Financial Stability Objectives Research Articles

Enhancing Prudential Standards in Financial Regulations

The financial crisis has generated fundamental reforms in the financial regulatory system in the U.S. and internationally. Much of this reform was in direct response to the weaknesses revealed in the precrisis system. The new “macroprudential” approach to financial regulations focuses on risks arising in financial markets broadly, as well as the potential impact on the financial system that may arise from financial distress at systemically important financial institutions. Systemic risk is the key factor in financial stability, but our current understanding of systemic risk is rather limited. While the goal of using regulation to maintain financial stability is clear, it is not obvious how to design an effective regulatory framework that achieves the financial stability objective while also promoting financial innovations. This paper discusses academic research and expert opinions on this vital subject of financial stability and regulatory reforms. Specifically, among other issues, it discusses the impact of increasing public disclosure of supervisory information, the effectiveness of bank stress testing as a tool to enhance financial stability, whether the financial crisis was caused by too big to fail (TBTF), and whether the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) resolution regime would be effective in achieving financial stability and ending TBTF.

EU proposal for regulation on money market funds

On 4 September 2013 the European Commission released a proposal that seeks to restructure the entire European money market fund (MMF) industry. This article outlines the premises of the proposal and discusses concerns related to the most controversial provisions. We believe that economically unfeasible requirements for constant net asset value (CNAV) MMFs will result in the exit of these funds. We believe that the primary objective of financial market stability cannot be achieved by eliminating CNAV MMFs in favour of variable net asset value (VNAV) MMFs. There is simply no evidence that VNAV MMFs are immune to runs. New systemic risk will emerge as a result. Other types of investment products will proliferate, including private liquidity funds, which the existing EU regulation is not addressing. The focus of the proposal is misplaced. Runs in a single fund, whether CNAV or VNAV, due to a credit event should not be the primary regulatory concern. Investing is always a risky business and regulation ought to empower investors with complete information to adequately manage these risks. We recognise that any regulatory rules will be imperfect. The never-ending search for the most efficient allocation of resources will drive investors away should the post-reform MMF structure prove too costly. The solution can be found in the balance between long-term funding needs of the real economy and the utility of these funds.

Time Variation in Asset Price Responses to Macro Announcements

Although the effects of economic news announcements on asset prices are well established, these relationships are unlikely to be stable. This paper documents the time variation in the responses of yield curves and exchange rates using high-frequency data from January 2000 through August 2011. Significant time variation in news effects is present for those announcements that have the largest effects on asset prices. The time variation in effects is explained by economic conditions, including the level of policy rates at the time of the news release, and risk conditions: Government bond yields increase in response to \\good news,\ but less so when risk is elevated. Risk conditions matter since they can capture the effects of uncertainty on the information content of news announcements, the interaction of monetary policy and financial stability objectives of central banks, and the effect of news announcements on the risk premium.

Perspectives on “marginal crisis risk” and “leaning against the wind” from the capital structure of housing investments

PurposeThe purpose of this paper is to relate the marginal crisis risk of Woodford to a number of financial fragility indicators. The paper expands the interest rate gap approach by considering the capital structure of investments and systemic risk, dating back to Modigliani‐Miller. The model allows for distinct impacts from asset inflation, leverage as well as incentives for speculative investments for a central bank that aims to lean against the wind.Design/methodology/approachFramed in terms of the housing market and household behaviour, the paper sets out an augmented loss function which takes a number of financial fragility indicators into account. By moving beyond the case where all risk increasing mechanisms are driven by external monetary policy shocks, the approach shows why a central bank should be inclined to lean against the wind even in the absence of interest rate gaps.FindingsTaking the return to equity into account, and moving beyond the case where all risk increasing mechanisms are related to external monetary policy shocks, the paper shows why a central bank might be inclined to lean against the wind even in the absence of interest rate gaps. The context‐specific nature of the monetary transmission mechanism in general, and the structure of the risk taking channel more specifically, calls for both internal financial market features as well as the link between financial markets and the real economy to impact on how and when to lean.Originality/valueThere seems to be increased awareness of the need to take financial stability considerations in monetary policy. In fact, Woodford argues that the balance between financial stability objectives and price and output stability is part of the choice when choosing between alternative short run paths for monetary policy. By taking a conventional approach to the capital structure of investments, this paper integrates asset inflation, leverage and incentives for speculation into a central bank's loss function in a way that to the best of the author's knowledge is novel.

