29 February 2012

Stefan Gerlach: Macro-prudential policy in Ireland

In the last 20 years or so, it has become widely recognised that in order to conduct monetary policy well, it is essential that there is clarity about the framework of policy. The clarity of the framework is equally important for effective macro-prudential policy. It is therefore natural to start my talk by reviewing it.

The framework consists of four parts:

1. the goal or objective of macro-prudential policy;
2. the indicators policy-makers will use to judge if systemic risk is present;
3. the policy instruments that are available to deal with these risks;
4. the decision-making procedures used to set policy.

The goal of macro-prudential policy

It should be noted that such commonality in behaviour can be encouraged by regulators. For instance, the use of mark-to-market valuation practices and value-at-risk methodologies, and the reliance on credit ratings, can lead firms to behave in similar ways, magnifying the impact of economic disturbances on markets. Remuneration practices that provide incentives for investors to hold similar portfolios can also have this effect.

Macro-prudential indicators

After having selected appropriate indicators, policy-makers face two problems. First, the indicators must be accurately benchmarked, that is, a judgement must be made of what their “normal” range is and when they signal that risks are accumulating. This may be done by comparing them against a historical average, a peer group or a model-based estimate of a “natural” level. Nonetheless, there will always be competing views on the size and importance of any deviation from that level, and a healthy dose of judgement is therefore essential when formulating policy.

Second, no matter how good the indicators are, there is an unavoidable limit to how informative any indicator can be arising from the possibility of multiple equilibria. That is, a certain reading of an indicator may be compatible with financial stability if confidence is high, and incompatible with stability if it is low. Moreover, the economy can switch from one state or equilibrium to another with little or no forewarning from the indicators.

Macro-prudential instruments

There is a risk of unintended consequences in the form of regulatory arbitrage or unexpected responses by financial institutions. For instance, measures aimed at limiting credit supply may simply push activity into the shadow banking system or lead foreign lenders to step forwards. Macro-prudential policy will therefore necessarily be a process of trial-and-error, at least initially.

Moreover, policy-makers will likely employ several tools and it may be difficult to assess their interactions in advance. Finally, there is a need to recalibrate macro-prudential policy in response to changes in monetary policy. Let me therefore leave the framework of macro-prudential policy for a moment and consider the links between monetary and macro-prudential policy.

Decision-making arrangements

The ESRB recently recommended that five criteria regarding the macro-prudential mandates of national authorities be set down in national legislation.

• First, central banks must play a pivotal role in macro-prudential policy. There are several reasons for this. Importantly, central banks have considerable analytical resources and technical expertise. In particular, they have staff with expertise in analysing financial sector developments. Moreover, they have oversight of payments systems and serve as lenders of last resort. Finally, there are obvious links between monetary policy and macro-prudential policy.
• Second, it is essential that policy-makers have access to information and data on the components of the financial system. This must include, for example, data on individual financial institutions and developments in payments and settlements systems.
• Third, the  macro-prudential policy-maker must enjoy independence. Every now and then, macro-prudential policy will have to be tightened to constrain the financial system during a boom. There will then no doubt be strong pressures from financial institutions and borrowers alike not to do so, and there is always a risk that political pressures will arise. For much the same reasons as monetary policy-makers are independent, macro-prudential policy-makers must also be.
• Fourth, good policy requires policy-makers to be accountable. Thus, the macro-prudential policy-makers should explain to the public, through regular reports and perhaps also to parliament or a parliamentary committee, what measures it has taken and why.
• Fifth, the objectives of policy must be clear in law and the policy-makers must have legal power to set the policy instruments as needed to achieve these objectives, that is, there must be a firm legal basis for macro-prudential policy.

Macro prudential policy in Ireland

As the Central Bank of Ireland is responsible for financial regulation and supervision, it has access to the relevant information and the technical expertise necessary to analyse macro-prudential risks. Furthermore, it controls many potential policy instruments necessary to conduct macro-prudential policy. An advantage of an integrated central bank and micro-prudential supervisor is that it allows macro- and micro-prudential policy to be pursued in unison and policy trade-offs that arise to be internalised and discussed within a single institution.

The primary role of the Central Bank in relation to macro-prudential policy is clear. Firstly, the 2010 amendment to the Central Bank of Ireland Act (1942) states that the “stability of the financial system overall” is an objective of the Bank. Although not legally binding, the Memorandum of Understanding (MoU) on roles and responsibilities in relation to the financial sector between the Department of Finance and the Central Bank of Ireland that was signed in 2011 states that the “Central Bank has the statutory objective of stability of the financial system overall”.

Similarly, the 2007 MoU on financial stability between the Department of Finance, the Central Bank and the Financial Regulator, also holds that the central bank is responsible for the stability of the financial system. That said, there is little doubt that the Department of Finance also has responsibilities in this area. Indeed, the MoU reflects the high level of cooperation on financial stability issues which operates in practice between the Department and the Central Bank.

Conclusions

Ensuring that policy-makers are willing and able to act on any information that suggests that financial stability may be at risk is crucial. Tightening macro-prudential policy will never be popular since the costs of doing so are obvious and the benefits much harder to pinpoint. Clarity regarding the objective of macro-prudential policy, where responsibility lies for policy and what the accountability arrangements are, as well as the independence of the decision-makers, are all essential features of a strong macro-prudential framework.

Full speech

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