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17Dealing with the Challenges of Macro Financial Linkages in Emerging Marketshttp://dx.doi.org/10.1596/978-1-4648-0002-3

Adapting Macro Prudential Approaches to Emerging and Developing EconomiesHyun Song Shin*

Introduction

Traditionally, the focus of prudential policy has been on the solvency of indi-vidual financial institutions. Indeed, prior to the global financial crisis of 2007–09 the overall approach and reasoning underlying prudential regulations could have been broadly characterized by the following set of propositions:

• Minimumcapitalrequirementsserveasabufferagainstlossofbankassets,therebyprotectingdepositorsfromloss.Thefactthatrisk-weightedassetsareusedasthedenominatorinthecapitalratiorevealsthepurposeofthecapitalrequirementassettingabufferagainstlossfortheseniorcreditors,especiallythedepositors.Ifdepositsareinsuredbythegovernment,thebankcapitalrequirementalsoservesasabufferagainstlossbytaxpayers.

• Minimumcapitalrequirementsensurethatthebanks’ownershaveastakeinthevalueofthebank’sassets,therebyensuringthatownershavesufficient“skininthegame”todetermoralhazardontheirparttowardexcessiverisktaking.

• Havingensuredfinancialstabilitythroughbankcapitalrequirementsandinthe presence of well-functioning international capital markets, the role ofmonetarypolicyistofocusonmacroeconomicstabilizationbysettinginter-estratestostabilizecomponentsofaggregatedemandsuchasconsumptionandinvestment.

Theglobal financial crisishas raisedquestions regarding theadequacyof apolicyframeworkbasedonthesepropositionsalone,andhasspurredareassess-mentofthepurposeandeffectivenessofprudentialregulations.However,the

* Hyun Song Shin is Hughes-Rogers Professor of Economics at Princeton University. He thanks Swati R. Ghosh and Stijn Claessens for comments and guidance on this chapter.

C H A P T E R 1

18 Adapting Macro Prudential Approaches to Emerging and Developing Economies

Dealing with the Challenges of Macro Financial Linkages in Emerging Marketshttp://dx.doi.org/10.1596/978-1-4648-0002-3

thinkinghasnotyetbornefruitintermsofanyfundamentalshiftinthedebateconcerning prudential policy.

Thus,theThirdBaselAccord(BaselIII),thenewcapitalandliquidityframe-work for banks, has continued the tradition of basing banking regulation onbuildingbuffersagainstloss.Thecenterpieceofthenewagreedframeworkisastrengthened common equity buffer of 7 percent together with newly intro-ducedliquidityrequirementsandaleveragecaptobephasedinoveranextend-edtimetablerunningto2019(BCBS2010).

Basel III also incorporates a countercyclical capital surcharge in the range of 0–2.5 percent that can be introduced at the discretion of national regulators. The rationale for the countercyclical surcharge is to lean against the procyclicality of the financial system by demanding a higher capital buffer at the peak of thefinancialcycle.Basel IIIalsoenvisagesadditional requirementsonsystemicallyimportantfinancialinstitutions(SIFIs)intheformofcapitalsurcharges,leveragecapsorleviesdesignedtoimposeahighermarginofsafetyoninstitutionsthataredeemed“toobigtofail.”

However, neither the countercyclical capital requirement nor the SIFI sur-chargehasfounduniversalandconsistentacceptanceamongthemembercoun-triesoftheBaselCommitteeonBankingSupervision(BCBS).Inthecaseofthecountercyclical capital requirement, disagreement among the BCBS membercountriesonauniformrateofthecapitalsurchargehasmeantthatcountriescan,ineffect,optoutoftherequirement.Thecountercyclicalcapitalsurchargeislefttothediscretionofthenationalregulators,whocanimposethemwithinarangeof 0–2.5 percent. In the case of SIFIs, discussions are currently focused ontheimpositionofapossiblecapitalsurchargeonglobalSIFIs(G-SIFIs),suchaslargebankswithcross-borderoperations.Discussionshaverevolvedaroundthedifficultiesofcross-borderresolutionand,hence,theneedtoovercomethemoralhazardengenderedbythebanksbeingtoobigtofail.Foremergingordevelopingcountries,though,theissuesraisedbycross-borderbankingaresomewhatdiffer-entandhavetodowiththeir impactduringboomsandtheir role increatingexcessliquidityasdiscussedlater.

Overall,thecommondenominatorinBaselIIIthatappliesuniversally(thatis, not considering the countercyclical capital or SIFI surcharges) is almostexclusivelymicroprudentialinitsfocus,thatis,concernedwiththeresilienceofindividualbanks,ratherthanbeingmacroprudentialandconcernedwiththeresilienceofthefinancialsystemasawhole.Itsfocusremainson“lossabsor-bency”ofbankcapital.

Achievinggreaterlossabsorbencybyitselfisalmostcertainlyinadequatetoachievingastablefinancialsystemfortworeasons:

• Lossabsorbencydoesnotaddressdirectlytheprocyclicalityofthefinancialsystemandtheexcessive asset growthduringbooms.

• Preoccupationwithlossabsorbencydivertsattentionfromtheliabilities side of banks’ balance sheets and vulnerabilities from the reliance on unstableshort-termfundingandshort-termforeigncurrencyfunding.

Adapting Macro Prudential Approaches to Emerging and Developing Economies 19


Thesetwoshortcomingshavespecialimportancefordevelopingandemerg-ing economies given their susceptibility to global liquidity conditions and therelativelyearlystageofthedevelopmentoftheirfinancialsystems.Indeed,theBasel process has focused almost exclusively on the imperatives of advanced-country financial systems, rather than on the needs of emerging markets anddeveloping countries.

This chapter discusses the principles behind macro prudential policies andhowtheseprinciplescanbetranslated intoapolicy framework. It is intendedprimarilyasaconceptualdocumentthatlaysouttheeconomicprinciplesthatunderpinmacroprudentialpolicyratherthanasa“howto”manualthatdetailsanexhaustivelistofpossiblepolicymeasuresandrelevantcountryexperiences.

Analytical Background

Inkeepingwithitsconceptualfocus,thechapterbeginsbyoutliningsalientele-ments of the theory and practice of balance sheet management by financialintermediaries.Against this backgroundof financial institutions’ balance sheetmanagement,thenextsectiondiscusseshowgloballiquidityconditionsandtheexternal environment affect banks’ funding options and their implications forfinancial stability.

Balance Sheet ManagementThebankingsystemoccupiesapivotalroleforfinancialstability.Principlesofbalance sheet management that can inform policy discussions are describedhere.1

Intextbookdiscussionsofcorporatefinancingdecisions,thesetofpositivenetpresentvalue(NPV)projectsisoftentakenasgiven,withtheimplicationthatthesizeofthebalancesheetisfixedanddeterminedexogenously.Inasimplifiedsetting,thechoicecanbedepictedas infigure1.1.Theassetsarefixed,givenexogenouslybythesetofprojects(assets)ingreythathavepositiveNPV.Havingfixedtheassetsideofthebalancesheet,thediscussionturnsonhowthoseassetsare financed—that is, on the liabilities side of the balance sheet.

Theleft-handpaneloffigure1.1showsabalancesheetinwhichtheassetsarefinancedpredominatelybyequity.Thearrowindicatesashiftinthefundingmixtoastateinwhichsomeoftheequityisreplacedbydebt.Onewaythiscould be accomplished is through the repurchase of equity by using the

Figure 1.1 Choice of Mix of Debt and Equity Financing

A

Assets

Equity

Debt

L A

Assets

Equity

Debt

L



proceedsofadebtissue.Theleverageofthefirmisdefinedastheratioofassetstoequity.Hencetheshiftdepictedinfigure1.1leadstoanincreaseinthelever-ageof the firmbutwithoutanychange in the sizeof thebalance sheet as awhole.

However,figure1.1isnotagooddescriptionofthewaybankingsectorlever-agevariesoverthefinancialcycle.Thedistinguishingfeatureofbankingsectorleverage is that it fluctuates through changes in the total size of the balance sheet. Credit increases rapidly during the boom phase and increases less rapidly (orevendecreases)duringthedownturn.Someofthevariationinthesizeofbank-ing assets can be accounted for by the fluctuations in the size of the pool of posi-tiveNPVprojectsbutsomeofthefluctuationiscausedbyshiftsinthebank’swillingnesstotakeonriskypositionsoverthecycle—thatis,onthebank’sriskappetite.

AdrianandShin (2010,2011) show that shifts in the leverageof financialintermediariesconformmorecloselytofigure1.2inwhichleverageincreasesbyanexpansionofassets,takingtheequityofthebankasagiven.

One plausible scenario with empirical backing that is consistent with thechangedepictedinfigure1.2iswhenthebankmanagesthesizeofitsloanbooksothat itsrisk-weightedassetsaremaintainedtobeequalto itscapital. Ifthebankassessesthattherisksof lendinghavedeclined, itcanexpandits lendingwithoutbreachingitsminimumcapitalrequirements.

Consider, for example,whathappenswhen theequityof thebank itself issubjecttoshocks—bothpositiveandnegative.Duringtheupwardphaseofthefinancialcycle,greaterprofitabilityofthebankbolstersitscapitalposition.Thisbolsteredcapitalpositionconstitutesapositiveshocktoequity.(Conversely,dur-ing the downward phase of the financial cycle, losses or provisioning for bad debt constitutesanegativeshocktoequity.)Evenifthebankweretotargetafixedleverageratio,thepositiveshocktoequitywouldcausethebanktoincreasethesizeofitsbalancesheet.Forinstance,supposethatafinancialintermediaryman-agesitsbalancesheetactivelysoastomaintainaconstantleverageratioof10andthattheinitialbalancesheetisasfollows:theintermediaryholds$100worthofassetsandthebankholdsmarketablesecurities,whichhavebeenfundedwithdebtworth$90andequityof$10asinfigure1.3.

Figure 1.2 Increased Leverage through Expansion in Assets

A

Assets

Equity

Debt

L A

Assets

Equity

Debt

L



Nowassumethatthevalueofthedebtisapproximatelyconstantforsmallchangesintotalassets.First,let’sassumethatthepriceofsecuritiesincreasesby1percentto101.Thisshockimpactsthebalancesheetasdepictedinfigure1.4.

Leveragefallsto101/11=9.18.Ifthebanktargetsleverageof10,thenitmusttakeonadditionaldebtofDtopurchaseDworthofsecuritiesontheassetsideso that:

Assets/equity (101 D)/11 10, which impl= + = iies that D 9.=

Thebanktakesonadditionaldebtworth$9andwiththeproceedspurchasessecuritiesworth$9.Thus,anincreaseinthepriceofthesecurityof$1leadstoanincreasedholdingworth$9.Thedemandresponsefortheassetsheldbythebankisupwardsloping.Afterthepurchase,leverageisbackupto10(figure1.5).

Ifthebank’sassetsconsistofloansratherthansecurities,thentheincreaseinequityisbetterviewedasaresultofimprovedprofitabilityofthebank,whensomeofthenetincomeisaccumulatedintobankequity.Thepracticeof“mark-ingtomarket,”whereassetsarevaluedaccordingtoprevailingmarketprices,willmean a more immediate reflection of the asset value increase on the bank’sequityposition.

Figure 1.3 Initial Balance Sheet

Assets Liabilities

Securities, 100 Equity, 10

Debt, 90

Figure 1.4 Price of Securities Increases

Assets Liabilities


Debt, 90

Figure 1.5 Bank Adds Debt

Assets Liabilities


Debt, 99

Themechanismworksinreverseonthewaydown.Supposethereisashocktothepriceofsecuritiessothatthevalueofsecurityholdingsfallsto$109.Ontheliabilitiesside,itisequitythatbearstheburdenofadjustment,sincethevalueofdebtstaysapproximatelyconstant(seefigure1.6).



Leverage is now too high (109/10 = 10.9).The bank can adjust down itsleveragebysellingsecuritiesworth$9andpayingdown$9worthofdebt.Inthisway, a fall in the price of securities leads to a sale of securities. The supply response isdownwardsloping,unlikethetextbookcaseofanupwardslopingsupply response. The new balance sheet is hence restored to where it stood before theprice changes and leverage is backdown to the target level of 10(figure1.7).

