UK: Macro And Microprudential Supervision

As the global financial crisis has unfolded the industry has grown accustomed to debating a new concept – that of macroprudential supervision and its focus on risks affecting the financial system as a whole. Much of the debate has until now been abstract. However, the publication last month of the minutes and recommendations of the Interim Financial Policy Committee has given UK firms their first insights into how macroprudential supervision will operate in practice, including how the Financial Policy Committee and Financial Services Authority will work together to identify, explore and ultimately deal with risks to financial stability.

The focus on both macro- and microprudential supervision is an essential part of the response to the crisis. It is clear that what starts "macro" quickly becomes "micro", requiring individual firms to come to terms with a new and quite different regulatory operating model and a new set of priority actions. The microprudential regulator's own work programme will at times be displaced by that of the macroprudential regulator. There will be further, and quite likely extensive, data requests which, without strong international co-ordination, could compete with those made by global and regional financial stability bodies. Public pronouncements by macroprudential regulators will be dissected for signs of emerging risks and concerns and clarity about the status of these statements will be essential. Otherwise the focus on the big issues that really matter will blur.

The inexorable rise of macroprudential Supervision

In April 2009, Claudio Borio of the Bank for International Settlements wrote a thought-provoking article1 which carried the sub-title "We are all macroprudentialists now." At the time, macroprudential supervision had become the watchword, regarded by global policymakers as a key part of the new regulatory framework to help ensure that the world would never again see a crisis of the magnitude of the one just experienced.

In the article, Mr Borio charted the emergence of the term macroprudential and explained its twin dimensions.

The first is the "cross-sectional" dimension: how risk is distributed across the financial system at any given point in time and, in particular how to deal with common exposures across financial institutions. The second is the "time" dimension: how system-wide risk evolves over time and how it can be amplified by interactions, both within the financial system and between it and the real economy.

The conclusion that readers were invited to draw was that macroprudential supervision had been overlooked,2 contributing to both the emergence and severity of the crisis, but was about to emerge from the shadows, ready to take its rightful place on the financial stability stage alongside the microprudential supervision of individual firms.

If we roll the clock on two years, it is very clear that macroprudential structures have sprung up across the globe. The US has its Financial Stability Oversight Council; the EU has its European Systemic Risk Board (ESRB) and the UK its Financial Policy Committee (FPC), albeit for the time being in interim form. So in this sense, Mr Borio was absolutely right, we are all macroprudentialists now.

The publication on 24 June of the Bank of England's Financial Stability Report3 (FSR) together with the minutes of the Interim FPC's4 first meeting provide what may be the first practical example of the new breed of macroprudentialists in action.

The minutes include six policy recommendations, five of them addressed to the Financial Services Authority (FSA), ranging from improved disclosures, forbearance and provisioning practices, and building bank capital buffers through to monitoring Exchange Traded Funds.

The substance of these recommendations is important. But so is the process. What start as possible macroprudential risks very quickly transform themselves into microprudential activities and actions. HM Treasury has been very careful to make it clear that the FPC, once formally established, may not give a policy direction that relates to a specified regulated firm.5 However, activities to determine whether or not a perceived risk is an actual one, and – if it is – to size it, have to take place at the level of individual institutions. There is no mystery to this – after all, the macro financial system consists of a very large number of micro firms. However, some firms are clearly more "macro" (ie. systemically important) than others and inevitably they will bear more of the brunt in terms of these new activities.

A number of interesting and material consequences follow from this:

The reach of the Financial Policy Committee

First, it is very clear just how powerful the FPC's influence will be on the work programme and priorities of the FSA now and the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) in future.

At its meeting on 16 June 2011, the FPC agreed the following policy recommendations:

1. The Committee advises the Financial Services Authority (FSA) to ensure that improved disclosure of sovereign and banking sector exposures by major UK banks becomes a permanent part of their reporting framework, and to work with the FPC to consider further extensions of disclosure in the future.

2. The Committee advises the FSA to compile data on the current sovereign and banking sector exposures of other UK banks not subject to the EBA stress tests. If these exposures are significant, then the FSA should publish an aggregate estimate.

3. The Committee advises the FSA to extend its review of forbearance and associated provisioning practices across UK banks' household and corporate sector exposures on a global basis.

4. The Committee advises UK banks that, during the transition to the new Basel III capital requirements, they should take the opportunity of periods of strong earnings to build capital so that credit availability is not constrained in periods of stress.

5. The Committee advises the FSA, as part of its regular supervisory dialogue with banks, to ensure that the proportion of earnings retained is consistent with the advice in the preceding recommendation.

6. The Committee advises the FSA that its bank supervisors should monitor closely the risks associated with opaque funding structures, such as collateral swaps or similar transactions employed by exchange-traded funds.

Record of the interim FPC meeting held on 16 June 2011.

As Paul Tucker, Deputy Governor Financial Stability at the Bank of England has said "What is different between the macroprudential regime we now have and the past is that the FPC will be steering and, once the legislation is complete, Recommending and sometimes Directing the microregulators to take action. That is a major change in the UK's regime."6 It certainly is.

