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EARLY IN NOVEMBER the South African Reserve Bank (SARB) released an interesting discussion paper entitled “A new macroprudential framework for South Africa”, inviting comment from all interested parties, in particular the financial institutions that will be impacted by the ideas raised in the paper.
In the paper the SARB sets out the rationale for its approach to macroprudential supervision of the financial system to mitigate systemic risk.
As has been the case for most central banks around the world, South Africa has been compelled by the international regulatory fallout from the 2008 financial crisis to beef up its regulatory regime, the challenge being to keep up with international best practice in this regard while making allowance for the peculiarities of South Africa’s financial system and its relationship with the real economy.
Enter macroprudential supervision
One of the most prominent findings in assessing the causes of the crisis was the necessity of distinguishing between risks emanating from individual financial institutions and markets, to be addressed by microprudential regulation, and risks originating from the malfunctioning of the financial system at a systemic level. From this the sharpening in interest in macroprudential supervision and regulation was born.
Right from the start the relationship between macroprudential supervision and monetary policy has been a contentious matter. It therefore does not come as a surprise that the SARB explicitly acknowledges the interaction and interdependence of macroprudential and monetary policy. The SARB then comes out strongly in favour of macroprudential policy rather than monetary policy to mitigate systemic risk.
To quote: “Monetary policy targeting price stability is a necessary condition for financial stability, but it is not a sufficient condition. The effectiveness of using monetary policy to address specific financial vulnerabilities such as excessive leverage and maturity transformation is not well established, and monetary policy is clearly less direct than regulatory or supervisory interventions.
Efforts to promote financial stability through adjustments in interest rates may also increase the volatility of inflation and employment, as excessively high interest rates may be required.
Evidence that low interest rates contribute to higher leverage and increased reliance on short-term funding suggests higher interest rates may lessen these vulnerabilities, but regulatory limits on leverage and short-term funding as well as stronger underwriting standards seem likely to provide more targeted and effective methods to address these vulnerabilities.”
Coordinating monetary and macroprudential policy
As is the case with many central banks, the SARB favours extensive coordination between macroprudential and monetary policy, inter alia accomplished at a practical level by overlapping membership of the Monetary Policy Committee (MPC) and the Financial Stability Committee (FSC) and the sharing of information between them.
The mandates of the two committees are separated not only by their respective objectives, but in particular also by the instruments (and therefore transmission mechanisms) they may employ in pursuit of their objectives.
At the heart of the need for the coordination of monetary and macroprudential policy is the reality that the functioning of each depends on the efficacy of the other. For example, the need for unconventional monetary policy measures as we have seen in recent years will certainly be lessened if macroprudential policy can ensure the continued smooth functioning of the financial system.
It also cannot be denied that macroprudential policies will influence the business cycle and therefore monetary policy.
On the other hand, the influence of monetary policy on risk taking in the financial sector will likewise have an impact on the challenges facing macroprudential policy. Sustained low interest rates can encourage credit booms that then require a macroprudential response, e.g. through lower loan-tovalue ratios and/or increased capital requirements.
The fundamental question remains how to allow for the effect of monetary policy on financial stability through its influence on asset prices.
The question whether monetary policy should “lean against the wind” to prevent asset price bubbles from developing has been overtaken by the creation of such bubbles by monetary policy in some developed countries in recent years, in particular in bond markets where yields have been driven to abnormally low (even negative) levels by quantitative easing policies.
Bearing in mind the adverse impact of low bond yields on pension funds and insurers, the purposeful driving down of bond yields flies in the face of the authorities expanding their definition of the financial stability problem beyond the banking sector.
In contrast, there is no doubt that macroprudential supervision must “lean against the wind” if it is to fulfil its objective of forestalling financial crises by preventing financial imbalances from building up.
Coordinating the conduct of monetary policy with that of macroprudential supervision raises the question whether the two policy fields should be dealt with on a similar institutional footing.
Or, to put it differently, since monetary policy, especially inflation targeting, is conducted within an established institutional framework, should macroprudential supervision be subjected to the same institutional criteria?
Policy objectives
Monetary policy has a well-defined objective, viz. price stability, operationalised by the SARB’s inflation-targeting range of 3 to 6%. The flexibility of the inflation-targeting regime allows for discretion in pursuing the objective of price stability, especially to take growth and employment concerns into account.
It is much more difficult to operationalise the objective of macroprudential supervision, viz. financial stability, to achieve a similar level of transparency in policy. (It is in fact questionable whether consensus has yet been reached on the definition of financial stability).