In this way, maintaining constant leverage entails upward-sloping demandresponses and downward-sloping supply responses for the assets held by the bank.The perverse nature of the demand and supply curves is even stronger when the leverage of the financial intermediation is procyclical, that is, when leverage is high during booms and low during busts.As demonstrated inAdrian and Shin(2010,2011),banks’activemanagementoftheirbalancesheetsandtheiruseofvalue-at-risk (VaR) models results in procyclical leverage because the boom(downturn) reduces (increases) measured risk and hence induces banks toincrease (decrease) their leverage.

If,inaddition,thereisthepossibilityoffeedback,theadjustmentofleverageandofpricechangeswillreinforceeachotherinamplificationofthefinancialcycle.Ifgreaterdemandfortheassetstendstoputupwardpressureonitsprice,thereispotentialforfeedbackinwhichastrongerbalancesheettriggersgreaterdemandfor theasset(that is,greater lending),which inturnraises theasset’spriceandleadstostrongerbalancesheets.Inthecaseofbankswithloansratherthansecuritiesonthebalancesheet,theamplificationgoesthroughthegreaterprofitabilityofthebanksduringtheup-phaseofthefinancialcycle.

Themechanismworksinreverseindownturns.Ifgreatersupplyoftheassettendstoputdownwardpressureonitsprice,thenweakerbalancesheetsleadtogreater sales of the asset, which depresses the asset’s price and leads to evenweakerbalancesheets.Figure1.8illustratestheamplificationmechanisminboththe upward and downward phases of the financial cycle.

Figure 1.6 Value of Securities Falls

Assets Liabilities


Debt, 99

Figure 1.7 Bank Sells Securities

Assets Liabilities


Debt, 90



Theamplifyingnatureofbankingsectorbalancesheetmanagementhasfar-reachingimplicationsforfinancialstability.Financialintermediariesarenottypi-calofthetextbookrationalportfoliooptimizerwhodecidesontheassetholdingsbased on an assessment of some fundamental value. Instead, banks and otherfinancialintermediarieshavequiteperverseportfoliochoicebehaviorwheretheholdingofassetsdependsontheir“balancesheetcapacity.”Balancesheetcapac-itydependsontwothings:theamountofbankcapitalandthedegreeofpermit-ted leverage.

Duringaboom,balancesheetcapacityisbolsteredfortworeasons.First,bankcapital is bolstered by increased profitability of the bank, or the capital gainsimpliedbytheincreaseinassetprices.Second,loweredmeasuredrisksduringthetranquilup-phaseof the financial cycle raisebanks’ leverage. Inparticular, if abankismanagingassetriskthroughmanagingitsvalue-at-risk,thenafallinmea-suredrisktranslatesdirectlyintoanincreaseinbankleverage(AdrianandShin2009).

Thisperspectiveofthebankingsectorbalancesheetcapacityalsoshedslighton one finding regarding the financial stability implications of banking-sectorforeigndirectinvestment(FDI)(seeOstryandothers2010).FDIflowsareusu-allyequitystakesheldbyforeigninvestorsandareconventionallyassociatedwithlong-term financing that has beneficial effects. In this sense, FDI is normallyregardedasbeingabenignformofcapitalinflow.However,banking-sectorFDIappearstohaveamoredestabilizinginfluence.ThispointisespeciallyrelevantwithrespecttotheexperienceofemergingEuropeduringtherecentglobalcrisis.Ostryandothers(2010)findintheirempiricalanalysisthatfinancial-sectorFDIisassociatedwithlargerstocksofdebtliabilitiesofthebankingsectoranddoesnothave theconventionallyexpectedbeneficial effect. Indeed,countrieswithlarger financial FDI fared worse in the current crisis, while those with largernonfinancialFDIfaredbetter.ThevulnerabilityofemergingEuropeinthewakeof the recent crisis and the region’s heavy dependence for capital on foreignbankinggroups,particularlythosefromWesternEurope,givessomecluesonthelikelymechanism.Largerfinancial-sectorFDIintheformofgreaterinflowsof

Figure 1.8 Amplification Mechanism

Target leverage

Increase B/S size Stronger balance

sheets

Asset price boom

Target leverage

Weaker balance sheets

Reduce B/S size

Asset price decline



bankingsectorcapitalisthebaseonwhichlargerbankingsectorbalancesheetcapacitywillbebuilt.Thus,thebanking-sectorFDIinflowwillbeaccompaniedbythedebtfinancingthatbuildsupthebankingsector’stotallendingcapacity.If the local savings pool (say, through local retail deposits) is not large enough to financetheexpansioninlending,theparentbankwillsupplyintragroupfundingthrough wholesale deposit funding or other wholesale funding. In this way, financial-sectorFDIinthebankingsectorisinextricablyboundwithgreaterdebtflowsintothebankingsectorandleadstoagrowthinthenondepositfundingusedbythelocalbankingsystem.Ostryandothers(2010)findthatbothdebtandfinancialFDIarestronglyassociatedwithcreditboomsandforeignexchange(FX)-denominated lending by the domestic banking system, which in turn isassociated with greater vulnerability. Both are key channels through which acountrybecomessusceptibletocrises.ThegreatervulnerabilitytocrisesholdsevencontrollingforcreditboomsandFX-denominatedlending,perhapsbecausehouseholdsandfirmsmayborrowdirectlyfromabroad(orflowsareintermedi-atedthroughnonbankfinancialinstitutions).

External Environment and Global LiquidityExternalfinancialconditionsprovidethebackdroptodomesticfinancialcondi-tions, especially when the domestic banking system is open to funding frominternationally active banking groups with cross-border operations and alsopurelydomesticallyfocusedbankswithcross-borderfinancialactivities.Thissec-tionoutlines theways inwhichtheexternalenvironmentandglobal liquidityimpactonfinancialstability.

Thelowinterestratesmaintainedbyadvanced-economycentralbanksintheaftermathoftheglobalcrisishaveignitedalivelydebateaboutcapitalflowstoemergingmarkets.Oneof thedistinguishing featuresof thecreditboomthatprecededtheglobalfinancialcrisisof2008wastheroleplayedbybankingsectorinflows. Banking sector inflows surged during the period leading up to theLehmanBrothersbankruptcy,incontrasttotheAsiancrisisandintheimmediateaftermathofthecurrentcrisis,whenbanking-sectorinflowsaccountedforlessthan20percentofcapitalinflows(seeIMF2011).Understandingtheexternalenvironment and the roleof cross-borderbanking is important inputting therecentcrisisincontext.

TheU.S.dollarbankfundingmarkethasspecialsignificanceinthisdebate.Aswellasbeingtheworld’smostimportantreservecurrencyandinvoicingcurrencyin international trade, the U.S. dollar is also the currency that underpins theglobalbankingsystem.Itisthefundingcurrencyofchoiceforglobalbanks.TheUnitedStateshostsbranchesofabout160foreignbankswhosemainfunctionistoraisewholesaledollarfundingincapitalmarketsandthenshipittotheirheadoffices.

SomeoftheborroweddollarsreturntotheUnitedStatestofinancepurchasesofmortgage-backedsecurities(MBS)andotherassets.ButmuchofitflowstoEurope,Asia, and LatinAmerica where global banks are active local lenders(figure1.9).Inthisway,globalbanksbecomethecarriersforthetransmissionof



liquidityspilloversacrossborders.Atthemargin,theshadowvalueofbankfund-ingwillbeequalizedacrossallregionsthroughportfoliodecisionsofglobalbanksso that global banksbecome the carriers of dollar liquidity acrossborders.Assuch,permissiveU.S.liquidityconditionsaretransmittedgloballyandU.S.mon-etarypolicybecomes,insomerespects,globalmonetarypolicy.

Foreign bank branches raise over US$1 trillion of funding, of which overUS$600billionischanneledtotheirheadquarters(CGFS2010).Thisfigurecov-ersjustthebranchesofforeignbanks,nottheirsubsidiaries.IfthefundingshippedtotheparentbytheU.S.-basedsubsidiariesisalsoconsidered,thetotalfundingshippedtoheadquarterswouldbesubstantiallyhigher.Akeyquantityistheinter-officeassetsofforeignbankbranchesintheUnitedStates—thelendingbybranch-estoheadquarters—asshowninfigure1.10.Interofficeassetsincreasedsteeplyinthelasttwodecades,sawasharpdeclinein2008,butbouncedbackin2009.

WhatisremarkableabouttheU.S.dollarfundingmarketisthateveninnetterms, foreign banks have been channeling large amounts of dollar fundingoutoftheUnitedStatestotheirrespectiveheadoffices.Figure1.11showsnetinteroffice assets of foreign banks in theUnitedStates.Net interoffice assetsmeasure thenetclaimof thebranchor subsidiaryof the foreignbankon itsparent. Normally, net interoffice assets would be negative, as foreign bankbranchesactaslendingoutposts.However,weseethatthedecade2001–11wasexceptional,whennetinterofficeassetsturnedsharplypositive,beforereversingintonegativeterritoryduringtheheightoftheEuropeancrisisin2011.Ineffect,between2001and2011,foreignbankofficesbecamefundingsourcesforthe

Figure 1.9 Role of Global Banks

Borrowersin A

Borrowersin B

Borrowersin C

Banksin A

Banksin B

Banksin C

Globalbanks

Wholesalefundingmarket



Figure 1.10 Interoffice Assets of Foreign Bank Branches in United States

31-Dec-08

30-Jun-08

0

100

200

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600

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800

900

Mar-8

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Sep-86

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Sep-01

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Sep-07

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, bill

ion

s

Source: Federal Reserve.

parent,ratherthanlendingoutposts.AsnotedinarecentBankforInternationalSettlements (BIS) report, many European banks use a centralized fundingmodel in which available funds are deployed globally through a centralizedportfolioallocationdecision(BIS2010a).ThenetinterofficepositionofforeignbanksintheUnitedStatesthereforereflectstheextenttowhichglobalbankswereengagedinsupplyingU.S.dollarfundingtootherpartsoftheworld.

Wethusfaceanapparentparadox:althoughtheUnitedStatesisthelargestnetdebtorintheworld,itisasubstantialnetcreditorintheglobalbankingsys-tem.Ineffect,theUnitedStatesisborrowinglong(throughtreasuryandothersecurities)butlendingshortthroughthebankingsector.Thissituationisincon-trasttocountriessuchasIrelandandSpainthatfinancedtheircurrentaccountdeficitsthroughtheirrespectivebankingsectorsandthathavesubsequentlypaidthepricethroughrunsbywholesalecreditorsontheirbanks.

Inthischapterwewillmakefrequentuseofthenetinterofficeaccountposi-tionofforeignbanksintheUnitedStatesasanempiricalproxyfortheavailabil-ityofwholesalefundingprovidedtoborrowersinthecapital-recipienteconomy.BrunoandShin(2011)conductedanempiricalstudyofthesensitivityofcapitalflows to global factors.

Althoughthere isa largedegreeof synchronizationofbanking-sector flowsacrossdifferentgeographicalregionsandcountries,thereisalsosomediversityinthepatternofbankingflows.EmergingEuropesawthemostrapidincreaseinbanking-sectorinflows,followedbycountriessuchasTurkeyandtheRepublicofKorea.Onefactorinthediverseregionalexperienceshastodowiththedivergentbusinessmodelspursuedbycross-borderbanksthatformthebridgebetweena



Figure 1.11 Trends in Assets of Foreign Banks in the United States

–2.0

–1.5

–1.0

–0.5

0

0.5

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1.5

2.0a. Assets and liabilities of foreign banks in the United States

b. Net interoffice assets of foreign banks in the United States

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05

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9

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US$

, tri

llion

sU

S$, b

illio

ns

Net interoffice assets Large time deposits Borrowings from banks in United StatesBorrowings from others Securities Loans and leasesCash assets

–400

–200

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9

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25-Oct-

95

20-Nov-9

6

17-Dec-9

7

13-Jan-9

9

09-Feb-00

07-Mar-0

1

03-Apr-0

2

30-Apr-0

3

26-May-0

4

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5

19-Jul-0

6

15-Aug-0

7

10-Sep-0

8

07-Oct-

09

03-Nov-1

0

30-Nov-1

1

Net interoffice assets of foreign banks in United States

Source: Federal Reserve Board H8 series on commercial banks.



particularregionandtheglobalbankingsystem.AnotherBISpaperonfundingpatternsofglobalbanksdrawsadistinctionbetweenglobalbanksthatoperateacentralizedportfolioallocationmodelandthosethatpursueamoredecentralizedoperationalmodel(BIS2010b).SpanishbanksthathavelargelocalsubsidiariesinLatinAmericaarecitedasanexampleofthedecentralizedmodeofoperation,where the local subsidiaries draw on local deposit funding and operate largely independently from the parent in terms of its asset allocation. In contrast,Europeanbanksoperateamorecentralizedportfolioallocationmodelwheretheportfolioallocationand fundingdecisionsaremadeat thegroupheadquartersandthebankinggroup’sglobalportfoliodecisionfollowsacentralizedpattern.

