publicly presented in the Cross Report on innovations in international banking (BIS, 1986). In that way, the macro-prudential approach became very closely associated with financial innovations. However, even before the Cross Report, Lamfalussy (1985, p. 411) had emphasized the accelerating speed of financial innovation and raised the issue of systemic stability: "You may argue that when risk-averse market participants shift risks [. . .] onto willing risk takers, every- body is going to be better off. This may well be the case, but increased collective happi- ness does not necessarily mean greater systemic stability. Or does it?". Later, Lamfalussy (1986), then the BIS General Manager, gave a negative answer to this question. His argu- ment was strongly influenced by his analysis of the Latin American debt crisis (Maes, 2010). In his view, the shift to a generalized use of floating interest rates in medium-term bank loans, during the petrodollar recycling in the 1970s, allowed banks to protect them- selves against the erosion of their intermediation margins. However, it also had the effect of passing on short-term market interest rate movements to borrowers. With negative real interest rates, credit demand was stimulated, leading to a period of over-expansion. The return to positive real interest rates in 1979 placed a crippling burden on many debtors. The ensuing debt crisis threatened the world financial system. It was in Lamfalussy's view a clear argument for a macro-prudential approach, complementing the micro-prudential supervision of financial institutions.

Later, in the early 2000s, the BIS macro-prudential approach gained prominence. Crockett (2000, p. 2) defined it as "limiting the costs to the economy from financial distress, including those that arise from any moral hazard induced by the policies pursued". As such, it is very much concerned with systemic risk. It contrasts with the micro-prudential objective, which focuses on limiting the failure of individual institu- tions (idiosyncratic risk). The macro-prudential approach focuses on the financial system as a whole, paying special attention to the risk of correlated failures and to institutions that have a systemic significance for the economy. It also emphasizes that systemic risk arises primarily through common exposures to macroeconomic risk factors. Further, White (2006) noted some interesting similarities with Austrian business cycle theories: a focus on imbalances in the economy, the assumption of systemic errors of judgment by economic agents, and an inherent tendency towards periodic crises. There are, further, also similarities with the work of Hyman Minsky, who was well appreciated at the BIS (see Borio et al., 2001). An additional characteristic of the macro-prudential approach is the view that aggregate risk depends on the collective behaviour of individual institu- tions, the so-called endogeneity of risk. A crucial implication is that actions that might be appropriate for individual financial institutions may not result in desirable aggregate outcomes (for instance, sales of assets in bad times).

The macro-prudential approach also has clear policy implications. These have been taken up in the Basel III regulatory framework (Borio, 2012), both the time dimension (how to address pro-cyclicality) and the cross-sectional dimension (the calibration of regulatory and supervisory arrangements depending on the systemic importance of the institutions concerned).

Another implication of the macro-prudential approach is that central banks should not only focus on price stability but also take financial stability as an objective. This is an object of serious debate. For instance, Issing (2012, p. 14) argues that the "line in the sand" should be drawn where maintaining price stability is endangered.

Compared with the late 1970s, the macro-prudential concept has gained in depth and dimension (Clement, 2010). It now commonly refers to a prudential framework that focuses on the financial system as a whole, and which through the application of specific tools seeks to limit risks deriving from the pro-cyclicality of the financial system (namely, how risk evolves over time, during the financial cycle) as well as from the distribution of risks within the financial system at any point in time (the so-called cross-sectional dimen- sion of risk; for instance, the "too big to fail" problem). Ultimately, however, the goal of a macro-prudential approach remains what it has been since the term was first used in the late 1970s and that is to limit the risks and costs of systemic financial crises.

See also:

Basel Agreements; Financial crisis; Financial innovation; Financial instability; Lamfalussy, Alexandre; Macro-prudential policies; Macro-prudential tools; Minsky, Hyman Philip; Negative rate of interest; Systemically important financial institutions.