Macroprudential Tools: Ring-Fencing, Resolution Regimes, and Oversight

**Other types of Macroprudential Tools** **Point 2: Ring-Fencing (Vickers Report)** Separation of retail banking (core utility functions like deposits and payments) from investment banking activities. Rationale: Protects essential banking services from risks posed by investment banking. Reduces...

**Other types of Macroprudential Tools** **Point 2: Ring-Fencing (Vickers Report)** Separation of retail banking (core utility functions like deposits and payments) from investment banking activities. Rationale: Protects essential banking services from risks posed by investment banking. Reduces contagion risk and improves the resolvability of large banks during financial stress. Resolvability: if a bank becomes insolvent, it can be resolved without causing widespread disruptions Context : The Vickers Report refers to the findings of the Independent Commission on Banking (ICB), chaired by Sir John Vickers, published in 2011. It was commissioned by the UK government in response to the 2008 financial crisis to recommend reforms to improve the stability of the UK banking system. 1\. **Ring-Fencing**: Separate retail banking (core services like deposits and payments) from riskier investment banking to protect essential services. 2\. Capital Requirements: **Strengthen the capital buffer for UK banks beyond international Basel III standards.** **Point 3: Resolution Regimes and Too Big to Fail (TBTF)** 1)Recovery and Resolution Plans (Living wills): Banks plan both: A\) A Recovery Plan: Outlines steps the bank will take to stabilise itself during financial distress and avoid failure. B\) A Resolution Plan: Details how the bank would be restructured or wound down if it becomes insolvent, ensuring minimal disruption to the financial system. Orderly resolution of failing banks, protecting financial stability. Resolution plans? Macro prudential or reaction after crisis? Recovery Plans: Preventive (macroprudential). Resolution Plans: Include both preventive (living wills) and post-failure tools (bailouts/bail-ins). Bailouts and bail-ins are part of the resolution phase but are reactive rather than preventive. 2\) Bail-In Mechanisms: Forces creditors (not taxpayers) to bear losses in the event of bank failure. If a bank becomes insolvent: The bank's creditors (primarily bondholders and shareholders, not insured depositors) bear the losses through a bail-in mechanism. Shareholders and bondholders can't "bail out" or abandon the bank: In a bail-in, creditors cannot simply walk away. Their claims on the bank (like bonds or shares) are used to cover the losses and recapitalise the bank. This ensures that the costs of failure are borne by those who invested in the bank, not taxpayers. Addresses moral hazard associated with TBTF institutions: Addressing moral hazard associated with Too Big to Fail (TBTF) institutions means reducing the risk that large banks take excessive risks because they believe they will be rescued by the government if they fail. **Point 4: Macroprudential Oversight by the (FPC) Financial Policy Committee** 1\. Advising on Capital Requirements: Recommends appropriate levels of capital banks should hold. 2. Loan-To-Value Limits: set a maximum percentage of a property's value that a borrower can finance through a mortgage. (If LTV limit is 80% the buyer must provide 20% down payment). Debt-To-Income Limits: Limit the amount borrowers can borrow based on their income, preventing excessive household debt. (if the DTI limit is 40%, a borrower's total debt payments (including the mortgage) cannot exceed 40% of their monthly income). 3\. Stress Tests: Simulate adverse economic scenarios to test banks' ability to withstand shocks, assessing systemic vulnerabilities in advance. Preemptively addresses systemic vulnerabilities in the financial system. Prevents Housing Bubbles: Controls excessive household leverage and speculative mortgage lending, avoiding unsustainable property price inflation. Promotes Stability: Ensures the financial system remains stable during economic downturns or market stress. **Point 5: Microprudential and Macroprudential Interactions** Coordination between **the Financial Policy Committee (FPC), Prudential Regulation Authority (PRA), and Financial Conduct Authority (FCA)** to [align] microprudential (institution-level) and macroprudential (system-wide) oversight. Ensures that systemic risks emerging in less-regulated areas of the financial sector are identified and mitigated. Enhances coherence between individual (microprudential) and system-wide (macroprudential) supervision. **Point 6: Time Varying Macroprudential Tools: Adjusted along the Economic cycle** Countercyclical Capital Buffers (CCBs): Adjusted to require higher capital during booms and release during downturns. Leverage Ratios: May be tightened during periods of excessive credit growth. Loan-to-Value (LTV) and Debt-to-Income (DTI) Limits: Adjusted to curb excessive lending in overheated housing markets or loosened during downturns to support borrowing. This adaptability helps mitigate procyclicality and promote financial stability. **Point 7: Stress Testing and Scenario Analysis** **Stress testing** involves simulating adverse economic scenarios (recessions, market crashes) to evaluate a bank's **solvency** (ability to cover liabilities) and **liquidity** (ability to meet short-term obligations). Identifies Weaknesses: Detects vulnerabilities in financial institutions under hypothetical stress scenarios. Ensures Preparedness: Confirms banks hold sufficient capital and liquidity to absorb shocks without destabilising the financial system. Promotes Stability: Reduces the risk of systemic crises by ensuring resilience during economic downturns or financial stress. **Tucker et al. (2013)** argue that: 1\. Instruments such as the **Countercyclical Capital Buffer (CCB), Sectoral Capital Requirements (SCRs), and stress-testing regimes** are essential for managing systemic risks. These tools **reduce procyclicality**, ensure that banks **maintain adequate capital and liquidity buffers**, and mitigate risks associated with excessive leverage and credit growth. 