Macro Prudential Framework

Drawingontheanalyticalbackgrounddiscussedearlier,weturntotheelementsofamacroprudentialframework.Amacroprudentialframeworkencompassestwokeyelements:

• Asetofindicatorsthatcaninformjudgmentsonthedegreeofvulnerabilitytofinancialinstabilityandhenceserveastheinformationalbasisforpolicyactions

• Anassociatedsetofpolicytoolsorautomaticstabilizersthatcankickinwhencircumstanceswarranttoanticipateandmitigatethevulnerabilities.

Macro Prudential indicatorsGiventhecentralityof thebankingsectorand itspotential foramplifyingtheprocyclicalityofthefinancialsystem,thepaceofassetgrowthisoffirst-orderinterest.Thechallengeforpolicymakersisknowingwhenassetgrowthmaybe“excessive”andfindingpolicytoolsthatcanaddressandcountertheexcessiveassetgrowthinatimelyandeffectivemanner.

Ratio of Credit Growth to GDPIndicatorsthatcapturesomenotionoftheratiooftotalprivatesectorcredittoGDPhavebeendiscussed.Thisratiohasbeenshowntobeausefulindicatorofthestageofthefinancialcycle,asdemonstratedbytheworkofBISeconomists,notablyBorioandLowe(2002,2004).

UndertheBaselIIIframework,theratioofcredittoGDPhasbeengivenacentralroleintheframeworkforcountercyclicalbuffer.Theinitialconsultationdocument(BCBS2009)issuedbytheBaselCommitteeinDecember2009firstproposed a countercyclical capital buffer surcharge to act as a further buffer againstlossduringtheupswingofthefinancialcycle.Subsequentdevelopmentoftheconceptfocusedonthecredit-to-GDPratioasameasureofprocyclicalitythatwouldtriggerincreasedcapitalrequirementsonbanks.ThefinalversionoftheBasel III framework left the implementationof thecountercyclicalcapitalbuffer to the discretion of national regulators, with the additional buffer in the range of 0–2.5 percent.



Conceptually,itisnaturalthatcreditgrowthshouldbescaledbynormalizingitrelativetosomeunderlyingfundamentalmeasure.NormalizingcreditgrowthbyGDPhasmanyadvantages.GDPisanaggregateflowmeasureofeconomicactivitythatreflectscurrenteconomicconditions,andonethatisreadilyavail-ableunderbasicnationalincomecalculations.Moreover,itisameasurethatishighly standardized across countries, which helps in competition and level-playingfielddisputesintheconsistentimplementationofinternationalbankingregulation rules.

However, therearemeasurementchallenges,evenfortheconceptofcreditgrowth.To serve as a signalofprocyclicality, credit growth shouldmirror therisk-takingattitudesofmarketpremiums,wheretheyarerelevant.Theneedforjudgment is important inemerginganddevelopingcountrieswhere long-termstructuralchangesthroughfinancialdevelopmentmayrendercreditgrowthsta-tisticslessusefulasagaugeofriskappetite.Forinstance,iftheratioofprivatecredit to GDP shows rapid increase because of informal credit arrangementsmovingintotheformalizedbankingsector,suchadevelopmenthasbenigncon-sequencesforfinancialstability.Incontrast,iftheratioofprivatecredittoGDPincreasesbecauseofahousingboomthatisfedbycheapcreditandtherecyclingof funding by nonfinancial companies, the financial stability implications aremoreworrying.Thesimplecredit-to-GDPratiomaysuffer fromthe fact thattheaggregatemeasuresofcreditgrowthmaymasksomesubtletiesthatcannotbesummarizedinonesimpleaggregate.Itisalsoconceivablethattheremaybeendogenous changes in economic relationships if the reduced-form economicrelationshipsthatunderpincreditandGDPareusedforpolicypurposes.

Apossiblecounterargumenttotheaccusationthatthecredit-to-GDPratiosmaybetoobluntisthatanypolicymakerwouldexercisejudgmentwheninter-pretingfigures.Also,itcouldbearguedthatthereisanasymmetrybetweentheupswingpartofthefinancialcycleandthedownswingpart.Duringtheupswing,itmaybearguedthatthepolicyof“leaningagainstthewind”canutilizeinforma-tioncontainedintherapidgrowthofthecredit-to-GDPratio.

Assenmacher-WescheandGerlach(2010)presentanopposingviewpointtotheemphasisplacedbyBorioandLowe(2002,2004)onthecredit-to-GDPratioas an informative signal of the buildup of vulnerabilities in the economy.Assenmacher-Wesche and Gerlach (2010) take a skeptical line on the linkbetween credit growth and property price increases. Although they find that creditshocksareassociatedwithincreasesinrealGDPandequityprices,theydonotfindevidencethatcreditgrowthhasalargeimpactonpropertyprices.Theauthorstakethisresultasevidencethatthebulkofthevariationincreditgrowthisrelatedtoexpectedfuturechangesinrealeconomicactivity,andtheyconcludethat the widely accepted view that fluctuations in credit growth have been a majordriverofpropertyprice shocks seemsnot tobe supportedby thedata.Assenmacher-WescheandGerlach’s(2010)studyusesdatafromtheOrganisationforEconomicCo-operationandDevelopment(OECD)countriescoveringtheperiod 1986–2008. Hence, their study applies to advanced economies ratherthantodevelopingandemergingeconomies.However,thedifficultyoffinding



conclusiveevidenceforthelinkbetweencreditandpropertypricesmaybemorewidely applicable.

Thefundamentaldifficultyisthatasimplecredit-to-GDPratiolacksacon-ceptualframeworkthatcaneasilylinkthemeasurementtomeasuresoffinancialvulnerability.Theskepticcouldalwaysarguethatasurgeincreditcouldeitherbecausedbyastructuralchangeintheeconomy,theincreaseinpositivenetpres-entvalueprojects,andhencethedemandforcreditthatisfullyjustifiedbythefundamentals,orsimplybythemigrationoflendingrelationshipstotheformalbankingsectorthatwerepreviouslytakingplaceintheinformalsector.Furtherresearchwillbenecessarytodeterminetowhatextentthesimplecredit-to-GDPratiocanserveasafinelycalibratedsignalthatcansupporttheuseofautomatictighteningofbankcapitalstandards,asenvisagedintheBaselIIIframework.

Bank Liability AggregatesBecauseofthedifficultiesinusingthesimplecredit-to-GDPratioastheappro-priate signalof thestageof the financialcycle,alternativesmaybepreferable.Measuresderivedfromtheliabilities sideofbanking-sectorbalancesheetsshowpromise. In particular, the growth of various components of noncore-to-coreliabilitiesofthebankingsectormaybeespeciallyusefulingaugingthestageofthefinancialcycle,asarguedbyShinandShin(2010).Thefollowingdiscussiondraws closely on this study.

Although traditional monetary aggregates such as M1 and M22 are also liability-sideaggregatesof thebankingsector(measuringmainly thedepositliabilities),therearereasonstobelievethatsuchtraditionalmonetaryaggre-gatescanberefinedandimproveduponsoastoserveaseffectiveindicatorsthatunderpineffectivemacroprudentialpolicy.

Banksarethemostimportantfinancialintermediariesinemerginganddevel-opingeconomies.Traditionalmonetaryaggregatesgiveawindowonthesizeandcompositionofbank liabilities.KeymonetaryaggregatessuchasM2trackthesizeofthedepositbaseofthedomesticbankingsystem,andhencecanserveasaproxy for theclaimof thehousehold sectoron thebanking sector. Inmoreadvanced financial systems where market-based debt instruments are moredeveloped,theclaimsontheintermediarysectorcouldincludemoneymarketfundsandothershort-termclaimsheldbythehouseholdsector.

Totheextentthatmonetaryaggregatesreflectthesizeandcompositionofthebanks’balancesheets,theymayplayaroleinmacroprudentialpolicy.Centralbanksthatcontinuetogivesomeattentiontomonetaryaggregatesintheirpolicyframeworks have increasingly emphasized the financial stability properties ofmonetaryaggregates,movingawayfromthemoretraditionalrationaleforfocus-ing on monetary aggregates based on the quantity theory of money and theassociation with inflation.

Traditional classificationsofmonetary aggregates focuson the transactionalroleofmoneyasamediumofexchange.Assuch,thecriterionisbasedonhowclose to cash—how “money-like”—a particular financial claim is. The classicstudybyGurleyandShaw(1960)emphasizedthedistinctionbetween“inside



money,”whichisaliabilityofaprivatesectoragent,and“outsidemoney,”(suchasfiatcurrency)whichisnot.Thetraditionalfocusofmonetaryanalysishasbeenonmoneyasamediumofexchange.

Demanddepositsarethearchetypalmoneymeasure,sincesuchliabilitiesofthebankingsectorcanbequicklytransferredfromonepersontoanother.Savingsdepositsarelessmoneylike,andhencefigureinbroadernotionsofmoney,suchasM2,butevenhere they falloutside theM2measure if thedepositor facesrestrictions on easy access to the funds. In this way, the traditional hierarchy of monetaryaggregatesgoesfromcashtothevery liquidclaimssuchasdemanddepositsandcontinuingtomoreilliquidclaimssuchastermsavingsdeposits.Thecriterionishoweasilyclaimscanbeusedtosettletransactions.InthecontextofthequantitytheoryofmoneyandthemainquantitytheoryaccountingidentityMV = PY,thetraditionalmonetaryaggregateismoreappropriateinidentifyingtheextenttowhichinflationislikely.

For financial stabilitypurposes,however,analternativeclassificationsystemfor liabilityaggregatesmaybeneeded that is conceptuallyabetter fit for thevulnerabilitytofinancialshocksandtheirpropagation.Thekeytaskwouldbetodrawonexistingknowledgeofthebehavioroffinancialintermediaries(asdis-cussedinthebalancesheetmanagementsectionofthischapter)andtofindthecounterpartsinbankingsectorliabilityaggregatesthathaveimplicationsontheprocyclicality of financial system. Traditional transaction-motivated monetaryaggregatesmaynotbethemostusefulmeasureinthisrespect.

Core and Noncore Bank LiabilitiesOnecluecanbeobtainedfromourearlierexamination(intheexternalenviron-mentandgloballiquiditysectionofthischapter)oftheroleofexternalfundingconditions in influencing banking-sector behavior.A useful distinction is thatbetween core and noncoreliabilitiesofthebankingsector.Coreliabilitiescanbedefined as the funding that the bank draws on during normal times, and issourced(inthemain)domestically.Whatconstitutescorefundingwilldependonthecontextandtheeconomyinquestion,butretaildepositsofthehouseholdsectorwouldbeagoodfirstconjectureindefiningcoreliabilities.

Whenbankingsectorassetsaregrowingrapidly,thecorefundingavailabletothebankingsectorislikelytobeinsufficienttofinancetherapidgrowthinnewlending. This shortage is because retail deposits grow in line with the aggregate wealthofthehouseholdsector.Inalendingboom,whencreditisgrowingveryrapidly,thepoolofretaildepositsisnotlikelytobesufficienttofundtheincreaseinbankcredit.Othersourcesoffundingmustthenbetappedtofundrapidlyincreasingbanklending.Thestateofthefinancialcycleisthusreflectedinthecompositionofbankliabilities.

Tobetter focus thediscussionaroundthekeyconcepts,we first layoutanaccountingframeworkforthefinancialsystemasawholethatwillbeusefullaterin distinguishing between core and noncore liabilities.

Supposetherearenbanksinthedomesticbankingsystem.Theterm“bank”should be interpreted broadly to include firms in the intermediary sector



generally.The exact composition of the sector will depend on the country’sfinancialsystem,includingitsdegreeofopennessandfinancialdevelopment.Wedenotethebanksbyanindexthattakesvaluesintheset{1,2,...,n}.Thedomes-ticcreditorsector(forexample,householdsanddomesticpensionfunds)isgiventheindexn + 1.Theforeigncreditorsectorisgiventheindexn + 2.