Financial Inclusion and Regulation in India

Policies to encourage increased access for the previously unbanked must be taken into consideration in the objectives of financial stability. The progress towards inclusiveness is more difficult to assess, because inclusiveness is a multidimensional concept. To achieve inclusiveness in all these dimensions requires multiple interventions. The success depends not only on introducing new policies and government programmes, but on institutional and attitudinal changes brought about, which take time. With appropriate policy changes the financial sector has the capability to grow tremendously having an enormous multiplier effect on inclusion and economic growth. While regulating the financial market, one should look into the constraints as well as the opportunities for financial inclusion. The policy makers should look into supply side issues of financial inclusion and what can be done to enhance the supply of financial services along with the demand side causes and solutions for financial inclusion. A step in the direction of financial inclusion may offer empowerment with entitlement, security and opportunity to millions of poor in India. The objectives of the study are twofold. First one is to analyse the development of financial inclusion by looking at the stakeholder interests, incentives, institutions and opportunities. Second, is to illustrate ‘what works, why and how’ for a better understanding of financial inclusion and the design and regulation of financial sector.

'Leaning Against the Wind' and the Timing of Monetary Policy

If monetary policy is to aim also at financial stability, how would it change? To analyze this question, this paper develops a general-form, axiomatic framework. Financial stability objectives are shown to make a monetary authority more aggressive. By that we mean that in reaction to negative shocks, cuts are deeper but shorter-lived than otherwise. Keeping cuts brief is crucial as bank risk responds primarily to rates that are kept low for too long. Within this shorter time span, cuts must then be deeper than otherwise to also achieve standard objectives.

“Leaning against the wind” and the timing of monetary policy

If monetary policy is to aim also at financial stability, how would it change? To analyze this question, this paper develops a general-form framework. Financial stability objectives are shown to make monetary policy more aggressive: in reaction to negative shocks, cuts are deeper but shorter-lived than otherwise. By keeping cuts brief, monetary policy tightens as soon as bank risk appetite heats up. Within this shorter time span, cuts must then be deeper than otherwise to also achieve standard objectives. Finally, we analyze how robust this result is to the presence of a bank regulatory tool, and provide a parameterized example.

Leaning Against the Wind and the Timing of Monetary Policy

If monetary policy is to aim also at financial stability, how would it change? To analyze this question, this paper develops a general-form framework. Financial stability objectives are shown to make monetary policy more aggressive: in reaction to negative shocks, cuts are deeper but shorter-lived than otherwise. By keeping cuts brief, monetary policy tightens as soon as bank risk appetite heats up. Within this shorter time span, cuts must then be deeper than otherwise to also achieve standard objectives. Finally, we analyze how robust this result is to the presence of a bank regulatory tool, and provide a parameterized example.

Macro-Prudential Policy and the Conduct of Monetary Policy

In this paper, we analyze the interactions between monetary and macro-prudential policies and the circumstances under which such interactions call for their coordinated implementation. We start with a review of the interdependencies between monetary and macro-prudential policies. Then, we use a DSGE model incorporating financial frictions, heterogeneous agents and housing, which is estimated for the euro area over the period 1985-2010, to identify the circumstances under which monetary and macro-prudential policies may have compounding, neutral or conflicting impacts on price stability. We compare inflation dynamics across four 'policy regimes' depending on: the monetary policy objectives – that is, whether the policy instrument, the short-term interest rate factors in financial stability considerations by leaning against credit growth; and the existence, or not, of an authority in charge of a financial stability objective through the implementation of macro-prudential policies that can 'lean against credit' without affecting the short-term interest rate.Our main result is that under most circumstances, macro-prudential policies have either a limited or a stabilizing effect on inflation.