2\. **Effective interaction** between the Financial Policy Committee (FPC), Prudential Regulation Authority (PRA), and Financial Conduct Authority (FCA) enhances systemic oversight. **This coordination aligns macroprudential regulation with broader economic objectives,** ensuring comprehensive risk management across institutions. 3\. **Macroprudential policies address gaps revealed during the 2008 financial crisis.** They argue that these measures are crucial for reducing systemic vulnerabilities, building financial resilience, and safeguarding overall economic stability. **Alfred Duncan and Charles Nolan (2019):** argue that: Current macroprudential tools, such as countercyclical capital buffers and lending restrictions, are too narrowly focused on banks and cyclical risks. They believe these tools are insufficient to address broader systemic risks, such as leverage, herding behavior, and the too-big-to-fail problem, which often extend beyond the regulated banking sector. They also stress that these tools must account for the interconnectedness of risks across the financial system and their interaction with other policies like tax and monetary frameworks to be truly effective. **The authors suggest that the Financial Policy Committee's role should expand to cover broader issues like tax policy, corporate governance, and competition. This means the FPC should look at how things like tax rules, company leadership structures, and lack of competition affect financial risks and stabilit**y. By addressing these areas, the FPC could help reduce risks and improve the overall health of the financial system. **Aikman et al. (2019**) argue that the **U.S. Financial Stability Oversight Council (FSOC) is far less effective than the UK's Financial Policy Committee (FPC) in managing systemic risks**. The FSOC lacks direct powers and can only make non-binding recommendations to other regulators, many of whom are not focused on financial stability. In contrast, the FPC has strong, direct powers, including setting capital buffers, limiting risky loans, and adjusting capital requirements for specific sectors. **Aikman et al. (2019)** argue that if **the U.S. Financial Stability Oversight Council (FSOC) had stronger macroprudential tools**---like those introduced under Basel III, such as countercyclical capital buffers and limits on risky lending---it could have **mitigated the vulnerabilities that contributed to the 2008 Global Financial Crisis. ** **Who should oversee macroprudential policy?** **1. Independent Oversight by a Central Financial Stability Committee** Should operate with autonomy to mitigate systemic risks without political or market interference. Central banks are best suited due to their expertise, access to data, and ability to assess systemic risks (Aikman et al., 2019; Borio, 2003). 2\. Need for Expertise and Independence Expertise in macroeconomic and systemic risk analysis is crucial for effective policy. **Independence from short-term political pressures (unlike the US FSOC)** ensures timely actions like imposing countercyclical capital buffers or loan-to-income limits (Aikman et al., 2019; IMF, 2018). 3\. Broad Mandate and Authority The **entity must have access to Basel III Framework tools**, including countercyclical buffers, leverage caps, and liquidity requirements. The **UK Financial Policy Committee (FPC) is an effective model with direct power**s and unlike the US FSOC, which lacks direct authority (Aikman et al., 2019). 4\. Comprehensive Regulatory Coverage **Authority** should **extend to both banks and nonbanks** to address systemic risks from shadow banking and broker-dealers. Regulatory frameworks **must evolve** to cover emerging risks, avoiding gaps that exacerbated the 2008 crisis (Adrian et al., 2017; Tucker, 2018). 5\. Strong Accountability and Governance **Regular reporting (e.g., Financial Stability Reports**) and parliamentary testimonies ensure transparency and public accountability. **Including external members with diverse expertise** reduces groupthink and enhances decision-making (Aikman et al., 2019). 6\. Avoiding Policy Fragmentation A centralised structure avoids conflicts and inefficiencies caused by fragmented oversight, as seen in the US FSOC's inability to act decisively before 2008. Unified authority ensures timely and coherent responses to financial risks (Aikman et al., 2019). **UK FPC vs US FCOS** **FPC = sub committee of the Bank of England (CB in the UK): role: manage macroprudential regulation in the uk** (FPC) in the UK was created as a result of the 2008 Global Financial Crisis. FPC: established in 2013 as part of a broader overhaul of the UK's financial regulatory framework. The creation of the FPC was outlined in the Financial Services Act 2012 to ensure macroprudential oversight and safeguard financial stability. =/ The US Financial Stability Oversight Council (FSOC): established under the Dodd-Frank Act (2010) following the 2008 Global Financial Crisis. The FPC is part of the Bank of England, while the FSOC is independent but chaired by the US Treasury Secretary. (FCOS under political influence, not the FPC part of CB) US FCOS: multi agency structure (member from Federal Reserve: Fed, Security and Exchange Commission: SEC, Federal Deposit Insurance Coporation: FDIC): coordination problem. **UK FPC: more coordinated, economically driven decision making (operate whithin the Bank of England, extremely independent institution)**