Eurozone banking union discussions are full of questions about the scope of Eurozone micro-prudential bank supervision. Yet, this article argues that there is surprisingly little debate on the macro-prudential supervision that is necessary to safeguard the wider European financial system. After all it is macro developments, such as rapidly rising housing prices, that lie at the heart of the ongoing crisis in Europe. To safeguard the financial system, Eurozone macro-prudential tools should be under the ECB, separate from micro-prudential functions, with input from national central banks when differentiation is necessary.
There is a strong tendency to focus on the stability and soundness of individual banks. Supervisors may thus be bogged down by the details of individual banks, while losing sight of emerging imbalances in the wider financial system. This may happen again in the building of the Banking Union. In the heated debate about the Single Supervisory Mechanism, policymakers are preoccupied with issues such as the range of supervision (Eurozone banks with assets of more than EUR 30 billion) and the division of labour between the ECB and the national supervisors. Another issue is the appropriate separation within the ECB between the monetary function performed by the Governing Council and the supervisory function executed by the newly envisaged Supervisory Board. With this pre-occupation with the micro-issues, we may miss out on the broader macro-trends in the financial system.
2. Integrated policy framework
This article proposes an integrated approach to the EU financial architecture: monetary stability, financial stability (macro-prudential), and financial supervision (micro-prudential). The EMU was built on the German approach to central banking. The ECB should only care about monetary stability. Both the 2007-2009 financial crisis and the on-going Eurozone banking and sovereign crisis show that the interface between the policy objectives of monetary and financial stability is important. The key question is what official role the ECB should play in financial stability within the EMU.
Tinbergen1 argues that you need at least one independent policy instrument for each policy objective. Applying this general principle, Mundell2 recognises that the different policy instruments and objectives are interrelated. Figure 1 illustrates the overall policy framework for the monetary and financial system. The analysis of the synergies and conflicts of interests between policy objectives is helpful to assigning policy areas to different institutions. When the synergies between objectives dominate, these objectives may be assigned to one institution. By contrast, when the conflicts of interests dominate, objectives may better be assigned to different bodies.
The first trade-off is the interaction between monetary and financial stability. New theories suggest that monetary policy and financial stability policies are closely linked. Adrian and Shin3, for example, document that balance sheets of financial intermediaries provide a window on the transmission of monetary policy through capital market conditions. This reinforces the important role of financial intermediaries in the financial system. Goodhart4 also stresses the financial stability role of central banks. It is often argued that monetary and financial stability are two sides of the same coin. After the financial crisis, central banks have resumed their financial stability role. The main synergy between monetary and financial stability is to steer the financial system.
A major conflict of interests is diverging trends on monetary and financial stability. While monetary stability focuses on retail consumption prices, financial stability looks at the development of asset prices, such as house prices and equity prices, and aims to counter the pro-cyclicality of the financial system (as well as the pro-cyclical working of micro-prudential supervision). There is a large literature on conflicts between monetary and financial policy goals. However, such conflicts are genuine. After setting the interest rate for monetary policy purposes, the central bank considers which macro-prudential tools are needed to stabilise the financial cycle (leaning against credit bubbles). The chosen interest rate is thus taken as given for financial stability purposes. Macro-prudential tools include inter alia countercyclical capital buffers to constrain undue credit growth, loan-to-value ratios to constrain rising real estate prices, margin or collateral requirements to constrain rising equity prices, and the macro-perspective of stress tests.
The second trade-off is between macro- and micro-prudential policies. Until recently, the prevalent approach to financial stability has implicitly assumed that making individual financial institutions safe will make the system as a whole safe. But this is wrong. As indicated below, this represents a fallacy of composition. It is more appropriate to think in terms of a hierarchy of objectives. The first two objectives, price and financial stability, are equally important and affect the economy at large. The latter objective, sound financial institutions, addresses individual financial institutions and aims to protect individual depositors and policyholders (against insolvency risk of the financial institution). The first two objectives aimed at the ‘system’ are more important than the latter objective aimed at individual firms. In a market driven economy, firms – including financial firms – should be allowed to fail to contain moral hazard, unless there is a systemic threat.
The fallacy of composition6 concerns the idea, fundamentally at the basis of original Basel banking supervision, that to safeguard the system it suffices to safeguard the components. But in trying to make themselves safer, financial institutions can behave in a way that collectively undermines the system. Selling an asset (such as equity), when the price of risk increases, may be a prudent response from the perspective of an individual bank or insurer. However if many banks and insurers act in this way, the asset price will collapse, forcing financial institutions to take yet further steps to rectify the situation. The responses of the financial institutions themselves to such pressures lead to generalised declines in asset prices, and enhanced correlations and volatility in asset markets. So the micro policies can be destructive at the macro level.
It may thus not always be possible to avoid a conflict of objectives. In that case it is unavoidable to define a hierarchy of objectives. In such situations, the macro-prudential concerns should override the micro-prudential concerns7.
3. The policy framework for Banking Union
The new integrated framework is designed at the European level, as part of the newly envisaged Banking Union. The ESCB, the European System of Central Banks comprising the ECB and the participating NCBs, has already the responsibility for monetary policy. I propose also to assign the macro-prudential policy to the ESCB, as explained below. The supervisory task in the prospective Banking Union is assigned to the ECB.
While much has been written on the Single Supervisory Mechanism, it is not yet clear which body can best execute the new strategy for macro-prudential policy. In the aftermath of the global financial crisis, financial stability committees with a broad remit are emerging worldwide. The European Systemic Risk Board (ESRB) was established following the Larosière Report, while the US Financial Stability Oversight Council (FSOC) was created by the Dodd-Frank Act. Macro-prudential policy belongs explicitly to the mandate of these committees. To a varying degree, the central bank, the supervisory agencies and the treasury are represented on the financial stability committees.
