Macro-Prudential Policy, Recapitalization of Banks Essay

Introduction

Macro-prudential is the policy that aims at evaluating the dependability, health, and vulnerabilities of financial structures. This analysis considers general risks as endogenous in the respect-shared behavior of institutions. The macro-prudential policy also aims at creating a boundary in systems to shun output costs that are related to financial instability (Bank of England, 2009). These policies are used to check the strength of the fundamental financial institutions in place, execute stress tests and scenario analysis. In this, macro-prudential policies will help to identify how well the system is sensitive towards any economic shocks.

The macro-prudential analysis is greatly involved in focusing on data that is associated with financial frameworks and regulatory environment, this enables it to acquire a greater understanding of strengths and weaknesses that could be in the financial systems put in place. The macro-prudential policy should include a system that is able to warn early enough of any vulnerabilities of financial stability (Bank of England, 2009). It should also include credible tools that can deal with increased vulnerabilities in their early phase so that action can be taken in time to maintain financial stability. In an ideal world, risk measures should always be connected to macro-prudential policy goals. Such instances include where risk is detected by measures put in place, thereby provoking policymakers to respond by monitoring and giving credible feedback that is used to calibrate policy responses (Dessler, 2004).

Importance of macro-prudential policy

Macro-prudential policies not only concern the utilization of prudential tools to make bring out a stable financial system but also stabilize individual institutions. The macro-prudential policy uses basic prudential practices to reduce system-wide financial risks. This greatly reduces the chances of having disruptions in providing important financial services that would have a negative effect on the economy (The World Bank, 2011). These basic tools used by the macro-prudential policy include; (a) identifying and addressing risks, exposures that may endanger the well-being of the system (b) Eliminating the increase of imbalances brought about by financial systems.

In discussions held worldwide, ideas have emerged on how macro-prudential policy may be designed and used to help reduce the accumulation of risks in the financial system. The main theme of this design is to ensure that financial systems become more resilient and stabilize the economy. The macro-prudential policy would well fit in a regulatory framework where the main obstacle is to realize re-orientation towards system risk (IMF Monetary & Capital Markets Group, 2011). Macro-prudential policy which is an ingredient that is lacking in the prevailing policy framework breaches the gap macroeconomic policies that have been put in place and individual rules of financial institutions.

The fundamental concern of macro-prudential policy is to ensure financial stability that is related to; credit supply, insurance against risk, and service payment. Where these instruments of macro-prudential policy are in place, it is possible to produce more and better objectives like preventing asset price fluctuations. By moderating the high increase in the availability of credit, the macro-prudential policy may be utilized to reduce the high fluctuations in asset prices (Bank of England, 2009).

In these discussions, two major sources of risk have been identified that macro-prudential policy would if possible, aim to address. The first one is in the banking system where there is a trend system in place becoming highly exposed to risk during the credit cycle upswing. It widely tries to examine whether it is possible to dampen cyclical over-exuberance. This is achieved by putting in place a regime of capital surcharges (IMF Monetary & Capital Markets Group, 2011). These surcharges are used to caption capital necessities. In a credit boom, this would create a bigger self-insurance for the entire system.

The second source of risk has been identified in the trend of individual firms to take inadequate account of the spread-out effects of their actions. This is simply referred to as the ‘network risk’ that is based on aspects such as size, connectivity, and complexity. In turn, institutions that do not avail of extra-organized insurance would experience low-profit margins.

Enough scope is availed to improve the toolkit in both circumstances. Relationships of financial distress with respect to the stage of a cycle refine models that bring together micro and macro aspects to bring about more advantage actions and risk-taking financial systems. The reliability of providing guidance at all times concerning network risk is established by best-performing indicators of systematic risks. To provide accurate alerts, it is important to classify thresholds for risk indicators.

Research has shown that monitoring of risk should be vigorous and constraint for macro-prudential policy purposes. This is where risks accumulate when the economic experts “take off their eyes from the ball.”

Importance of macro-prudential policy in central bank

Micro-prudential measures are one of the two traditional tools mostly known about central bank policies. The second one is interest rates. Micro-prudential policies used as a monetary policy tool are enhanced to attain price stability. This creates employment opportunities and supports economic growth. Interest rates are used to govern individual banks from getting into distress.

