The role of macroprudential policies during economic crises
Speech (by videoconference) by Mr Agustín Carstens, General Manager of the BIS, at the 45th regular session of the Council of Arab Central Banks and Monetary Authorities' Governors, Abu Dhabi, 19 September 2021.
Introduction and overview
Thank you, Mr Chairman (Your Excellency Mr Al Maraj), for the introduction and many thanks to the Arab Monetary Fund for this invitation to be with you at this meeting of the Council of Governors. I note with admiration that this is the 45th session of the Council. At the Bank for International Settlements (BIS) we know the benefits of creating opportunities for central bankers to compare experiences. We are also keenly aware that high-level meetings must offer good value for busy Governors. Congratulations for a job well done. I wish you many more successful meetings!
Today's topic is macroprudential policy. In particular, how it can be helpful in fighting an economic crisis that may not have originated in the financial sector but, as all crises ultimately do, has a financial stability dimension. I am happy to offer some thoughts from the perspective of someone who has closely observed a number of crises and who has learnt from the challenges which the real world manages to present to central bankers.
Over the past twenty years, policymakers have been paying increasing attention to the macroprudential approach to financial stability policy, an interest that can be traced back to the insights of Andrew Crockett, one of my predecessors as BIS General Manager.1 This approach involves the use of prudential policy instruments from a system-wide ("macro") perspective. It is fair to say that the Great Financial Crisis (GFC) has given a major boost to this perspective, as a complement to the previously dominant microprudential perspective, which focuses on the resilience of individual institutions considered on a stand-alone basis.
That said, as originally conceived, macroprudential policy paid special attention to mitigating systemic risks that either build-up over time because of the procyclical behaviour of the financial sector or relate to the concentration of risk in a few systemically important components. Its main focus has been on risks arising from financial factors.
The policy response to Covid-19 has added a new angle. It has shown how the macroprudential perspective and the corresponding deployment of tools can also be useful in addressing the financial strains that can originate from an unpredictable shock ultimately caused by non-economic factors. That is why today's meeting, designed to derive lessons from this recent experience, is especially timely.
In this spirit, I would like to touch on three questions. The first is backward-looking: what has the contribution of macroprudential policy been to the overall response to the pandemic-induced crisis? The second is forward-looking: what are the macro-financial risks in the recovery phase of this crisis? The third is more timeless: what are the more general messages we can draw about the use of macroprudential policy? I will address these three questions paying specific attention to the perspective of emerging market economies (EMEs).
The use of macroprudential tools during the Covid episode
Macroprudential policy is a relatively new toolbox. It would be fair to say that theory was lagging behind practice prior to the GFC. To be clear, the tools themselves are not particularly novel. Many, such as bank capital requirements, have been the workhorse of microprudential policy. Others, such as loan-to-value ceilings, had already been deployed extensively in some jurisdictions. The new element is the toolbox itself, that is the framework within which tools are organised for deployment and the perspective guiding their calibration.
A major element of the post-GFC policy reform agenda was the formalisation of the macroprudential framework, both domestically and internationally.2 This came with the introduction of new tools, such as countercyclical capital and additional buffer requirements for systemically important institutions. Together with the development of a coherent perspective guiding their use, theory caught up with practice. However, the focus of policy remained primarily on dealing with financial shocks and mitigating the risks to systemic stability.
The Covid shock presented unique policy challenges that pushed the use of macroprudential policy for new goals. The pandemic had neither economic nor financial origins but brought about a massive and sudden hit to both aggregate demand and supply. The policy response was extraordinary: it involved the rapid deployment of the full range of instruments (including some central bank tools used for the first time in some countries) on an unprecedented scale.3 Another important aspect was that, thanks to the post-GFC major financial reforms, not least Basel III, the banking sector was in a strong financial position when the crisis struck. Far from being the problem it could be part of the solution, by absorbing the shock and continuing to support the real economy.
Indeed, the recession would have been much deeper and longer without the provision of credit to households and firms seeking to bridge the sharp drop in their income. Minimising the immediate damage to production processes and to working relationships also reduced the economic scars and prepared the ground for a swift rebound. In line with these objectives, prudential policy interventions were two-pronged: to facilitate credit extension and to ensure that banks remained resilient.
