8. Macro-Prudential Policies

Question 1

How financial cycles occur?

Answer 1

some event changes the economic outlook. New opportunities for profit are seized and overdone. Once the excessive character of the upswing is realized, the financial system experiences a sort of “distress”.

Question 2

What roles do property markets play in financial cycles?

Answer 2

Property markets are at the centre of pro-cyclical interactions between asset prices and banks,
- banks that are confident property prices will rise may provide loans that fund almost all of the purchase price (or which are a high fraction of the borrower’s income) because they are confident they won’t lose money should the borrower default and the bank repossesses the home
- when property prices fall, banks make losses on mortgages and cut back on providing credit to the wider economy, perhaps triggering a recession and further reducing property prices
- these points apply to residential property, where most purchase are debt-financed via mortgages, but commercial property booms and busts have traditionally been more dangerous
- commercial property deals are often speculative and take time to plan and execute. Often, by the time the cycle has turned, investors are left with lots of debt and projects that are no longer economically viable

Question 3

How can capital adequacy rules cause credit crunches?

Answer 3

Consider a bank starting to incur serious losses on its loans and expecting to go below its regulatory capital ratio.
The bank could raise more equity capital by selling shares to private investors.
But this would dilute the claim on future dividends of the current owners.
And with bank having made recent losses, the cost of equity finance would probably be high.
The other option is to maintain the equity capital at its current level and instead reduce risk-weighted assets. There are two ways to do this:
1. Reduce Assets - In particular, the bank can use incoming payments
from loans to pay off liabilities instead of using them to issue new loans.
2. Take Less Risk - Invest any new funds in government bonds rather than
make potentially risky loans to customers.
These actions can contribute to causing a credit crunch

Question 4

What is the meaning of macro-prudential policy?

Answer 4

Policies aimed at reducing the financial sector’s procyclical tendencies and making the financial system as a whole more stable (increasing resilience)
- macro-prudential policies focus on systemic risk rather than risk associated with one or more institution

Question 5

Specific examples of macro-prudential policy

Question 6

How is macro-prudential policy set in the EU?

Answer 6

• EU Regulation (1092/2010) established a European Systemic Risk Board (ESRB) responsible for the macroprudential oversight of the EU financial system and the prevention and mitigation of systemic risk.
• The SSM Regulation (1024/2013) assigns the ECB specific powers in the field of macroprudential policies. It is responsible for assessing macroprudential measures adopted by national authorities in the countries subject to ECB banking supervision

Question 7

How is macro-prudential policy set in Ireland?

Answer 7

Central Bank of Ireland:
- Has “stability of the financial system overall” as an objective under the
Central Bank Act.
- Is designated by the ESRB as the national macro-prudential authority
and is represented on its board.
- Is the designated national authority responsible for certain
macro-prudential powers in the Capital Requirements Regulation and
Directive

Question 8

How is macro-prudential policy set in the UK?

Answer 8

The UK Financial Policy Committee
13 members:
- 6 Bank of England staff (the Governor, four Deputy Governors and the Executive Director for Financial Stability Strategy and Risk)
- 5 external members who are selected from outside the Bank
- Chief Executive of the Financial Conduct Authority and one non-voting member from HM Treasury
Powers include the ability to
1 - Set the countercyclical capital buffer (CCyB) rate for the UK
2 - Set sectoral capital requirements for UK financial institutions
3 - Set a leverage ratio requirement for UK financial institutions
4 - Set loan-to-value and debt-to-income limits for UK mortgages on owner-occupied properties
5 - Set loan-to-value and interest cover ratio limits for UK mortgages on
buy-to-let properties

Question 9

Financial Cycle Mechanisms in Normal Times

Answer 9

the financial sector and the real economy tend to reinforce each other during normal economic cycles:
Pricing of Risk:
- the longer an expansion goes on, the more financial market participants start to forget about risk
-risky assets increase in price and risky borrowers receive lower-cost finance
Asset Prices:
- These rise during an expansion and provide borrowers with better collateral
- With better collateral, banks think borrowers have become a lower risk and borrowers think they can safely borrow more
- the same mechanisms operate negatively on the financial sector during a downturn though often in a more intense fashion than during expansions