Bankihastwotypesofassets.First,thereareloanstoenduserssuchascor-porationsorhouseholds.Denotethetotalloansbybanki to such end users of credit as yi.Next, therearetheclaimsagainstotherfinancial institutions.Callthesethe“interbank”assets,althoughthetermcoversallclaimsonotherinter-mediaries.Thetotalinterbankassetsheldbybanki are

x j jij

n

π=

∑1

where xjisthetotaldebtofbankj and pjiistheshareofbankj’sdebtheldbybanki.

Note that pi,n + 1 istheproportionofthebank’sliabilitiesheldbythedomesticcreditorsector(forexample,intheformofdeposits),whilepi,n + 2 is the propor-tionofthebank’sliabilitiesheldbyforeigncreditors(forexample,intheformofshort-termforeigncurrency-denominateddebt).Since“banks”n + 1andn + 2 are not leveraged, we have xn + 1 = xn + 2 =0.Thebalancesheetidentityofbank i is given by

y x e xi j ji i ij

n

+ = +=

∑ π1

Theleft-handsideoftheequationisthetotalassetsofthebank.Theright-hand side is the sum of equity and debt. Letting x = [x1 … xn] and y = [y1 … yn], we can write in vector notation the balance sheet identities of all banksas

y x e x+ ∏ = +

where Pisthematrixwhose(i,j )th entry is pij.Solvingfory,

y e x I= + − ∏( ).

Defineleverageastheratiooftotalassetstoequity,givenby

a

ei

ii= λ .

Then defining Lasthediagonalmatrixwithli along the diagonal, we have

y e e I I= + − − ∏( )( )Λ

where P is the matrix of interbank liabilities. By post-multiplying the aboveequationbytheunitcolumnvector



u =

1

1

wecansumuptherowsofthevectorequationabove,andwehavethefollowingbalance sheet identity:

y e e zii

ii

i i ii

∑ ∑ ∑= + −( )λ 1

where zi is given by the ith row of (I - P)u.Here,zi has the interpretation of the proportionof thebank’s liabilities thatcomefromoutsidethebankingsector,thatis,theproportionoffundingthatcomeseitherfromtheultimatedomesticcreditors (for example, deposits) or the foreign sector (for example, foreigncurrency-denominatedbanking-sectorliabilities).

Therefore, we can rewrite the aggregate balance sheet identity in the follow-ing way:

Total credit Total equity of banking sect= oor Liabilities to nonbank

+ domestic creditors Liabilities+ to foreign creditors.

This accounting framework helps us understand the connection between(1) the procyclicality of the banking system, (2) systemic risk spillovers, and(3)thestockofnoncoreliabilitiesofthebankingsystem.

Withinthisaccountingframework,thecore liabilitiesofabankcanbedefinedasitsliabilitiestononbankdomesticcreditors(suchasthroughretaildeposits).Thus, the noncore liabilitiesofabankareeither(1)aliabilitytoanotherbankor(2) a liability to a foreign creditor. Two features distinguish noncore liabilities. First,noncoreliabilitiesincludeclaimsheldbyintermediariesonotherinterme-diaries.Second,theyincludeliabilitiestoforeigncreditors,whoaretypicallytheglobalbanks,andhencealsointermediaries,albeitforeignones.Evenforliabilitiestodomesticcreditors,ifthecreditorisanotherintermediary,theclaimtendstobe short term.The distinction between core and noncore liabilities becomesmeaningful once there are differences in the empirical properties of the twotypes of liabilities.

Table 1.1, taken from Shin and Shin (2010), is a two-way classification ofbanking sector liabilities that distinguishes the traditional concern with theliquidityofmonetaryaggregatesfortransactionpurposestogetherwiththeques-tion of whether the liabilities are core or noncore. The distinction between core andnoncoreliabilitieshaswidespreadapplicability,buttheprecisedemarcationlinebetweencoreandnoncorefundingdependsontheparticulareconomyandthecontextoffinancialdevelopment.Foradvancedeconomieswithdevelopedfinancial systems, noncore liabilities will include nondeposit funding that israisedinthewholesalebankfundingmarket.

Itwouldbereasonabletoconjecturethatcoreliabilitiesaremorestable(or“sticky”)thannoncoreliabilities.Forinstance,retaildepositsofhouseholdsavers



wouldbemorestablethancorporatedeposits,whichinturncouldbesubdividedintononfinancialcompanydepositsandfinancial institutiondeposits.Again, itwouldbeareasonableconjecturethatnonfinancialcorporatedepositsaremore“sticky”thanfinancialcompanydeposits.Indeed,thereisconsiderableempiricalsupportforthedifferentpropertiesofbankliabilitiesdependingonwhoholdstheclaim.

Hahmetal.(2010)examinethecomponentsofKoreanbanks’liabilities,sub-dividedintothetwo-dimensionalcategorizationillustratedintable1.1,thatis,byclassifyingliabilitiesintohowliquidtheyareandwhoholdsthem.Theypres-entevidenceofaclearhierarchywithineachliquiditycategoryoftherelative“stickiness”oftheliability,dependingonwhethertheliabilityisduetothehouse-hold sector, nonfinancial corporate sector or financial corporate sector.

As mentioned, the dividing line between core and noncore liabilities willdependonthefinancialsysteminquestionanditsdegreeofopennessandthelevelofdevelopmentof its financialmarketsand institutions.Foradevelopedfinancial system like the United States or Western Europe, the distinctionbetweencoreandnoncoreliabilitiesseemsreasonablywellcapturedbythedis-tinctionbetweendeposit andnondeposit funding.Figure1.12,which is takenfromShin(2009),showsthecompositionoftheliabilitiesofNorthernRock,theU.K.bankwhosefailurein2007heraldedtheglobalfinancialcrisis.

In the nine years from 1998 to 2007, Northern Rock’s lending increased6.5times.Thisincreaseinlendingfaroutstrippedthefundsraisedthroughretaildepositswiththerestofthefundinggapbeingmadeupbywholesalefunding(securitizednotesandotherlendingasshowninfigure1.12).NorthernRock’scaseillustratesthegenerallessonthatduringacreditboom,therapidincreaseinbanklendingoutstripsthecoredepositfundingavailabletoabank.Astheboomprogresses,thebankresortstoalternative,noncoreliabilitiestofinanceitslend-ing.Therefore, theproportionofnoncore liabilitiesofbanksservesasausefulindicator of the stage of the financial cycle and the degree of vulnerability of the bankingsystemtoadownturnofthefinancialcycle.

Foremergingordevelopingeconomies,morethoughtisneededtofindause-fulclassificationsystembetweencoreandnoncoreliabilities.Inanopenemerging

Table 1.1 Classification of Core versus Noncore Liabilities

Core liability Intermediate Noncore liability

Highly liquid Cash Demand deposits (households)

Demand deposits (nonfi-nancial corporate)

Repos Call loans Short-term FX bank debt

Intermediate Time deposits and CDs (households)

Time deposits and CDs (nonfinancial corpo-rate)

Time deposits and CDs (banks and securities firms)

Illiquid Trust accounts (house-holds) Covered bonds (households)

Trust accounts (nonfinan-cial corporate)

Long-term bank debt securities (banks and securities firms) ABS and MBSa

Source: Shin and Shin 2010.Note: CDs = certificates of deposit.a. ABS is asset-backed securities; MBS is mortgage-backed securities.



economywherethebankingsystemisopentofundingfromglobalbanks,rapidincreasesinthenoncoreliabilitiesofthebankingsystemwouldshowupascapi-tal inflows through increased foreign exchange-denominated liabilities of thebankingsystem.Forthisreason,foreignexchange-denominatedliabilitiesofthebankingsectorcanbeexpectedtoplayakeyroleindiagnosingthepotentialforfinancial instability.

ForthecaseofKorea,ShinandShin(2010)proposedadefinitionofnoncoreliabilities as the sum of (1) foreign exchange-denominated bank liabilities,(2)bankdebtsecurities,(3)promissorynotes,(4)repos,and(5)certificatesofdeposit.3Note that thismeasure of noncore liabilities is an approximationof“true”noncoreliabilitiesdefinedinouraccountingframeworkabove,astheclas-sificationisstillbasedonfinancialinstrumentsratherthanactualclaimholders.Forinstance,bankdebtsecuritiessuchasdebenturesandcertificatesofdeposit(CDs)canbeheldbyhouseholds,andmustbeexcludedfromthenoncorelia-bilities.Figure1.13chartsthenoncore liabilitiesoftheKoreanbankingsector,taken fromShin andShin (2010)with theFX liabilities shownas“other FXborrowing.” It is noticeable how the first peak in noncore liabilities coincideswiththe1997crisis.Afteralullintheearly2000s,noncoreliabilitiesincreaserapidlyintherunuptothe2008crisis.

NotethatthemajorpeakoccurssomeweeksaftertheoutbreakofthecrisisbecausethetotalamountsaremeasuredinKoreanwon,andtheoutbreakofthecrisiscoincideswitharapiddepreciationofthewon,whichimpliesanincreaseinthewonvalueoftheforeigncurrency-denominatedbankliabilities.

The pronounced procyclicality of the noncore liability series for Korea should notcomeasasurprise,givenwhatweknow(seeearlierdiscussioninthischapter)

Figure 1.12 Northern Rock Bank’s Liabilities, 1998–2007

0

20

40

60

80

100

120

Jun-9

8

Dec-98

Jun-9

9

Dec-99

Jun-0

0

Dec-00

Jun-0

1

Dec-01

Jun-0

2

Dec-02

Jun-0

3

Dec-03

Jun-0

4

Dec-04

Jun-0

5

Dec-05

Jun-0

6

Dec-06

Jun-0

7

US$

, bill

ions

Equity Other liabilities Securitized notes Retail deposits

Source: Shin 2009.



aboutthebalancesheetmanagementpracticesofbanksandtheperversenatureofthedemandandsupplyresponsestoassetpricechangesandshiftstomeasuredrisks. During a credit boom, when measured risks are low and funding fromglobal banks is easy to obtain, we would expect to see strong credit growthfuelledbycapitalinflowsintothebankingsector,ofteninforeignexchange.

Figure1.14showshowcapitalflowsassociatedwithforeigncurrencyliabili-tiesofthebankingsectorplayedakeyroleintheforeignexchangeliquiditycrisisof2008inKorea.Figure1.14plotsandcomparesthenetofcapitalinflowsandoutflowsfor twosectors: theequitysectorandthebankingsector.Theequitysector actually saw net inflowsduringthecrisisintheautumnof2008.Contraryto thecommonmisperception(perpetuatedby televisionbroadcasts fromthestockexchangeafterturbulenttrading)thattheexitofforeigninvestorsfromtheKorean stockmarket is themain reason for capital outflows,we can see thattheflowsintheequitysectorwasnet positiveimmediatelyafterthecrisis.

Therearegoodreasonsforwhytheequitysectorshouldseenetpositiveflowsduringacrisis.Equityoutflowshavetwomitigatingfactors.Duringacrisis,not

Figure 1.13 Noncore Liabilities of the Korean Banking Sector

0

100

200

300

400

500

600

700

800

Jan-9

1

Jan-9

3

Jan-9

5

Jan-9

7

Jan-9

9

Jan-0

1

Jan-0

3

Jan-0

5

Jan-0

7

Jan-0

9

Won

, tri

llion

s

[Other] FX borrowing [Lf] debt securities [Lf] repos

[M2] promissory note 2 [M2] promissory note 1 [M2] certificate of deposit

Source: Shin and Shin 2010.



onlydostockpricesfallsharplybutthereisasteepdepreciationofthelocalcur-rencyrelativetoU.S.dollars.Forbothreasons,foreigninvestorssuffera“doublewhammy” if they withdraw from the local stock market. Provided that theexchangerateisallowedtoadjust,equityoutflowswillnotbethemainculpritindrainingforeigncurrencyreserves.WhenKoreaninvestorshaveequityinvest-mentsabroad,therepatriationflowsbacktoKoreawilloutweightheoutflowsfromforeigninvestors.