Macroeconomic Stability, Financial Stability, and Monetary Policy Rules

AbstractThis paper reviews arguments for and against attributing an explicit financial stability objective to monetary policy. The discussion is conducted from the perspective of middle‐income countries (MICs), where bank credit plays a critical role both on the supply and demand sides. It also discusses, on the assumption that a more proactive role is desirable, what monetary policy should react to and to what extent it should be combined with macroprudential regulation. There are robust arguments in favour of monetary policy reacting in a state‐contingent fashion to a measure at the private‐sector credit gap, not only because of financial stability considerations but also because of the high degree of uncertainty regarding real‐time estimates of the output gap in MICs. Nevertheless, monetary policy is not a substitute for macroprudential regulation; in particular, it cannot address the cross‐section dimension of systemic risk.

Central Bank Independence and Macro-Prudential Regulation

We consider the optimality of various institutional arrangements for agencies that conduct macro-prudential regulation and monetary policy. When a central bank is in charge of price and financial stability, a new time inconsistency problem may arise. Ex-ante, the central bank chooses the socially optimal level of inflation. Ex-post, however, the central bank chooses inflation above the social optimum to reduce the real value of private debt. This inefficient outcome arises when macro-prudential policies cannot be adjusted as frequently as monetary. Importantly, this result arises even when the central bank is politically independent. We then consider the role of political pressures in the spirit of Barro and Gordon (1983). We show that if either the macro-prudential regulator or the central bank (or both) are not politically independent, separation of price and financial stability objectives does not deliver the social optimum.

The Macroeconomic Effects of Reserve Requirements

Monetary authorities in emerging markets are often reluctant to raise interest rates when dealing with credit booms driven by capital inflows, as they fear that an increase attracts even more capital and appreciates the currency. A number of countries therefore use reserve requirements as an additional policy instrument. The present study provides evidence on their macroeconomic effects. We estimate a vector autoregressive (VAR) model for the Brazilian economy and identify interest rate and reserve requirement shocks. For both instruments a discretionary tightening leads to a decline in domestic credit. We find, however, very different effects for other macroeconomic aggregates. In contrast to interest rate policy, a positive reserve requirement shock leads to an exchange rate depreciation and an improvement in the current account, but also to an increase in prices. The results suggest that reserve requirement policy can complement interest rate policy in pursuing a financial stability objective, but cannot be its substitute with regards to a price stability objective.

Reserve Requirements for Price and Financial Stability - When are They Effective?

Reserve requirements are a prominent policy instrument in many emerging countries. The present study investigates the circumstances under which reserve requirements are an appropriate policy tool for price or financial stability. We consider a small open economy model with sticky prices, financial frictions and a banking sector that is subject to legal reserve requirements and compute optimal interest rate and reserve requirement rules. Overall, our results indicate that reserve requirements can support the price stability objective only if financial frictions are important and lead to substantial improvements if there is a financial stability objective. Contrary to a conventional interest rate policy, reserve requirements become more effective when there is foreign currency debt.

Central Bank Independence and Macro-Prudential Regulation

We consider the optimality of various institutional arrangements for agencies that conduct macro-prudential regulation and monetary policy. When a central bank is in charge of price and financial stability, a new time inconsistency problem may arise. Ex-ante, the central bank chooses the socially optimal level of inflation. Ex-post, however, the central bank chooses inflation above the social optimum to reduce the real value of private debt. This inefficient outcome arises when macro-prudential policies cannot be adjusted as frequently as monetary. Importantly, this result arises even when the central bank is politically independent. We then consider the role of political pressures in the spirit of Barro and Gordon (1983). We show that if either the macro-prudential regulator or the central bank (or both) are not politically independent, separation of price and financial stability objectives does not deliver the social optimum.