Committee decision-making tends be more balanced than decision-making by individuals. But this is typically true for committees acting as a body of a single institution (e.g. the executive board of a company or the monetary policy committee of a central bank) or a single system of related institutions (e.g. the European System of Central Banks or the Federal Reserve System). The benefits of committee decision-making need not directly extend to committees representing more or less independent institutions with differing objectives that are supposed to work together. Visser and Swank8, for example, show that reputational concerns induce members to manipulate information and vote strategically if their preferences differ considerably.
Another issue is that each institution has its own culture. In an empirical survey, Goodhart, Schoenmaker and Dasgupta9 show that central bankers and supervisors have different skill-sets and cultures. The dominant culture at central banks is centred around economists, while supervisors tend to be dominated by accountants and lawyers. That will also lead to a different perspective: macro versus micro.
My proposal is that:
• The ESCB gets final responsibility for macro-prudential policy (including powers to apply macro-prudential instruments); and
• The ESRB, as financial stability committee, is used to discuss financial stability developments and to dovetail monetary, macro-prudential and micro-prudential policies.
The ESRB would be the forum to discuss macro-prudential policies for the wider European Union. It will allow for aligning macro-prudential policies of the outs (UK, Sweden, Denmark and most NMS) and the Eurozone. Moreover, it allows for input from the sectoral European supervisory authorities (EBA, EIOPA and ESMA). But to ensure the pro-active use of macro-prudential tools, the conduct of macro-prudential policy would be assigned to the ESCB.
There is an important issue of coordination between the European and national level. The financial cycle tends to differ between countries, also within the Eurozone. So, the countercyclical capital buffer (to reign in excessive credit growth) is set at the country level in the Basel III framework. Furthermore, house prices, an important driver of the financial cycle, are local in Europe. The same is true for the US, where house price developments can differ significantly between states. Housing markets thus tends to be local, even in some cases regional, but certainly national.
Next, interfering in housing is political. While the ESCB was allowed to develop its own definition of price stability, there should be political involvement of the relevant authorities. If, for example, housing prices were rising sharply in, say, the Netherlands, but nowhere else, one would want the Dutch relevant authorities to have a proportionate much greater say in that decision than central banks and treasuries from elsewhere. This is just another aspect of the problem that macro-prudential needs to be applied at a more granular level than Europe. To some extent the same problem may occur in other large geographical areas, like Canada, the US, or Australia.
4. Way forward
A possible way forward to ensure a proper division of functions at the ECB is to assign the monetary policy and macro-prudential functions at the level of the Governing/General Council. As some ‘outs’ may join the Banking Union, a macro-prudential committee reporting to the General Council may be the appropriate setting for macro-prudential issues. The supervisory function will be performed by the newly envisaged Supervisory Board. The decision on the application of macro-prudential tools will then be taken in the General Council, whose members comprise the Executive Board of the ECB, the presidents of the NCBs and the chair of the Supervisory Board10.
This construction allows for both national and micro-supervisory input in the macro-prudential deliberations. It also allows for the appropriate separation between the macro-prudential perspective (of the General/Governing Council) and the micro-prudential perspective (of the Supervisory Board).
About the Author
Dirk Schoenmaker is Dean of the Duisenberg School of Finance and Professor of Finance, Banking and Insurance at the VU University Amsterdam. He has widely published on international banking and financial stability, including a new book on ‘Governance of International Banking’ and a textbook on ‘Financial Markets and Institutions: A European Perspective’. He is a member of the Advisory Scientific Committee of the European Systemic Risk Board, the new authority for macro-prudential policy at the European Central Bank. He is a consultant for the IMF, the OECD and the European Commission.
1. Tinbergen, J. (1952), On the Theory of Economic Policy, North Holland, Amsterdam.
2. Mundell, R. (1962), The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability, IMF Staff Papers 9, 70-79.
3. Adrian, T. and H. Shin (2008), Financial Intermediaries, Financial Stability, and Monetary Policy, Federal Reserve Bank of New York Staff Report No.346.
4. Goodhart, C. (2010), The Changing Role of Central Banks, BIS Working Papers, No. 326, Bank for International Settlements, Basel.
5. Kremers, J. and D. Schoenmaker (2010), Twin Peaks: Experiences in the Netherlands, Special Paper, no. 196, LSE Financial Markets Group, London.
6. Brunnermeier, M., A. Crockett, C. Goodhart, A. Persaud and H. Shin (2009), The Fundamental Principles of Financial Regulation, 11th Geneva Report on the World Economy, CEPR, London.
7. Hanson, S., A. Kashyap, and J. Stein (2011), A Macroprudential Approach to Financial Regulation, Journal of Economic Perspectives 25, 3–2
8. Kremers, J. and D. Schoenmaker (2010), Twin Peaks: Experiences in the Netherlands, Special Paper, no. 196, LSE Financial Markets Group, London. 8. Visser, B. and O. Swank (2007), On Committees of Experts, Quarterly Journal of Economics 122, 337-372.
9. Goodhart, C., D. Schoenmaker, and P. Dasgupta (2002), The Skill Profile of Central Bankers and Supervisors, European Finance Review 6, 397-427.
10. Article 19.1 of the draft Council Regulation on prudential supervision in the Banking Union specifies that the Chair of the Supervisory Board shall be elected from the Executive Board of the ECB.