These two policies used to stabilize prices and ensure good banking were considered enough to create a powerful economy and robust financial system. Because of the financial crisis, these two policies have become unreliable. This is so because, while banks deem safe under the micro-prudential policy framework, their behavior can provoke risks of overall financial systems. In addition, the central bank uses interest rates as a tool stable prices in the economy. This is not the most appropriate tool for controlling the increase in the prices of assets.

This had led to macro-prudential policy becoming the complete policy with credible objectives that can eliminate the accumulation of system risk that may cause financial discomfort. Macro-prudential policy unlike the micro-prudential policy focuses on the larger economy to ensure that all financial systems are stable and reliable.

In an attempt to show the importance of macro-prudential policy, the Basel Committee on Banking Supervision (BCBS) has introduced its tools under the standard of Basel III. This upholds financial stability.

Since 2003, The Bank of Thailand (BOT) has appreciated and implemented a macro-prudential policy. The macro-prudential measures put in place are to control high credit risk because of overlaying on credit growth in mortgages. This increased credit risk would create imbalances with negative impacts. Controlling the high increase in demand for mortgages helped moderate risk in the economy. BCOT, under a subcommittee on Financial Market Stability, has currently included macro-prudential polity in its financial stability structure. Macro-prudential policy, separately from macro-prudential policy and monitory policy will increase/ improve the efficient realization of financial stability in Thailand.

Recapitalization of Banks

This is where banks are required by the central bank to increase the asset books. To fully effect, this government is required to get a shareholding part in the participation of banks. This can be done effectively in two main stages:

1. The government releases new debt to the economy
2. The government buys new existing shares.

This brings about uncertainty in the value of assets that are held by banks, which affects their ability to lend. Hence, Assets Protection Schemes that have been put in place allow banks to insure uncertainties in the future.

Policy instruments that could be used to prevent future build-up of systematic risk in an economy.

The cumulative increase in risk generally increases the rigor of institutions within the financial system. The fundamental aim of macro-prudential tools is to reduce the accumulation of risk in the upswing, ensuring that institutions are more resilient; this leads to reduced chances of having defaulters in a wide range of financial institutions. These tools also ensure that there is a lower impediment to taking a risk as well as lending in times of downswing. If all these tools and measures are put in place and are made effective, the resilience of financial systems in institutions would stand in both phases of the credit cycle. Moderation of banks and other institutions towards risk-taking has been put in place through a number of regulations that they must adhere to. These include set margins on overall lending criteria or limitations on loan value in respect to income.

Systematic capital surcharges

This is the overall solvency risk that could occur in financial systems. The macro-prudential policy should apply a ‘surcharge’ approach along with the macro-prudential capital requirements. These surcharges should create a variance to counter the accumulation of overall risk during the credit boom. There is a slow improvement in balance sheet growth that is a result of requiring banks to raise equity. Banks then would increase their cost of lending. In this view, capital surcharges would reduce drastically to deliver banks with necessary incentives to maintain a supply of credit (Haldane, 2011).

There exist fundamental differences in capital surcharges calibration and the micro-prudential necessities. For macro-prudential purposes, it is much important to get the overall state of risk-taking and credit circumstances rather than that implicated by just a particular institution. In this sense, the overall decision would be based on the whole system and getting the macro data but implemented using prudential instruments.

According to Walter Bagehot the turmoil of the economy is related to panics and manias in financial; markets, says that at times people have money that seeks to be invested and this leads to speculation (Bank of England, 2009). This speculation then leads to people having panic. In relation to change in asset prices upwards, it is not vivid whether the turmoil is as a result of being stupid, ignorant, or lack of opportunism.

In this scenario by Bagehot, it is clear that the phases he identifies are evident in an economic crisis. High levels of liquid cash would lead to some participants in the money market overlooking basic the principle of banking and lending. The most basic principle is; evaluating the capability of the borrower to repay without default from his cash flows without going to the extent of finding someone to refinance.