Macroprudential policy interventions played a key role. Policymakers sought to maximise lenders' ability to supply funding. Many, like the Central Bank of the United Arab Emirates, allowed institutions to tap into their macroprudential capital conservation buffers and those for systemically important banks to leverage their capital base. Similarly, liquidity rules were relaxed in view of the financial system's strong starting position and central banks' resolve to supply abundant liquidity.
Importantly, banks were given incentives and assistance to participate in purpose-designed programmes in support of the hardest hit economic segments. Funding of households and small and medium-sized enterprises (SMEs) is an area where banks have been historically strong. Risk weights for SME loans were modified and exposure limits increased. Banks in some jurisdictions were incentivised to supply bridge loans to help firms to pay salaries. Similarly, loan-to-value ratios and other exposure ceilings to mortgages were increased to facilitate households in managing their balance sheets, in addition to debt repayment moratoriums offered to those who became unemployed (eg in Saudi Arabia). And the schedule of implementation for new rules relating to the accounting recognition of loss was pushed into the future.
At the same time, policymakers wanted to ensure that the financial system continued to remain robust and a contributor to the process of recovery after the crisis.4 For one, banks were asked to refrain from discretionary payouts to shareholders in order to preserve capital and liquidity resources. Also, where applicable, authorities sought to specify the perimeter of measures to target those most affected. For instance, relaxing the rules regarding banks' recognition of non-performing exposures only for those borrowers experiencing demonstrable difficulty in servicing their loans due to the impact of Covid. Importantly, the announced measures were introduced for a limited period and linked to the development of the crisis.
Overall, the financial system responded in the desired way. It avoided a catastrophic credit crunch, which would have deepened the crisis, and remained resilient. In the economies in this region, the role of macroprudential policy was particularly important, given the dominant role of banks in intermediation. The central bank purchases of corporate bonds used in other jurisdictions would have had only limited effects on the real economy.
Of course, prudential policy could hardly achieve this success alone.
One key factor has been the substantial support from fiscal and monetary policy. The public purse underwrote, to a substantial extent, banks' exposures to pandemic-hit borrowers. Guarantees, together with other more direct fiscal support measures, helped to contain banks' credit risk and provided an incentive for lenders to keep credit flowing. And central banks mitigated banks' liquidity risks through ample funding support. They also cut policy rates substantially and, for the first time in many jurisdictions, actively used their balance sheets.
Another factor has been the generally good cyclical position in which economies (in particular EMEs) entered the crisis. When the pandemic shock hit, EMEs were generally on a positive growth trajectory and inflation was under control. Central banks' persistent past efforts to strengthen their policy frameworks paid handsome dividends: they provided monetary policy with extra room for manoeuvre.5 Fiscal space was less ample in some countries, but the universal nature of the pandemic helped to quell the concerns of foreign investors. As a result, there was little stigma associated with policymakers undertaking extraordinary policy action, with the main risk being perceived as "doing too little". The initial capital outflows were quickly reversed, supported by the immediate response by major currency area central banks to provide other central banks with foreign currency liquidity, including through swaps agreements.
What are the risks going forward?
Keeping with the system-wide and through-the-cycle perspective of macroprudential policy, I would now like to turn to the risks ahead because they are important in understanding the role of policy in crises. These risks are related to the lingering effects of the pandemic on private and public balance sheets and on the pace of economic recovery.
The low point from the pandemic shock may be behind us but its effects and associated risks are not. Lockdowns are still a possibility and the economic recovery seems uneven. This reflects, in part, the relative strengths of individual economies and in part the differential pace of vaccination. Even if some of the economies in this region are leaders in the vaccination effort, they can still be affected by lack of progress, or setbacks, elsewhere. Marked uncertainty will continue to characterise the way this unusual global economic cycle unfolds.