However,thebankingsectorisdifferentforthreereasons.First,foreigncur-rencyliabilitiesofthebankshaveafacevaluethatmustbemetinfull.Second,thefacevalueisinforeigncurrency.Third,thedynamicsofdeleveragingsetoffamplifyingeffectsthroughpricechangesandshiftsinmeasuredrisks.

Forallthreereasons,thedeleveragingofthebankingsectorisassociatedwithprecipitouscapitaloutflows.Unlikelong-terminvestors,suchaspensionfunds,mutualfunds,andlifeinsurancecompanies,leveragedinstitutionsarevulnerabletoerosionoftheircapital,andhenceengageinsubstantialadjustmentsoftheirassetseventosmall shocks.Thefeedback loopgeneratedbysuchreactionstopricechangesamplifiesshocks.

Asfigure1.14shows,thebankingsectorinKoreasawsubstantialcapitalout-flowsintheaftermathoftheLehmancrisis.InthethreemonthsfollowingtheLehmanbankruptcy, theoutflow from thebanking sectorwasUS$49billion,whichmorethanaccountsforthedecreaseinKorea’sforeignexchangereservesfromoverUS$240billionbeforetheLehmancrisistoUS$200billionattheendof 2008. Deleveraging by banks and the associated amplification effects havefiguredprominentlyinemergingeconomyfinancialcrises.

Figure 1.14 Net Capital Flows of Equity and Banking Sector in Korea

–25

–20

–15

–10

–5

0

5

10

15

2005/01

2005/04

2005/07

2005/10

2006/01

2006/04

2006/07

2006/10

2007/01

2007/04

2007/07

2007/10

2008/01

2008/04

2008/07

2008/10

2009/01

2009/04

2009/07

2009/10

US$

, bill

ion

s

Bank FX liabilities Equity

Source: Shin and Shin 2010.



Cross-Section Measures of Risk and Core and Noncore LiabilitiesIn aboomwhencredit is growing rapidly, thegrowthofbankbalance sheetsoutstripsthegrowthinthepoolofretaildeposits.Asaresult,thegrowthofbanklendingresultsingreaterlendingandborrowingamongtheintermediariesthem-selves, or results in the “sucking in” of foreign debt.Thus, the “cross-section”dimension of risk where banks are vulnerable to a common shock is closelyrelatedtothe“time-series”dimensionofriskhavingtodowithprocyclicalityofthebalancesheetwhereassetsarelargerduringthepeakofthefinancialcycle.

Toillustratetheprinciplethatthecross-sectionandtime-seriesdimensionsofriskarecloselyrelated,considerthesimplecasewherethereisnoforeigncredi-torsector.Figure1.15depictsastylizedfinancialsystemwithtwobanks:Bank1andBank2.Bothbanksdrawonretaildepositstolendtoultimateborrowers.Theycanalsoholdclaimsagainsteachother,iftheysochoose.

Imaginealendingboominwhichtheassetsofbothbanksdoubleinsize,butthepool of retail deposits stays fixed.Then, theproportionofbanking-sectorliabilitiesintheformofretaildepositsmustfall.Inotherwords,rapidlyexpand-ingbankassetsaremirroredbyincreasedcross-claimsacrossbanks.Thegrowthinbankassetsandincreasedsystemicriskaretwosidesofthesamecoin.

Therelationshipbetweenbanking-sectorassetsandincreasedcrossexposureacrossbanksholdsmoregenerally in theaccounting identitydescribedearlier.Recallourdefinitionofcoreandnoncoreliabilities.Thecore liabilitiesofabankareitsliabilitiestoclaimholderswhoarenotfinancialintermediariesthemselves,suchasretaildeposits.Anyliabilityofanintermediaryheldbyanotherinterme-diary would be a noncore liability.

Fromourearlieraccountingidentityforthefinancialsystemasawhole,wecandefinethetotalcoreliabilitiesofthebankingsectoras:

Total core liabilities = −=∑ e zi i ii

n( )λ 1

1

where, as before, eiistheequityofbanki, liistheleverageofbanki, zi is the ratioofbanki’scoreliabilitiestoitstotalliabilities,andnisthenumberofbanksin thebanking system.Since total core liabilities (suchas retaildeposits) areslowmoving,arapidincreaseintotalbankassets(equitymultipliedbyleverage)mustresultinlowerzivalues,implyingagreaterrelianceonnoncorefunding.Moregenerally,inthepresenceofaforeigncreditorsector,theincreaseinbanklendingwillresultnotonlyinincreasedcrosslendingbetweenbanksbutalsoin

Figure 1.15 Cross-Claims between Banks

Depositors

Bank 1

Bank 2

Ultimateborrowers

Interbankclaims

Deposits

Deposits

Loans

Loans



the sucking in of foreign debt. In this way, there are close conceptual linksbetweenprocyclicality,systemicriskspillovers,andthebankingsystem’sstockofnoncoreliabilities.Thestageofthefinancialcycleisreflectedinthecomposi-tionoftheliabilitiesofthebankingsector.Inaboom,wehavetheconjunctionof three features:

• Totallendingincreasesrapidly• Noncore(especially foreigncurrency) liabilities increaseasaproportionof

total liabilities• Systemicriskincreasesthroughgreatercrossholdingsbetweenintermedi-

aries.

Measuresofcrossexposuresacrossintermediaries(suchastheCoVaRmea-sure, thevalue-at-risk (VaR)of the financial systemconditional on institutions beingindistressmeasureduetoAdrianandBrunnermeier[2009])maybeusefulcomplementaryindicators,bearinginmindthatcrossexposuresthemselvesareprocyclical, and track noncore liabilities.The study of cross exposures acrossfinancial institutions is still in its infancy, but there has been a growing interest in thisissue,especiallyfromresearchersincentralbanksfromadvancedeconomiesthatsufferedfinancialdistressduringtherecentfinancialcrisis.Amongadvanced-economycentralbanks,theBankofEnglandhasbeenoneofthemostactiveinresearchintothesystemicriskgeneratedbycrossexposuresbetweenfinancialintermediaries.InNovember2009,theBankofEnglandpublishedadiscussionpaperontheroleofmacroprudentialpolicythatdiscussestheissuesandpolicyconcerns regarding the United Kingdom’s experience with the failure ofNorthernRockbankandthesubsequentinterventionandresolutionintheU.K.bankingsystem(BankofEngland2009).Althoughthereisagapbetweentheconcernsofanadvancedeconomyandthoseofanemergingeconomy,manyofthe lessonsonexcessiveassetgrowthandthegrowthofvolatilemarket-basedliabilitiesarecommonthemes.

Nonfinancial Corporate Deposits as a Measure of Noncore LiabilitiesThediscussionsofarisappropriateforaneconomy(suchasKorea)inwhichthedomesticbankingsectorhasaccesstofundingfromtheglobalbankingsystem.However, in financial systems at an early stage of development or where thebankingsectorisrestrictedbyregulationfromhavingaccesstotheglobalbankingsystem,thedistinctionbetweencoreandnoncoreliabilitiesofthebankingsys-temmaylookdifferent,althoughtheprinciplesfromthesystemwideaccountingframeworkwillapply.

Whenthedomesticbankingsectorismostlyclosedfromtheglobalbankingsector,depositswill constitute the lion’s shareofbanking-sector liabilities, andtraditionalmonetary aggregates such asM2 itself becomeshighly variable andprocyclical,encompassingvolatilebankingliabilities.Insuchinstances,itmaybemoremeaningfultodecomposeM2intoitscoreandnoncorecomponents.Thenoncore component may include the deposits of nonfinancial companies that



recyclefundingwithintheeconomyandhencebecomeintegratedintotheinter-mediarysector.ChinaandIndiaaretwoexamplesofcountrieswherethedistinc-tionbetweencoreandnoncoreliabilitiesmaybeusefullyemployed.Inbothcases,foreign exchange-denominated bank liabilities or market-based funding instru-mentsplayamuchsmallerrolethaninamoreopeneconomysuchasKorea.

Somewhatparadoxically,perhaps,onewaytoillustratetheroleofnonfinan-cialfirmsinfinancialintermediationistodrawontheexperienceofJapaninthe1980sduringtheliberalizationofitsfinancialsector.Japan’s1980sexperiencewastakenupbyHattori,Shin,andTakahashi(2009),whoexaminedtheroleofthenonfinancialcorporatesectorinamplifyingthefinancialcycle.Somethemesthatoverlapwithmacroprudentialpolicyareworthmentioning.

ThefocusofHattori,Shin,andTakahashi(2009)isoncorporatelendingfol-lowingthesectoralchangesthattookplaceinJapanaftertheliberalizationofthesecurities markets and the accompanying liberalization of the rules governingbankdeposits.

As a result of the financial liberalization of the 1980s, securities marketsenabledtheopeningupofnewfundingsources—bothdomesticandforeign—forcompaniesthathadtraditionallyreliedonthebankingsector.Ofparticularinter-est is the role played by Japan’s large manufacturing firms. Before the 1980s,manufacturing firms in Japan receivedmostof their financing fromthe tradi-tional banking sector, both for long-term investment and short-term liquidityneeds.However,withtheliberalizationofthesecuritiesmarketbeginninginthemid-1980s,nonfinancialcompanieswereabletotapnewsourcesoffundingfromoutsidethetraditionalbankingsector.Newissuanceofequity,corporatebonds,warrants,andcommercialpaper(CP)increasinglybecameimportantsourcesoffundingfornonfinancialfirms.Thenewfundingwassuppliedbybothdomesticsaversandothernonleveragedfinancialinstitutions,suchaslifeinsurancecom-panieswhopurchasedthebondsandothersecuritiesissuedbyJapanesecompa-nies.Foreigninvestorsalsofiguredprominentlyamongthenewfundingsources.

However,thesequencingofreformsmeantthattheliberalizationofnonfinan-cialcorporatefundingproceededaheadoftheliberalizationofthebankingsec-tor.Asnewfundingsourcesopeneduptolargemanufacturingfirms,itbecameprofitableforthemtorecycleliquidityandactasde factofinancialintermediariesbyraisingfundinginthecapitalmarketsthroughsecurities,andthendepositingthefundsinthebankingsystemthroughtimedeposits.Throughthischannel,thefinancialassetsofnonfinancialcorporationsincreaseddramaticallytogetherwiththeirfinancialliabilitiesinthelate1980s(seeHattori,Shin,andTakahashi2009fordetails).Figure1.16illustratesthechangeinfinancialstructureentailedbytherecyclingofliquidity.

Whennonfinancialfirmsplaytheroleofde factofinancialintermediaries,thestockofM2willseerapidincreasesduetotheincreasingdepositclaimsonthebankingsector.Meanwhile,thebankingsectoritselfwillbeunderincreasingpres-sureto findnewborrowers, since its traditionalcustomers(themanufacturingfirms),nolongerneedfunding,insteadhaveundergoneareversalofrolesandarepushing deposits into the banks, rather than receiving loans from the banks.



Figure 1.16 Structural Change in Financial Intermediation in Japan, 1980s

Bankingsector

Outsideclaim holders

End-userborrowers

Loans

Equity

Debt claimsFirms

Firms

Households

Equity and securities

Deposits

Financial intermediary sector

Source: Hattori, Shin, and Takahashi 2009.

Under such circumstances, thedistinctionbetween core andnoncorebankingsector liabilities does not coincide neatly with the distinction between deposit and nondeposit liabilities.

Inmanydevelopingcountriesthatareatanearlierstageoffinancialdevelopment,oraremoreclosedtotheglobalbankingsystem,theprinciplebehindthedistinctionbetweencoreandnoncoreliabilitiesisbetterexpressedasthedistinctionbetween:

• Theretail deposits of the household sector and• Thewholesale depositsofnonfinancialcompanies.

Thenew liquidity requirementsonbankscontemplatedunder theBasel IIIrules(thenetstablefundingratio[NSFR]andtheliquiditycoverageratio[LCR])recognizethatretaildepositsaremuchmore“sticky”andarelesslikelytorun,whereasthewholesaledepositsofcorporatesaremore“flighty”(BCBS2010).

Adapting Monetary Aggregates and Macro Prudential Indicators

Traditionalmonetaryaggregatesweredefinedaroundtheirlegalform,andhowliquidtheyareintransactions.Forthereasonsoutlinedearlier,thesetraditionalaggregateswillbelesseffectiveasamacroprudentialmonitoringtoolwithoutfurther adaptation.