Institutions have come up with initiatives, which have been grouped, into “ECOFIN road map”. These are just in line with the agenda set at the global level. It consists of four main objectives that are regulatory and non-regulatory in nature. They include:

1. Improving and enhancing transparency in the market, this is with respect to experiences from banks involving assets.
2. Improving valuation principles to go in line with distress arising from an appraisal of illiquid balance sheet items.
3. Intensification of prudent structure in the banking sector. This may include liquidity of risk management.
4. Investigating market dynamics

In line with transparency, commissions set in place have worked hard with concerned market groups to identify self-regulatory proposals to obtain secure markets (Macro-Prudential policy, 2009). Several European industry associations have joined hands in ensuring there is improved transparency for investors. Among them include; International Capital Markets Association (ICMA), The London Investment Banking Association (LIBA), the Commercial Mortgage Securities Associations (CMSA), and European Securitization Forum (ESF).

Regarding the improvement of valuation principles, an assessment of the prevailing market conditions should continuously be done. However, the main purpose is to make sure current accounting provisions are adhered to. On Intensification of prudent structure commissions set in place rapidly works to ensure much more enhancement to Capital Requirements Directive (CRD).

It is only reasonable investors that are closely associated with national authorities or governments that follow basic principles of transparency. All the reliable information from all sources should be used to analyze the causes and consequences of market dynamics. It is also important that other stakeholders be consulted so that the most efficient and effective way is implemented (IMF, 2011). This is because industry-led actions tend to be faster and more effective compared to regulatory responses.

Responses to global Economic Crisis

The boom that occurred 2003-2007 brought about procrastination obstructed many people to realize that a financial crisis was mounting. Due to this, the essential changes in policies and practices were also obstructed. It is clear that there was an element of underestimation of the severity of the situation by experts of finance and the economy. For this reason, although strong macro-prudential policies are in place in 2009, the situation remains uncertain. From this crisis, the most important thing was to increase recovery with adequate macroeconomic measures and increase efficiency as well as improve structures put in place to regulate the financial sector.

According to Servaas Deroose director of ECFIN, the ECOFIN Council road map of 2007 provides the basic point of view (The World Bank, 2011). The idea of having a roadmap is to strike a balance between restoring confidence to investors and maintaining enough incentives for improvement and entrepreneurship of financial systems and institutions. He categorizes problems that relate to investor confidence into three main factors:

1. Information asymmetries for the inadequacy of transparency
2. Lack of confidence in risk management and risk measurement instruments
3. More universal distress over non-organized markets

The responsibility played by credit rating agencies in each one of these categories has come out of a particular study.

It is very important to have in mind that a lot of modern financial systems are reflected by these sources of investor distress. Highly sophisticated structures that have been put in place have enabled the transfer of risk. This has led to key benefits to the economy. It has brought about increased growth in the economy and efficiency in the provision of resources.

However, problems have also emerged from the processes that have led to a crisis in economic growth. However, responses towards this turmoil are not supposed to bring any restriction in delivering financial benefits. ECOFIN, having this consideration at hand strikes a balanced based approach (Thomas, 2011). Four main objectives of this roadmap come in place to give a credible response to this turmoil. These include:

1. Improving the transparency of financial reports in the market, goes in hand with banks publicizing their assets.
2. Conducting an investigation on market issues like the responsibilities of the credit rating agencies.
3. Making the prudential framework governing the banking sector more powerful.
4. Improvement of valuation standards used in the valuation of more liquid assets.

This roadmap has brought together both the regulatory and non-regulatory measures to meet these objectives. The Capital Regulatory Directive gets the updates from the regulatory actions. Initiatives in industries show that responsibility for maintaining risk in the financial systems greatly lies in the private sector. The roadmap has received criticism that it can only prevent a crisis rather than solve current crises. However, this is not true since it identifies measures that can be used to restore investor confidence such as transparency and credit ratings. Recent crises provide opportunities to revisit plans to prevent, resolve, and cross boarder collaboration frameworks. The core objective of the European Union is to increase regulatory and supervisory support to remain competitive and preserve liberal stability in the environment (The World Bank, 2011). This will provide domestic and foreign investors with common ground for competition. Dedication to greater and deeper integration of in Estonia has led to tangible benefits (The World Bank, 2011). This will also happen in Europe (Galati and Moessner, 2011).