Monetary policy is facing some tough trade-offs. Inflationary pressures may be building up globally.6 Bottlenecks in production and logistics networks, higher commodity prices and labour market frictions have pushed up prices in food, energy and some manufacturing products. While several central banks are changing monetary policy tack, the overall stance remains broadly accommodative – rightly so given the need to nurse the recovery. Sustained higher inflation will require a policy response as would a build-up of financial imbalances.
Fiscal space is also more restricted. The major crisis-induced fiscal stimulus has resulted in substantially higher debt-to-GDP ratios. Sovereign risk could become much more prominent in the years ahead, and could severely constrain monetary and prudential policy, especially if the pace of recovery disappoints.7 In this scenario, unstable government finances and weak banking sector balance sheets could give rise to powerful damaging spirals. Banks have direct exposures to the government through bond holdings and public guarantees on pandemic-related loans. And they also have indirect exposures through the major influence of the state of public finances on the economy and on the private sector's cost of funding, including from international sources.
The pandemic is also leaving higher private sector debt in its trail. Households and firms that borrowed to manage the economic hit will have to service this debt as relief measures and moratoriums are gradually lifted. For those already in a weak position at the onset of the crisis, the burden might not be sustainable, especially in the hardest-hit sectors, whose longer-term prospects have deteriorated. Historically, bank losses lag severe recessions by about a couple of years, even in the absence of specific support measures to borrowers – and in view of the uncertainties inherent in the pace of recovery, tail risks are particularly elevated at present.8 Banks will have to manage this challenge while the gradual lifting of the emergency prudential measures will also raise the bar of the standards they will have to meet.
For small open economies, the external sector can add to the domestic risks. Global financial conditions – on balance very easy given the nature of the shock – could suddenly reverse, especially if central banks in major currency areas tighten policy and international investors become concerned with country risk. The weaker banks in economies dependent on foreign funding could come under stress unless their economy has already fully recovered.
Therefore, macroprudential authorities must strike a delicate balance. On the one hand, banks' capital and liquidity buffers must be replenished where needed, and the transition towards the full adoption of new prudential and financial reporting standards resumed when the crisis is over. On the other hand, pandemic-hit borrowers may need continuing support in view of the inherent uncertainties along the recovery path. Indicative of these trade-offs are concerns with imbalances fuelled by exceptionally accommodative financial conditions. Elevated valuations of risky assets and soaring property prices are two examples. In several economies, rapid growth of property prices on the back of low borrowing costs together with a surge in household savings as a result of the contraction in consumption are becoming a potential risk to stability. In fact, some central banks, such as the Bank of Korea, are taking measures to lean against them.
Striking the right balance requires different policies to act in a concerted way and look beyond the short-term. Macroprudential tools can play their role in gradually nudging the financial sector to rebuild its buffers and in making sure that the balance sheet scars of Covid heal properly and promptly.
3. Conclusions / messages
In the last part of my remarks, I would like to reflect on the previous points, which focused mostly on the pandemic crisis, and draw some more general lessons for the macroprudential toolkit and its use. We learnt the hard way during the GFC that macroprudential tools are needed to mitigate the adverse effects of the financial cycle. What we are learning now is how they can be used in response to a different set of circumstances.
My high-level conclusion is that macroprudential policy is a very useful addition to the policymakers' arsenal in dealing with non-financial crises, but it is no fairy tale magic wand. Let me elaborate.
Macroprudential tools are good complements to other policies when a sudden non-economic shock requires a rapid and forceful policy response. Macroprudential policy measures can be part of a stimulus package and help to mitigate a damaging credit crunch. In this way, macroprudential policy offers more strategic options and flexibility to policymakers. They can reinforce the efficacy of other policies. Relaxation of buffers strengthens transmission channels of policy through the balance sheet of financial institutions, allows fiscal stimulus to quickly reach more corners of the real economy and leverages the capacity of the banking system to make credit allocation decisions at the micro level. Moreover, macroprudential measures that limit distributions by banks can ensure that stimulus resources are not diverted away from their main target. Finally, judicious use of macroprudential instruments can help to protect the domestic financial system from capital flow volatility during crises and thus provide useful space for other policies by mitigating side effects and attenuating trade-offs.9
These strengths also point to some preconditions and limitations: macroprudential tools cannot be introduced during a crisis, they are most effective as part of a holistic package and when carried out against the backdrop of robust overall policy frameworks.