Theparticularadaptationsmaybeusefullysummarizedinthefollowingthreepoints:

• Forcountrieswithopencapitalmarkets,internationalcapitalflowsintothebankingsectorwillbekeyindicatorsoffinancialvulnerability.Duringaboomwhen bank assets are growing rapidly, the funding required outstrips thegrowthofthedomesticdepositbase,andisoftenmetbycapitalflowsfrom



theinternationalbanks,whichisreflectedinthegrowthofshort-termforeigncurrency-denominated liabilities of the domestic banking system.As such,short-termforeigncurrency-denominatedbankliabilitiescanbeseenasthevolatilenoncoreliabilitiesofthebankingsector.

• Forcountrieswithrelativelyclosedfinancialsystems,wheredomesticbanksdonothavereadyaccesstofundingprovidedbytheglobalbankingsystem,abetterapproachwouldbetoadaptexistingconventionalmonetaryaggregatestoaddressfinancialstabilityconcerns.Thekeydistinctionisnothowliquid theclaimsare,butratherwho holds the claims. The distinction between house-holdretaildepositsandcorporatedepositsinthebankingsectorwillplayaparticularlyimportantroleinthisregard.

• More generally, invoking the accounting principle that defines core versusnoncoreliabilitiesofthebankingsectormayproveusefulinguidingclassifica-tionexercises.Coreliabilitiesaretheclaimsofthehouseholdsectorontheintermediary sector. Noncore liabilities are the claims of the intermediarysectoronitself.Theremaybeambiguitiesinapplyingthisprinciple(asexem-plifiedbythecaseof1980s’Japan).

Asapracticalmatter,theclassificationintocoreandnoncoreisnotclearcut.Bankdepositsofasmallormedium-sizeenterprisewithanowner-managercouldbe seen as household deposits. However, a larger firm with access to marketfinancemightbeabletoissuebondsandthendeposittheproceedsofthebondsaleinthebankingsystem,ashappenedinJapaninthe1980s,forinstance.Thelattercaseshouldnotbecountedasacoreliability,sincethecreditorfirmisactinglikeanintermediarywhoborrowsinthefinancialmarketstolendtothebanks.

Otherambiguitiesarepresentedbyitemssuchastrustliabilitiesofthebank-ingsector.Muchof thetrust liabilitiesaretononfinancialcorporatesandfacemanyofthedefinitionalhurdles.Inaddition, itmaybebettertohaveamoregraduateddistinctionbetweencoreandnoncoreliabilities,allowinganinterme-diatecategorytotakeaccountofsuchambiguities.

Nevertheless,thedistinctionbetweencoreandnoncorebankliabilitiespro-videsabetterwindowontheactualexposureofthebankingsectortofinancialriskanditswillingnesstoincreaseexposures.Assuch,therelativesizeofnoncoreliabilitiescanbeusedasamonitoringtooltoreflectthestageofthefinancialcycleandthedegreeofvulnerabilitytopotentialsetbacks.

Macro Prudential Tools

Macroprudentialpolicytoolsaimtomitigatethebuildupofvulnerabilitiestofinancial instability.Forthereasonsoutlinedearlier, theprimaryaimofmacroprudential policy is to secure financial stability by leaning against permissivefinancial conditions (should they be deemed excessive), and to lean againstexcessivelyrapidloangrowthbythebankingsector.Macroprudentialpoliciescomplementexistingtoolsinbankingregulation,suchasminimumcapitalratios.



Animportantconsiderationinformulatingmacroprudentialpolicyisthelinkwithbroadermacroeconomicstabilizationpolicy,andespeciallywiththecon-ductofmonetarypolicy.Theroleofmonetarypolicyinsecuringfinancialstabil-ity has broad resonance, both in advanced and in developing and emergingcountries.

Inthissection,wefocusonthespecifictoolsofmacroprudentialpolicyandtheirlinktothedebateoncapitalcontrols.Totheextentthattheexternalenvi-ronmentintheglobalbankingsystemisakeydeterminantofthevulnerabilityoftheeconomytofinancialexcesses,considerationsofmacroprudentialpoliciescannoteasilybeseparatedfromthecurrentlyactivedebateonthemeritsofcapi-talcontrols.TheInternationalMonetaryFund(IMF)hasrecentlysuggestedthemoreneutralterm“capitalflowmanagement”(CFM)policies(IMF2011),ratherthan the more emotive term “capital controls,” reflecting the more receptiveattitudebytheIMFtotheimpositionofcapitalcontrols. Indeed,somemacroprudentialtoolshavemanysimilarattributestothetoolsusedincapitalcontrols.Forthisreason,itisusefultoadaptthethree-parttaxonomyintherecentIMFreport(IMF2011,41)oncapitalflows:

• Prudential tools.These toolsencompassexistingornewtoolsofprudentialregulationthathaveaprimarilydomesticfocusandarenotaimedprimarilyatcorrectingcapitalflowdistortions.ExamplesincludeLTVrules,capsontheloan-to-deposit ratio, and leverage caps.

• Currency-based tools.Thesetoolsareprudentialmeasuresthataddressvulner-abilitiesthatoriginatefromdistortionsintheexternalenvironmentsuchasgloballiquidityconditions,butwhichrestrictactivityorimposecostsbasedoncurrencydistinctionsratherthanontheresidencyoftheinvestor.Anex-ampleisthelevyonshort-termforeignexchange-denominatedliabilitiesofthebankingsectorimplementedbyKorea(the“macroprudentiallevy”).

• Residency-based tools. These tools are the traditional capital control (capital flowmanagement) tools that restrict activityor impose costsbasedon theresidenceoftheinvestor.Examplesincludeadministrativerestrictionsonown-ership,taxesonportfolioinflows,suchasBrazil’staxonfinancialoperations(Impostosobreoperaçõesfinanceiras;IOF).Capitalcontrolsraiseacomplexsetofissuesconcerningtheirultimateobjectives,thatis,whethertheobjectiveistoholddowntheexchangerate,ortolimitthetotalvolumeofinflowstoslowdowntheappreciationoftheexchangerate.Theseissuesmeritaseparatediscussion,andwillnotconcernushere.Inthischapter,wewillfocusexclu-sivelyonthefinancialstabilityimpactofmacroprudentialpolicies.

Prudential Tools

Capital Requirements that Adjust Over the CycleThebalancesheetmanagementofbanksisinherentlyprocyclical,asexplainedearlierinthischapter.Theriseinassetvaluesthataccompaniesaboomresultsinhigher capital buffers at financial institutions, supporting further lending in the



contextofanunchangingbenchmarkforcapitaladequacy.Inabust,thevalueofthis capital can drop precipitously, possibly even necessitating a cut in lending.4

Capital requirements as currently constituted, therefore, can amplify thecredit cycle, making a boom and bust more likely. Capital requirements that,instead, lean against the credit or business cycle, that is, rise with credit growth andfallwithcreditcontraction,canthusplayanimportantrole inpromotingfinancialstabilityandreducingsystemicrisk.

Wehavecommentedonsomeofthemeasurementissuesassociatedwiththeimplementationofcountercyclicalcapitalbuffers.Theframeworkforcountercy-clicalcapitalbuffersasenvisagedintheBaselIIIframeworkhasfocusedontheratioofcreditgrowthtoGDP.Thereare twopreconditions for thesuccessfulimplementationofsuchcountercyclicalmeasures.First,thequantitativesignalsthattriggeractionsmustreflectaccuratelythefeatures(suchasexcessivelylooselendingconditions)thatarebeingtargetedbypolicymakers.Second,theimple-mentationprocedureshouldbesuchthatpolicymakerscanmovedecisivelyandinatimelymannerinheadingoffthebuildupofvulnerabilities.Wehavecom-mentedonthefirstpoint,andherewefocusonthesecondpoint.

Ifthetriggeringofcountercyclicalcapitalrequirementsispredicatedontheexercise of discretion and judgment by the authorities, the political economyproblemsassociatedwiththeexerciseofsuchdiscretioncanputtheauthoritiesunderpressurefrommarketparticipantsandotherinterestedparties.Thepoliti-caleconomyproblemissimilartothatofcentralbanksthattightenmonetarypolicy to head off property booms. Since private-sector participants (such asconstruction companies or property developers) are the beneficiaries of theshort-termboom,theycanbeexpectedtoexertpressureonpolicymakersorengageingenerallobbying.Thepoliticaleconomyproblemswillbemoreacuteiftherearecontroversiesontheexactstageofthefinancialcycleorthedegreeofconclusivenessoftheempiricalevidenceinvokedbythepolicyauthorities.

Thus,thetwoissuesmentionedabove—theaccuracyofthequantitativeindi-catorsandthepoliticaleconomyproblems—arecloselyrelated.Oneofthedis-advantages of the countercyclical capital buffer is that it relies on triggering additionalcapitalrequirementsinresponsetoquantitativesignals.Althoughsuchquantitativemeasuresarerelativelystraightforwardinsimpletheoreticalmodels,theremaybeconsiderablechallengestosmoothanddecisiveimplementationinpractice.

Forward-Looking ProvisioningForward-lookingprovisioning requires thebuildupof loss-absorbingbuffers intheformofprovisionsatthetimeofmakingtheloan,andsharessimilaritieswiththecountercyclicalcapitalbuffer.However,akeydifferencebetweenprovision-ingandequityisintheiraccountingtreatment.Inthecaseofforward-lookingprovisioning,theprovisionisnotcountedasbankcapital,andhenceislesslikelyto influencebankmanagement that targetsa specific returnonequity (ROE)level.Totheextentthatthebankusesitscapitalasthebaseonwhichtobuilditstotalbalancesheet,alargerequitybasewillresultinalargerbalancesheet,



andhencegreateruseofdebttofinancetheassets.Duringthecreditboom,thebuildup of greater assets using debt financing will contribute to the buildup of vulnerabilities.

The accounting treatment of the loss buffer as a provision rather than asequity thus has a potentially crucial effect on bank behavior. By insisting onforward-lookingprovisioning,thebank’sequityisreducedbytheamountoftheprovision.Duringaboom,suchareductionofbankcapitalcanplayanimportantrolein“lettingoffsteam”inthepressuretobuildupthebank’sbalancesheetbyremovingsomeofthecapitalbaseofthebank.

Althoughforward-lookingprovisioninghasbeenimportantincushioningtheSpanishbanking system from the initial stages of the global financial crisis, itremainstobeseenwhetherbuildinguploss-absorbingbuffers,byitself,canbesufficienttocushiontheeconomyfromtheburstingofamajorpropertybubble,asSpaindiscoveredintherecentfinancialcrisisinEurope.

Loan-to-Value and Debt-Service-to-Income CapsWhenmonetarypolicyisconstrained,administrativerulesthatlimitbanklend-ingsuchascapsonloan-to-value(LTV)ratiosanddebt-to-income(DTI)ratiosmaybe auseful complement to traditional tools inbanking supervision.LTVregulationrestrictstheamountoftheloannottoexceedsomepercentageofthevalueofthecollateralasset.DTIcapsoperatebylimitingthedebtservicecostsoftheborrowernottoexceedsomefixedpercentageofverifiedincome.

Conceptually, it isusefultodistinguishtwomotivationsfortheuseofLTVandDTIrules.Thefirstistheconsumerprotectionmotive,wheretheintentionis to protect household borrowers who may take on excessively burdensomedebtrelativetothereasonablemeanstorepaythemfromwageincome.Underthis motivation, LTV and DTI rules would be similar to the rules againstpredatory lending to uninformed households.Although this motivation is animportanttopicinconsumerprotectionpolicy,itisnotrelevantformacropru-dentialpolicy,andisnotdiscussedinthischapter.Instead,themacroprudentialrationaleforimposingLTVandDTIcapsistolimitbanklendingtopreventthebuildup of noncore liabilities to fund such loans, and also to lean against the ero-sion of lending standards associated with rapid asset growth.

Itisimportanttoreiteratewhyconventionalmicroprudentialtoolssuchasminimumcapitalrequirementsareinsufficienttostemexcessiveassetgrowth.Minimumcapital requirements rarelybiteduring a lendingboomwhenbankprofitabilityishigh,andwhenmeasuredrisksarelow.