Whereas the FSA is currently able to give the industry some indication of its likely work programme in its annual Business Plan (but even that is subject to change as new issues emerge), from now on firms will have to get used to the prospect of a new set of FSA priorities following each FPC meeting. It also makes clear the extent of the FPC's reach and the primacy given to the financial stability objective. This is not surprising given that, in future, the Bank of England, FPC and the PRA will share the same financial stability goal, the distinction being in the way in which each body pursues it.

It is also likely that the FCA will, from time to time, be given a similar list of actions to pursue, for example, to ascertain the extent to which a particular class of FCAregulated firms is engaged in collateral swaps. In this case the scope for tension between the FCA's own primary objective and the financial stability objective is arguably much greater, and suggests that the FCA will occasionally face some tough prioritisation decisions between its own concerns and those identified by the FPC.

International coordination

The second issue concerns international co-ordination. Both the International Monetary Fund (IMF) and the Financial Stability Board (FSB) have to some extent a global brief on macroprudential issues, particularly concerning the identification of emerging macroprudential risks. But neither has any formal power to direct or instruct national authorities to take certain actions either to investigate possible macroprudential risks or to mitigate those that have emerged. Nevertheless, both bodies clearly have a significant influence on the priorities of their members, which in turn means that their warnings and exhortations are unlikely to be ignored.

The ESRB does, on the other hand, have relevant formal powers to collect information in relation to macroprudential oversight and to issue risk warnings and recommendations for remedial action. These risk warnings and recommendations can be issued to a wide variety of recipients: the EU as a whole, one or more member states, one or more of the European Supervisory Authority (ESAs) or one or more national supervisory authorities.

The existence of bodies at the global, regional and national levels to deal with emerging systemic risks is a very powerful and necessary combination. The current crisis has shown that the greatest systemic risks know no national boundaries and nothing suggests that the position will be any different in future.

But at the same time, there are unanswered questions about how these bodies co-ordinate, interact and prioritise. If they do not, at least to some degree, there is a risk of competing and contradictory recommendations, warnings and data requests. This would not only be confusing for industry, but could also undermine the effectiveness of any risk reducing actions pursued by an individual country.

Macroprudential data collection, on a micro level

This leads to the third issue, that of macroprudential data collection. Macroprudential supervision is in large part concerned with aggregate data7 and what these convey about the distribution of risk across the system and/or how it is evolving over time. Much of the relevant data is already being collected. However, where this is not the case individual firms will be asked to provide them, initially as a one-off exercise, but possibly regularly if macroprudential supervisors decide that the data are sufficiently important that they need to be monitored permanently.8

Once again, it looks as if this data collection task will fall in the first instance to the microprudential supervisors. This must be right in that it provides a single point of contact between an individual firm and the relevant supervisory machinery (micro and macro, at national, regional and global levels), whereas any other approach would increase the scope for confusion. But it does indicate another reason for some international co-ordination of data gathering initiatives (otherwise the risk of firms being subject to multiple, competing and possibly conflicting data requests channelled through their microprudential supervisors rises significantly). In this regard, the paper on macroprudential oversight recently published by the Institute of International Finance sets out an important principle on data gathering.9

The focus on data also signals to firms that they will need to be ready to react in short order to provide good quality data in response to the demands of macroprudential supervisors, at national, regional and global levels.

Communication by the macroprudential Supervisor

The fourth and final issue concerns the status of pronouncements by macroprudential supervisors. There is little room for doubt about status when macroprudential supervisors are using their formal powers, where these exist. But, as noted above, the pronouncements and warnings by bodies such as the IMF and FSB do not come with powers and sanctions attached. And even those bodies which do have powers, such as the ESRB and FPC, may make statements and warnings which are not recommendations, directions or instructions in any formal sense.

It is also likely that speeches by FPC members will in future be subject to the same forensic scrutiny as is currently given to speeches by members of the Monetary Policy Committee. Clearly such statements would not be made without good reason, and firms would be well advised to heed them or risk them being turned from informal statements into formal measures. But this will add to the challenges faced by firms (and by microprudential supervisors) in terms of tracking, prioritising and acting on macroprudential recommendations, in their broadest sense. It is therefore essential that there is clarity about the status of these macroprudential "obiter dicta" and some discipline in making them.

So ... we are all microprudentialists too

These challenges should all prove to be surmountable once the financial services industry has had some time to adjust to the emergence of macroprudential supervision. And any frictional costs will less than the benefits that will flow from having a well-functioning approach to identifying and managing risks to the financial system. After all, the recognition that we are all macroprudentialists is not only a recent one but also an essential one. But it is already clear that what starts macro very quickly becomes micro. It is therefore imperative not to lose sight of the fact that we are all microprudentialists too.


1 index.php?q=node/3445"

2 Arguably macroprudential risk analysis was not overlooked. There was no shortage of financial stability reports in the run-up to the crisis. But it is difficult to identify many concrete actions that were taken specifically to mitigate those risks


4 http://www.bankofengland. fpc/pdf/2011/record1106. Pdf

5 Draft Financial Services Bill, Part 1 – Amendments of Bank of England Act 1998, section 9G

6 http://www.bankofengland. / 2011/speech506.pdf

7 Macroprudential supervisors will also be concerned with individual firm data when the firm concerned is deemed to be systemically important.

8 In this case the data will undoubtedly be standardised for aggregation purposes and used for peer analysis. They may well not be data that firms themselves use to monitor, let alone manage, their risks

9 press+197.php.

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