Buffers can only be built in good times and they cannot be relaxed in a crisis if they were not sufficient at its onset. Pre-crisis preparation and a prompt response are essential for success. This is self-evident when financial vulnerabilities arise during a boom, when tightening of prudential policy can have the additional desirable effect of throwing some sand in the wheels of finance. But it applies also in the case of a sudden exogenous shock. The existence of buffers is reassuring and their release is most effective when credibility is maintained that they will be used wisely and rebuilt promptly.
Macroprudential policy cannot be the main tool in the response to a crisis like the one triggered by the pandemic. The natural protagonists are fiscal and monetary policy with macroprudential measures playing an important supporting role in complementing the overall package. In addition, interventions releasing capital and liquidity buffers may have limited effect if they are not coupled with fiscal authority guarantees or with liquidity provision by the central bank. Banks will be reluctant to dip into their buffers when facing high macroeconomic risk, not least out of concern about the way rating agencies, creditors and counterparties may perceive this action.
Success depends critically on credibility, and the successful use of macroprudential tools in crises is greatly dependent on the coherence and robustness of the overall policy framework, including all stabilisation policies.
These last two points suggest a more general lesson to me. Many were positively surprised by the efficacy of EME central banks' interventions in response to Covid-19 and in the policy space they seemed to have available. This did not surprise those who had, over the past several years, observed EMEs making strides in building coherent policy frameworks with a longer-term decision-making perspective. They were able to act countercyclically in response to Covid in large part because their house was "in order" and they had built credibility capital over several years.10 The same factors allowed them to successfully deploy macroprudential tools as an integral component of the overall effort to fight this sharp recession.
They will need to keep building on this record going forward. The same coherence of the overall policy framework must be maintained (and enhanced) in the recovery period, using the flexibility that a multi-pronged approach affords in replenishing the fiscal, monetary and prudential resources that will fight the next battle.
A good policy is the one that is always looking ahead and uses the space available to prepare for the next challenge. We know challenges will arise even once we have put the pandemic behind us. Credibility of the overall policy framework, like prudential buffers, is gradually built-in good times in order to be most usefully tapped in bad times.
1 A Crockett, "Marrying the micro- and macro-prudential dimensions of financial stability", remarks at the Eleventh International Conference of Banking Supervisors held in Basel on 20–21 September 2000. For a discussion of the origins of the term "macroprudential" see P Clement, "The term "macroprudential": origins and evolution", BIS Quarterly Review, March 2010, pp 59–65.
2 See Bank for International Settlements, "Moving forward with macroprudential frameworks", Annual Economic Report 2018, June.
3 See Bank for International Settlements, "A monetary lifeline: central banks' crisis response", Annual Economic Report 2020, June.
4 See C Borio and F Restoy, "Reflections on regulatory responses to the Covid-19 pandemic", FSI Briefs, no 1, April 2020.
5 See Capital flows, exchange rates and policy frameworks in emerging Asia, a report by a Working Group established by the Asian Consultative Council of the Bank for International Settlements, November 2020; and Capital flows, exchange rates and monetary policy frameworks in Latin American and other economies, a report by a group of central banks including members of the Consultative Council for the Americas and the central banks of South Africa and Turkey, April 2021.
6 See F Budianto, G Lombardo, B Mojon and D Rees, "Global reflation?", BIS Bulletin, no 43, July 2021.
7 See Bank for International Settlements, "Covid and beyond", Annual Economic Report 2021, June.
8 See M Juselius and N Tarashev, "Could corporate credit losses turn out higher than expected?", BIS Bulletin, no 46, August 2021.
9 See Bank for International Settlements, "Monetary policy frameworks in EMEs: inflation targeting, the exchange rate and financial stability", Annual Economic Report 2019, June.
10 See C Cantu and A Aguilar, "Monetary policy response in emerging market economies: why was it different this time?", BIS Bulletin, no 32, November 2020.