WhereasLTVratiocapsarefamiliartools,theuseofDTIcapsislesswide-spread.ForKoreaandsomeAsianeconomiessuchasHongKongSAR,theuseofDTIratioshasbeenanimportantsupplementarytoolformacroprudentialpurposes.DTIruleshavetheadvantagethatbankloangrowthcanbetied(atleastloosely)towagegrowthintheeconomy.Withoutthisfundamentalanchor,anLTVrulebyitselfwillbesusceptibletotheamplifyingdynamicsofacreditboom,whichinteractswithanincreaseinthevalueofcollateralassetsduringahousingboom.EventhoughtheLTVruleisinplace,ifhousepricesarerising



sufficiently fast, the collateral value will rise simultaneously, making the con-straint bind less hard.

InthecaseofHongKong,theuseofDTIrulestakesonaddedsignificancebecauseHongKong’scurrencyboardisbasedontheU.S.dollar,andhencedoesnot have an autonomous monetary policy.Thus, monetary policy shocks aretransmitteddirectlytoHongKong.

Leverage Caps and Loan-to-Deposit CapsCapsonbankleveragemaybeusedtolimitassetgrowthbytyingtotalassetstobankequity(MorrisandShin2008).TherationaleforaleveragecaprestsontheroleofbankcapitalasaconstraintonnewlendingratherthantheBaselapproachofbankcapitalasabufferagainstloss.

TheexperienceofKoreaholdssomelessonsintheuseofleveragecapsandloan-to-depositratiocaps.InJune2010,theKoreanregulatoryauthoritiesintro-ducedanewsetofmacroprudentialregulationstomitigateexcessivevolatilityof foreign capital flows. Specificpolicymeasures included explicit ceilings onforeignexchangederivativespositionsofbanks,regulationsonforeigncurrencybankloans,andprudentialregulationsforimprovingforeignexchangeriskman-agementoffinancialinstitutions.Thesepolicymeasureswereintendedtolimitshort-termforeigncurrency-denominatedborrowingsofbanks.

Korea’sleveragecaponbankFXderivativepositionsintroducedinJune2010wasaimedatlimitingthepracticeofbankshedgingforwarddollarpositionswithcarrytradepositionsinKoreanwonfundedwithshort-termU.S.dollardebt.

ArelatedmeasureinKoreaisthecapontheratioofloanstodeposits.TheKorean supervisory authority announced in December 2009 that it wouldreintroduce the loan-to-deposit ratio regulation that had been scrapped in November1998asapartofthegovernmentderegulationefforts.Accordingtotheregulation,theratioofKoreanwon-denominatedloanstowon-denominateddepositsshouldfalltobelow100percentby2013.Therationaleforthispolicywas to restrict loan growth, by tying the growth of lending to the deposit base.

Sincethedepositbaseconstitutesthebaseline,thedefinitionofwhatqualifiesasdepositshas strictguidelines.For instance,negotiablecertificatesofdepositarenotincludedinthemeasureofdepositsinthedenominatorincomputingtheratio.Although the requirement to meet the 100 percent ceiling was set fortheendof2013,banksanticipatedtheeventualcapandbeganreducingtheirloan-to-valueratiosinanticipationoftheimplementationofthecap.

However,apotentialweaknessoftheregulationisthatitdoesnotapplytotheKoreanbranchesofforeignbanks.Sinceforeignbankbranchessupplyasub-stantialamountofforeignexchange-denominatedlendingtoKoreanbanksandfirms, the exemptionof foreignbankbranches leaves a gap in the regulation.However,thisgapwouldnothavebeeneasilypluggedwithintheframeworkofaloan-to-depositcapbecauseforeignbankbranches,bytheirnature,relymostlyon funding from headquarters or from wholesale funding, rather than localdeposit funding.



For domestic banks, the loan-to-deposit ratio cap has two effects. First, itrestrainsexcessiveassetgrowthbytyingloangrowthtothegrowthindepositfunding.Second,thereisadirecteffectonthegrowthofnoncoreliabilities,andhenceonthebuildupofvulnerabilitiesthatcomefromtheliabilitiessideofthebalancesheet.Inthisrespect,therearesimilaritiesbetweentheloan-to-depositcap and the levy on noncore liabilities, to be discussed later. Indeed, at the theo-retical level, the loan-to-deposit cap can be seen as a special case of a noncore liabilitieslevywherethetaxrateiskinked,changingfromzerotoinfinityatthethresholdpoint.However,thecomparisonwiththenoncoreliabilitieslevyislesseasy because the loan-to-deposit cap applies only to loans, not total assets or total exposures(includingoff-balance-sheetexposures).

Currency-Based ToolsWenowturntothecurrency-basedtoolsthathavebeenusedascapitalcontrolmeans,aswellasforprudentialreasons.

Unremunerated Reserve RequirementsPerhapsthebest-knowntraditionalformofcapitalcontrolhasbeenunremuner-ated reserve requirements (URR), through which the central bank requiresimportersofcapitaltodepositacertainfractionofthesumatthecentralbank.TheprevalenceoftheURRislargelybecausethecentralbankhasbeeninchargeof both prudential policy and macroeconomic management, and because thecentral bank normally has had discretion to use URR policies without goingthroughthelegislativeproceduresassociatedwithotherformsofcapitalcontrols,suchasleviesandtaxes.

TherecentIMFstaffdiscussionnote(Ostryandothers2011)hasacompre-hensivediscussionofcountries’experiencesintheiruseofURRs.Mostcentralbanksimposesometypeofreserverequirementfordeposits,especiallywhenthedeposits areunder government-sponsoreddeposit insurance.The rationale forthereserverequirementisthatitisanimplicitinsurancepremiumpaidbythebankinreturnfordepositinsurance.

Themacroprudentialmotivation forURR is to impose an implicit taxoncomponentsoffinancialintermediaryliabilitiesotherthaninsureddepositsthatare likely to impose negative spillover effects. The introduction of a reserverequirementforthenondepositliabilitiesofbankswouldraisethecostofnon-depositfundingforbanks,andtherebyrestraintherapidgrowthofsuchliabilitiesduringbooms.Inthisrespect,thereserverequirementonnondepositliabilitieswouldhaveasimilareffecttoataxor levyonsuchliabilities, tobediscussedlater. Recent examples of the use of URR are discussed in Ostry and others(2011,28).

AlthoughtheURRisanimplicittaxonabalancesheetitem,theimpliedtaxrate itself will vary with the opportunity cost of funds, and hence with the pre-vailing interest rate.The variability of the implicit tax rate necessitates someadjustmentofthereserverates,andtherequirementswillneedtoberaisedtoa



high level when interest rates are low. This is potentially one disadvantage of the URRrelativetoothermeasures.

Anotherissueisthechallengesofmanagingthecentralbank’sbalancesheetasaconsequenceofURRs.Thereserveswouldhavetobeheldonthecentralbank’sbalancesheetasa liability,withimplicationsforthefluctuationsinthemoneysupplyinlinewiththeprivatesector’suseofnondepositliabilities,andtheselectionofcounterpartassetsonthecentralbank’sbalancesheet.

Althoughnotcentral, therearealsodifferences intherevenue implicationsbetween the reserve requirement and a levy or tax.The reserve requirementwouldraiserevenuetotheextentthatthenetincomeontheassetsheldbythecentralbankthatisfundedbythereserveswouldbepositive.Hence,thebiggertheinterestspreadbetweentheassetandliability,thelargertheincome.

Oneadvantageofthereserverequirementisnotsharedbythelevy:thebankswouldhaveaccesstoaliquidassetincasethereisaliquidityshortageorruninthe financialmarket. In this respect, the reserve requirementhas someof thefeaturesoftheBaselIIIliquidityrequirementonbanks(BCBS2010).

A disadvantage of the reserve requirement is that it applies only to banks,rather than to the wider group of financial institutions that use noncore liabilities. Whenfacedwiththepossibilityofarbitrage,orwithstructuralchangesthatshiftintermediationactivityfrombankstothemarket-basedfinancialintermediaries,thereserverequirementwouldbelesseffective.

Levy on Noncore LiabilitiesAsdiscussedearlier,thestockofnoncoreliabilitiesreflectsthestageofthefinan-cialcycleandtheextentoftheunderpricingofriskinthefinancialsystem.Alevyortaxonthenoncoreliabilitiescanservetomitigatepricingdistortionsthatleadtoexcessiveassetgrowth.Thefinancialstabilitycontributionrecommendedbythe IMF in its report (IMF2010b)on thebank levy to theGroupofTwentyFinanceMinistersandCentralBankGovernors(G-20)inJune2010isanexam-pleofsuchacorrectivetax.

Thelevyonnoncoreliabilitieshasseveralfeaturesthatimpactoverallfinan-cialstability.First,thebaseofthelevyitselfvariesoverthefinancialcycle.Thelevybiteshardestduringtheboomwhennoncoreliabilitiesarelarge,sothatthelevy has the properties of an automatic stabilizer even if the tax rate itselfremainsconstantovertime.Giventhewell-knownpoliticaleconomychallengestotheexerciseofdiscretionbyregulators,theautomaticstabilizerfeatureofthelevymayhaveimportantadvantages.

Second,thelevyonnoncoreliabilitiesaddressesfinancialvulnerabilitywhileleavingunaffectedtheessentialfunctioningofthefinancialsysteminchannelingcorefundingfromsaverstoborrowers.Bytargetingonlynoncoreliabilities,thelevyaddressesexternalitiesassociatedwithexcessiveassetgrowthandsystemicriskarisingfrominterconnectednessofbanks.Inotherwords,thelevyaddressesthe“bubbly”elementofbankingsectorliabilities,ratherthanthecoreliabilitiesofthebankingsystem.



Third,thetargetingofnoncoreliabilitiescanbeexpectedtoaddressthevul-nerabilityofemergingeconomieswithopencapitalaccountstosuddenreversalsin capital flows caused by deleveraging by banks. Indeed, for many emergingeconomies,thelevyonnoncoreliabilitiescouldbeaimedmorenarrowlyattheforeign currency-denominated liabilities. Shin (2011) discusses some of thepotential advantages of a levy on noncore liabilities of this sort.

Therevenueraisedbythelevyisasecondaryissue.Themainpurposeofthelevyistoalignincentives.Agoodanalogyiswiththe“congestioncharge”usedtocontrolcartrafficincentralLondon.Underthischarge,cardriverspayadailyfeeof£8todriveintocentralLondon.ThepurposeofthechargeistodiscouragedriversfrombringingtheircarsintocentralLondon,therebyalleviatingtheexter-nalitiesassociatedwithtrafficcongestion.Inthesameway,thenoncoreliabilitiesbanklevyshouldbeseenprimarilyasatoolforaligningtheincentivesofbanksmorecloselywiththesocialoptimum.Therevenueraisedbythelevywouldbeofbenefit(perhapsforamarketstabilizationfund)butisasecondaryissue.

In December 2010, Korea announced that it would introduce a Macro Prudential LevyaimedattheFX-denominatedliabilitiesofbanks,bothdomesticbanks and the branches of foreign banks.The proposal passed the legislativeprocessinApril2011,andimplementationbeganinAugust2011.5 The rate for theKoreanlevyhasbeensetat20basispointsforshort-termFX-denominatedliabilities of up to one year, falling to 5 basis points for long-term liabilitiesexceedingfiveyears.Theproceedsfromthelevywillbeheldinaspecialaccountof the preexisting Exchange Stabilization Account, managed by the financeministry.The proceeds may be used as part of the official foreign exchangereserves.

ThereisakeydifferencebetweenKorea’smacroprudentiallevyandtheout-wardlysimilarlevyintroducedbytheUnitedKingdom.IntheUnitedKingdom,the revenue goes into the government’s general fiscal account, hence can beregardedasarevenue-raisingmeasure.IncontrastrevenuefromtheKoreanlevyis ring-fenced for specific use in financial stabilization.

Figure1.17plots the recenthistoryofcapital flows to theKoreanbankingsector.SinceKorea’sJune2010introductionofmacroprudentialcontrols,therehasbeenamoderationofshort-termflows.Therehavebeencontinuedoutflowsofshort-termliabilities,asseenbythenegativevalueofthebarsforshort-termflows.Longer-termliabilitieshavereplacedtheshort-termliabilities.ThesedatadonotestablishthesuccessofKoreanmacroprudentialpolicies,aswehavenotcontrolledforthebroaderbackdropincapitalmarkets.However,BrunoandShin(2013) showthatKorea’smoderationcanbeconsideredexceptional in thatamore detailed panel study revealed that capital flows into Korea became lesssensitivetoglobalfactors,evenascapitalflowstootheradvancedandemergingeconomiesexperiencedanincreasedsensitivityoftoglobalfactors.ThisfindinglendssupporttothehypothesisthatKorea’smacroprudentialpoliciesweresuc-cessfulinmoderatingtheinflowsofvolatileshort-termliabilitiesofthebankingsector.