Whereas the inflation rate is the primary variable measuring price stability, financial stability allows only for secondary variables as indicators of systemic risk, viz. the objective of financial stability can only be pursued indirectly, which somewhat compromises transparency in policy making.
It will be extremely difficult if not impossible to define the objective of macroprudential supervision in terms of a single variable with which the public is familiar and whose progress over time will signal possible policy action to interested parties.
Whereas inflation is a continuous phenomenon that follows the business cycle, financial stability is about event risk (typically tail-end risk) that would require the determination of threshold values for important financial variables identified as early-warning indicators that would trigger a predetermined response if they were breached. Unlike inflation, financial stability has to take contagion effects into account explicitly.
The development of the risks will in general follow a cyclical course, as for inflation (although the financial cycle will normally have a longer duration than the economic cycle).
The choice between a rules-based approach (e.g. anti-cyclical capital requirements for banks that adjust automatically with an increase in lending) and a discretionary approach will therefore be more acute.
Transparency
Monetary policy transparency is enhanced by regular statements from the MPC, the biannual Monetary Policy Review, and frequent speeches by top officials of the SARB.
Transparency in macroprudential supervision will likewise benefit from the biannual Financial Stability Review and regular speeches, although the need to prevent unnecessary anxiety in financial markets will result in greater caution in pronouncements.
An important difference between monetary and macroprudential policy in helping the broad public to understand the actions taken is that monetary policy will be adjusted more frequently with shorter lags in its effects than is likely to be the case for macroprudential policy.
The lesser quality of transparency in macroprudential policy implies that it will not be possible to exploit expectations about future policy as part of the transmission mechanism to the extent that is possible with monetary policy.
Accountability
The accountability of policymakers is also easier to accomplish under inflation targeting. Whether the monetary policy authorities are delivering on the objective of price stability will be easy to determine by comparing actual inflation to the targeting range. If inflation was to move outside the targeting range, monetary policy has to be adjusted to gradually bring it back inside the range.
Although it would be just as clear whether financial stability was being achieved or not, the fact that we are dealing with the occurrence or non-occurrence of an event means macroprudential policymakers will not have time on their side when things go wrong.
The pressure of accountability and the need to be pre-emptive will therefore push macroprudential policy to be more conservative,
even if the prevention of a crisis will not always be interpreted as justification for the steps taken.
(How will the authorities ever be able to prove it was their actions that prevented a crisis from occurring?) Reputational costs will be even bigger in macroprudential policy due to the severe consequences of policymakers getting it wrong.
Independence
Central bank independence from political interference and inflation targeting go hand in hand.
Although the MPC has from time to time been pressured by interest groups, e.g. organised labour, to adopt a particular policy stance, the broad nature of its main policy instrument (the repo rate) has helped it to resist such pressure. However, as recent events have shown, the distributional effects of monetary policy are putting central bank independence under strain.
Because macroprudential policy instruments affect individual institutions directly, they may to a greater extent be the target of lobbying and attempts at regulatory capture by financial institutions.
As for political independence, the FSC could come under pressure because of the sectoral impact of its policies. Financial stability policies may, for example, clash with the use of financial repression measures to favour specific policy objectives or interests.
The distributional impact of macroprudential policies may therefore be even greater than that of monetary policy, which will heighten political interest.
However, if the central bank is responsible for both monetary and macroprudential policy, it will be difficult to differentiate between the approaches to central bank independence under the two types of policy. The risk is that if a lesser degree of independence is accepted for macroprudential supervision it could bring the political independence of the monetary policy function into contention.
In conclusion
Macroprudential policy is still in its infancy and not a settled discipline like monetary policy ? it is probably where monetary policy was 30 to 40 years ago.
The relationship between the two policy fields will therefore still evolve over time. It could be a long time before new macroprudential policy frameworks now being put in place are tested by an actual systemic financial crisis and until then the debate on its efficacy will remain rather theoretical in nature.
The above discussion still leaves the coordination of macroprudential policy with microprudential supervision and fiscal policy to be addressed, as they also are intertwined with the other two policy branches.
For example, the identification of so-called systemically important financial institutions (SIFIs) and their subjection to tighter regulation will necessarily imply an overlap between macroprudential and microprudential policy, while tax policy influences risk-taking behaviour, eg
the choice between using loan or equity finance.
The potentially high fiscal cost of financial crises also means the fiscal authorities have a valid interest in policies aimed at avoiding these from arising.
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