The primary goals of central banks are primarily to deal with stabilization of prices in its economy, which may not necessarily concern its financial stability. Since other sectors of financial systems are mostly under the responsibility of various authorities, it becomes difficult to have a thorough systemic risk analysis. With these considerations in the larger economy, new institutions have been established to mandate the preservation of financial stability. For example, the European Union, has established an institution called – the European Systematic Risk Board. The United States of America has also established its institution referred to as The Financial Stability Oversight Board. These institutions bear independent mandates to strengthen the powers of existing financial stability systems or preserve the existing ones (Koestenbaum, 2002).

Macro-prudential policies will have to contrast the accumulation of economic risk when there seems to exist a positive cycle in business and control an increase in more usage of credit facilities when the business cycle in on its downturns. This will enhance in reducing the probability and impacts of the financial bust. While moderating business cycles in the economy, there exists a clear overlap of policies that depend on instruments and those that deal with other policies. It is true that these policies-monetary policies, affect the price of assets and the interest rate of getting credit (European Central Bank, 2011). These are the relevant variables of macro-prudential policy the effect of a macro-prudential policy that is felt on these variables is most likely to affect influence communication strategies of monetary policy set in place.

According to research and analysis of strategic association, a clear outline occurs between macro-prudential policy and monetary policy within the framework macroeconomic in the banking sector. This shows a standard monetary policy. Instruments used in momentary policies assume that macro-prudential policy regulates banks’ capital requirements (Kouzes and Posner, 2007).

Since the main fundamental concern of macro-prudential policy is to ensure that there exists financial stability in the economy, its policies are important in ensuring that an accumulation of risk does not occur. These instruments of policymaking are related to; credit supply, insurance against risk, and payment of service. When these instruments of macro-prudential policy are in place, it is possible to produce more and even better objectives that include preventing the occurrence of high asset price fluctuations in the future (European Central Bank, 2011). By moderating the high increase in demand for credit facilities, these macroprudential instruments can be used to reduce the high fluctuations in asset prices in the future.

Restraining discretion in a macro-prudential system

There are many available options of discretion that can be used to make a macro-prudential system more transparent, reliable, and predictable. These options include:

1. Objectives – It would be very hard to come up with a comprehensive numerical macro-prudential policy in the short run. However, a lot of set frameworks operate efficiently towards making sure of the existence of stable financial services.
2. Decision-making framework – A set of detailed processes and analyses to strengthen decision; the making process has been put in place. This has enhanced the efficiency of macro-prudential policy decisions. The communication of macro-prudential policy would set out a list of instruments that were used in decision-making (Dennis, 2011). For example, when using these instruments to address cyclical risk; the various groups of ‘risk weight’. In addition, some components of stress may be available when using stress testing to calibrate surcharges.
3. Decision-making – With the definition of decision-making frameworks, it is important to finally communicate and understand the policy decisions themselves. These policy decisions could be made known to the public as a way to ensure there is transparency in decision-making (IMF, 2011). It is also important that the authorities can give a clear explanation of the decisions they have put in place.
4. Accountability – The decisions made through macro-prudential policy constitute an important element in the social setup. For example, the degree to which an individual institution’s actions can lawfully be of benefit or the degree to which the community/ economy sees stability. Appropriate accountability must hence be guaranteed to the community about the macro-prudential decisions. Reports can be published to the public/ community through the media to enhance transparency (Dennis, 2011). This will in return lead to the policy decision to be elaborated. It may not be possible for macro-prudential instruments to be based on the permanent rule. All the collected and available information would be analyzed but it’s important to introduce constraints to enhance transparency.

Conclusion

Macro-prudential is the policy that aims at evaluating the dependability, health, and vulnerabilities of financial structures. This policy is essential to ensure that these financial institutions operate effectively and efficiently. Through its measures, Macro-prudential policy ensures that financial institutions utilize their financial resources and an effective manner. This means that the basic needs are given priority over other auxiliary needs. In addition, this policy ensures that there is transparency and accountability of the utilization of financial resources. This in turn tends to reduce the chances of corruption, fraud, and misappropriation of funds. As a result, many financial institutions have adopted and implemented this policy in the course of their operations.

References

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Dessler, G. (2004) Management: principles and practices for tomorrow’s leaders. New York: Prentice Hall

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Koestenbaum, P. (2002) Leadership: The inner side of greatness, a philosophy for leaders. San Francisco: Jossey-Bass.

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Macro-Prudential policy, (2009), Another way to enhance financial stability. Web.

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