Relative Merits of URR versus Levies and TaxesThetimedelayinimplementingthemacroprudentiallevyinKoreaoffersusefullessonsontherelativemeritsofunremuneratedreserverequirementscomparedwithleviesandtaxes.Thelegislativeprocessrequiredtoimplementalevycanentail considerable delays in the introduction and effectiveness of the policy. In Korea,theprocesstook18months:initialdiscussionsbeganinFebruary2010;announcementofimplementationfollowedinDecember2010;legislativehur-dleswereclearedinApril2011;andimplementationwassetforAugust2011.

Whentheexternalenvironment ischangingrapidly, such longdelaysmakethenewintroductionofalevycumbersomeandimpracticalasthefirstlineofdefense.Nevertheless,asinKorea’scase,alternativemeasuresthatrelyonexist-ing legislation or other temporary measures can be used in the interim untillonger-termpolicymeasurescomeintoforce.

Inpractice,thechoicebetweenURRandleviesortaxesisdrivenbypracticaladministrativeexpediency,ratherthanbymattersofprinciple.Typically,thecentralbankisthebestestablishedpolicyinstitutionthathasdirectcontactwiththefinan-cialmarketsand institutions.The long-establishedstatusof thecentralbanks inmostcountriesexplainswhyURRshavebeenmoreprevalentthanleviesortaxes.

Thereare,however,exceptionstothisrule.Brazil’staxonfinancialoperations(IOF)wasintroducedsometimeago(in1993),andthelegislationhasbeenineffectsince.Althoughthetaxratehasbeensetatzeroattimes,theinfrastructureremainedinplaceto“dustitoff”ascircumstancesdemanded.

Figure 1.17 Capital Flows to Korean Banking Sector

2005/01

2005/05

2005/09

2006/01

2006/05

2006/09

2007/01

2007/05

2007/09

2008/01

2008/05

2008/09

2009/01

2009/05

2009/09

2010/01

2010/05

2010/09

2011/01

2011/05

2011/09

2012/01

2012/05

2012/09

2013/01

–22.0

–17.0

–12.0

–7.0

–2.0

3.0

8.0

13.0

US$

, bill

ion

s

Bank long-term loan liabilities

Bank long-term debt securitiesBank short-term loan liabilitiesBank short-term debt securities

Central bank deposit liabilities

LehmanCrisis

June 2010

Source: Bruno and Shin 2013, data from Bank of Korea balance of payment statistics.



Unlikeatax,aURRcanusuallyberemoved(orsettozero)moreeasilybecausethebudgetisnotdirectlyreliantonitsrevenues.Similarly,themacroprudentiallevy set by Korea has been designed so that the revenue does not have budgetary implications,preciselyinordertoforestallpotentialpoliticaleconomyconcerns.

Residency-Based ToolsCapitalcontrolshavetwobroadrationales.Thefirstisasamacroeconomicpolicytoolaimedatleaningagainsttheappreciationoftheexchangerate.Thesecondisasaprudentialtool,usedforfinancialstabilityobjectives.Thedistinguishingfeatureofcapitalcontroltoolsisthattheydiscriminateonthebasisofresidenceoftheinvestor—thatis,onwhethertheinvestorisdomesticorforeign.ThetoolsincludeinflowtaxessuchasBrazil’sIOF,aswellasadministrativemeasuresthatrestrictorbancertainactivitiesorinvestmentsthatforeigninvestorscanhold.

Althoughcapitalcontrolshavebeenemployedtoaffectthepaceofexchangerateappreciation,evidenceoftheireffectivenessremainscontroversial.However,there ismuchbetterevidenceonthe financial stability implicationsofcapitalcontrols.

Regardingthefinancialstabilityobjective,arecentIMFpositionpaperfindsastrongempiricalassociationbetweencapitalcontrolsontheonehandandless

Table 1.2 Taxonomy of Macro Prudential Tools

Policy tool Advantages Drawbacks

Asset-side toolsa

Loan-to-value (LTV) cap

Low administrative burden

Ineffective during rapid housing boom

Debt-to-income (DTI) cap

Ties loan growth to wage growth

High administrative capacity needed for data on income

Loan-to-deposit caps Low administrative burden

Distorts bank funding

Not applicable to foreign banks

Reserve requirement Low administrative burden

Ineffective with low interest rates, burdens central bank

Liabilities-side toolsb

Levy on noncore bank liabilities

Price-based measure

Acts on broad liability aggregates

Needs legislation.

Cannot narrowly target FX vulnerability

Levy on FX- denominated bank liabilities

Price-based measure

Enhances monetary policy Counters FX risk

Needs legislation

Narrow base of levy

Bank capital- oriented toolsc

Countercyclical capital requirements

Conforms to Basel III Difficulty in calibration Level playing field issues

Forward-looking provisioning

Modifies bank incentives Objections from accounting standard setters

Leverage cap Modifies bank incentives Not price based

Open to circumvention

Vulnerable to bank FDI

a. Asset-side tools limit bank loan growth directly.b. Liabilities-side tools limit vulnerability to liquidity crises and limit loan growth indirectly.c. Bank capital-oriented tools limit loan growth primarily through altering incentives of banks.



severeformsof(1)creditboomsand(2)FXborrowing,ontheother(Ostryandothers2011,21).

In reference to the recent global financial crisis, the authors regard it as a natu-ral experiment for theeffectivenessof capital controls, andnote that theevi-dence is “suggestive of greater growth resilience in countries that had eithercapitalcontrols(especiallyondebtliabilities)orprudentialmeasuresinplaceintheyearspriortothecrisis”(Ostryandothers2011,23).

There are also important implications for monetary policy autonomy. DeGregorioandothers(2000)foundthatcapitalcontrolsallowedChile’scentralbanktotargetahigherdomesticinterestrateover6–12months.Capitalcontrolslikelyhavetheirfinancialstabilityeffectsthroughtheireffectonthecomposition ofcapitalflows,ratherthanonthetotalamountoftheflows.DeGregorioandothers(2000)andCardenasandBarrera(1997)showthatcapitalcontrolsarelikelytohaveshiftedthecompositionofinflowsawayfromshort-termclaimsanddebtclaimstowardlonger-termclaimsthathavemorebenignfinancialstabilityimplications.Magud,Reinhart,andRogoff(2011)conductedameta-analysisofexisting survey literature on the effects of capital controls. After analyzing37empiricalstudies,theyfoundthatcapitalcontrolsoninflows(1)makemon-etarypolicymore independent, (2)alter thecompositionofcapital flows,and(3)reducerealexchangeratepressures(althoughtheevidenceonthisismorecontroversial); however, they (4)donot reduce the volumeofnet flows (andhence the current-account balance).

Table 1.3 Summary of Policy Priorities

Financial liberalization/openness

Monetary policy autonomy Medium/low High

None • Asset-side tools

• (LTV, DTI, loan-to-deposit caps)

• Asset-side tools

• (LTV, DTI)

• Bank capital-oriented poli-cies (dynamic provisioning, leverage caps, countercyclical capital requirements)

Low/medium • Asset-side tools (LTV, DTI, loan-to-deposit cap)

• Monetary policy

combined with

• Liabilities-side tools

• (noncore liabilities levy)

• Asset-side tools (LTV, DTI, loan-to-deposit cap)

• Monetary policy

combined with

• Liabilities-side tools (noncore liabilities levy)

• Bank capital-oriented tools (leverage cap)

High • Monetary policy

• Reserve requirements

• Bank capital-oriented tools (dynamic provisioning, leverage caps, countercyclical capital requirements)

• Monetary policy

• Bank capital-oriented tools (dynamic provisioning, leverage caps, countercyclical capital requirements)



Totheextentthatcapitalcontrolshaveaneffectonthecompositionofcapitalflows and the likely pace of currency appreciation that gives some additionalautonomytomonetarypolicy,theyseemtohavearolewithinthebroadermacroprudentialpolicyframework.

Concluding Remarks

Inthischapterwehavegivenanoverviewofthepolicyoptionsthatcancomplementtraditionaltoolsofbankregulationandmonetarypolicyinreiningintheexcessesinthefinancialsystem.Table1.2providesataxonomyofmacroprudentialtoolswhileTable1.3summarizesthepolicyframeworkwithinwhichtheymaybeimplemented.

Macroprudentialpoliciesaimto leanagainstexcessiveassetgrowthduringbooms,andtherebyachievemoresustainablelong-termloangrowth.Themirrorimageofmoderatingassetgrowthisthemitigationofvulnerabilitiesonthelia-bilities side.The policy debate on macro prudential policies on the FinancialStabilityBoardandtheBaselCommitteeonBankingSupervisionhastakenplacewiththefocuslargelyonthedevelopedfinancialsystemsthatwereattheeyeofthestormintherecentfinancialcrisisof2007–09.However,wehaveseeninthischapter that the financial stability challenges facing emerging and developingeconomiesareperhapsevenmoreacutebecauseof thesusceptibilityof theseeconomiestotheconjuncturerulinginglobalcapitalmarketsandontherela-tivelyearlystageoftheirfinancialsystems.

To the extent that the current global conjuncture with permissive globalliquidityconditionsisdrivenbyexpansivemonetarypoliciespursuedbyadvancedeconomycentral banks,macroprudentialpolicies aimed at achieving financialstabilityhavemanypointsofcontactwithcapitalcontroltools,ortousethemoreneutralterminologycurrentlyinfashion,capitalflowmanagementtools.

Becausecapitalflowmanagementtoolsoftenhavebroadermacroobjectives,suchas leaningagainst theoverly rapidappreciationofdomesticcurrency, thedividing linebetween tools for financial stability and tools formacroeconomicmanagementcanbefuzzy.Thesameistrueforthedividinglinebetweenmone-tarypolicyandpoliciestowardfinancialstability.Contrarytothetextbookdivi-sionbetweenthetwo,monetarypolicyhasfinancialstabilityimplicationsthroughchangesinthesizeandcompositionofbankbalancesheets,whereasprudentialpolicieswillhavedirectimplicationsforcreditgrowthandaggregatedemand.

Althoughthestudyofmacroprudentialpolicyframeworksisinitsinfancy,thereisarapidlyaccumulatingbodyofworkonthesubject.Basedonexistingliteratureandrecentinsights,thischapterhasprovidedananalyticalframeworkregardingthemotivationsforandeffectsofmacroprudentialrulesonfinancialinstitutionsthatcanbeconsideredamongarangeofpolicyproposals.

Anassessmentofmacroprudentialpoliciesmustbuildonthefurtherdevel-opmentofanalytical toolsthatarebetteradaptedtostudyingthe interactionsbetweeninstitutionsandmarketsinthebroaderfinancialsystem.Furtherexperi-encewiththeuseofmacroprudentialtoolscanbeexpectedtocontributetothesubsequentrefinementsoftheframeworkdiscussedinthischapter.



Notes

1.The discussion in this subsection is taken from Adrian and Shin (2011), whichpresentsamoredetailedanalysisofhowbankingbalancesheetmanagementrelatesto corporate finance principles.

2.Themonetarybase,oneofseveralstandardmeasuresofthemoneysupply,isthesumofcurrencyincirculationandreservebalances.M1isthesumofcurrencyheldbythepublic and transaction deposits at depository institutions (which are financial institutionsthatobtaintheirfundsmainlythroughdepositsfromthepublic,suchascommercialbanks,savingsandloanassociations,savingsbanks,andcreditunions).M2isdefinedasM1plussavingsdeposits,small-denominationtimedeposits(thoseissuedinamountsoflessthan$100,000),andretailmoneymarketmutualfundshares.

3.TheinclusionofCDsinnoncoreliabilitiesismotivatedbythefactthatCDsareoftenheld by financial institutions engaged in the carry trade, and who use CDs as analternativetoholdingKoreangovernmentsecuritiesintheircarrytrade.

4.Forexample,seeKashaypandStein(2004)andAdrianandShin(2010).

5.IMF2012,50,http://www.imf.org/external/np/pp/eng/2013/012713.pdf.

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