A systemic approach to financial regulation A European perspective

Résumé La crise financière globale a mis en évidence la pertinence et la virulence du risque systémique dans la finance innovante moderne. Celui-ci se fonde sur les dérives extrêmes des marchés du crédit et leurs corrélations étroites avec les mouvements de prix d’actifs. Les dysfonctionnements et les désordres de la finance sont si profonds et généralisés que des réformes radicales sont à l’ordre du jour. Dans cet article, nous défendons l’idée que la politique macro-prudentielle doit être le pivot de ces réformes. L’approche étant « top-down », elle empiète à la fois sur la politique monétaire et sur la politique micro-prudentielle. Classification JEL : G 01 ; G 28 ; E 58.

Reforming European financial supervision: adapting EU institutions to market structures

EU policymakers have created a new European System of Financial Supervision, consisting of three European Supervisory Authorities and a European Systemic Risk Board. This article examines some of the legal and institutional issues, including the ESAs’ authority to develop an EU code of financial regulation and to oversee its implementation by Member States and resolve related disputes. The article argues that the creation of the ESAs and ESRB is a proportional response to the increased integration of EU financial markets and the cross-border nature of systemic risk. The article suggests, however, that the ultimate effectiveness of these supervisory reforms will depend on whether they achieve a balance between crisis prevention supervisory measures and crisis management involving the rescue or resolution of financial firms. A better balance needs to be struck to achieve financial stability objectives.

Mali: Ex Post Assessment of Longer-Term Program Engagement: Staff Report; Statement by the Executive Director for Mali; and Public Information Notice on the Executive Board Discussion

Ex Post Assessments are intended to provide an opportunity to step back from continuing program relations to consider an analysis of the economic problems facing the country, review progress under IMF-supported programs, and draw forward-looking lessons for future IMF engagement. The program objective of macroeconomic and financial stability was broadly achieved, as evidenced by the moderate fiscal deficits, low and relatively stable rates of inflation, and the maintenance of a sustainable external debt position; but raising economic growth remained a challenge. Structural reforms are also necessary to encourage investment and employment.

Determinants of Property Prices in Hong Kong SAR: Implications for Policy

This paper uses an econometric model of residential property prices in Hong Kong SAR to assess the effectiveness of alternative policies in slowing the increase in property prices. The rapid rise in property prices is well explained by macroconomic fundamentals; real GDP per capital, real domestic credit, construction costs, land supply, and the real interest rate. Policy can influence the property market though land supply and prudential and tax policy, with the latter policies taking the form of a stamp duty on property transactions and a tighter loan-to-value ratio (LTV) on lending. Land supply is the most effective policy insturment for restraining property price increases but it operates with a significant lag. The LTV and stamp duty dampen speculative activity that drives up property prices. While these policies can slow the increase in the short run, they should be guided by their long run objectives of financial stability and counteracting speculation.

Determinants of Property Prices in Hong Kong Sar: Implications for Policy

This paper uses an econometric model of residential property prices in Hong Kong SAR to assess the effectiveness of alternative policies in slowing the increase in property prices. The rapid rise in property prices is well explained by macroconomic fundamentals; real GDP per capital, real domestic credit, construction costs, land supply, and the real interest rate. Policy can influence the property market though land supply and prudential and tax policy, with the latter policies taking the form of a stamp duty on property transactions and a tighter loan-to-value ratio (LTV) on lending. Land supply is the most effective policy insturment for restraining property price increases but it operates with a significant lag. The LTV and stamp duty dampen speculative activity that drives up property prices. While these policies can slow the increase in the short run, they should be guided by their long run objectives of financial stability and counteracting speculation.

Efficiency and risk in European banking

We assess the inter-temporal relationship between bank efficiency, capital and risk in a sample of European commercial banks employing several definitions of efficiency, risk and capital and using the Granger-causality methodology in a panel data framework. Our results suggest that lower bank efficiency with respect to costs and revenues Granger-causes higher bank risk and that increases in bank capital precede cost efficiency improvements. We also find that more efficient banks eventually become better capitalized and that higher capital levels tend to have a positive effect on efficiency levels. These results are generally confirmed by a series of robustness tests. The results have potentially important implications for bank prudential supervision and underline the importance of attaining long-term efficiency gains to support financial stability objectives.