Macroprudential Thinking for Capital Markets Activities

Every June, the Bank for International Settlements (‘BIS’) publishes one of the most influential texts for finance, its annual report. It covers the bank’s own activities, to be sure; but critically for all other actors, it sets forth the content and direction of high-level, central bank thinking on their plans.

This year, two elements were pre-published, which is unusual. This may indicate a particular need felt to inform the market on both progress and planning for macroprudential regulation, mainly of banks, but not only; and to comment also on the crypto-currencies vogue, and the problems arising from them – not least environmental given the need for enormous computing power required of distributed ledgers.

The focus for Thomas Murray’s clients comes with the announcement, in the form of a bit of forewarning, about where macroprudential planning may go for the world’s capital markets. Like it or not, agree with it or not, it is best to pay careful attention to the direction.

What the BIS understands by ‘macroprudential regulation’

Although the term dates back to the 1970s, it remained largely in the shadows until the turn of this century, when BIS General Manager Andrew Crockett called for a “macroprudential” approach to financial stability. In the same speech, he differentiated the macroprudential dimension of financial stability – the stability of the financial system in its entirety – from the microprudential dimension – the stability of individual institutions. What distinguishes the two perspectives is less the specific instruments – they are often the same – than why they are used and how they are calibrated.

It took the financial crises of 2007-2009 to expose the limitations of a microprudential perspective. After the crisis, as these limitations were recognised in policy circles, more and more countries adopted financial stability mandates and implemented macroprudential measures. As a result, the term “macroprudential” has entered the mainstream vocabulary of central bankers and other policymakers. The number of macroprudential measures adopted post-crisis has significantly increased for advanced and emerging market economies.

The Financial Stability Board, International Monetary Fund, and BIS have set out the key elements of a macroprudential framework in a series of notes prepared for the G20. It is impossible to question the authoritative nature of these notes. They identified three intermediate objectives:

  1. to increase the financial system’s resilience to aggregate shocks by building and releasing buffers;
  2. to constrain financial booms; and
  3. to reduce structural vulnerabilities that arise from common exposures, interlinkages, and the critical role of individual intermediaries.

Adopting a macroprudential orientation to financial stability comes with a number of challenges. First, the ultimate objective – financial stability – is hard to define, as all authorities would agree. It is something one senses more than something one can define, a direction in which to go rather than a destination at which to arrive. For this reason, central bank policymakers often resort to intermediate objectives, such as improving lending or risk management standards, strengthening banks’ robustness and reducing fluctuations in outstanding credit allocated to the economy. Such intermediate objectives can help communicate macroprudential measures and improve the coordination between different policymakers responsible for financial stability. But again, this is a sense of direction only, because even intermediate objectives may be too vague when it comes to assessing the impact of particular measures.

Second, macroprudential goals can sometimes be in conflict with other policy objectives. This is an issue because macroprudential authorities typically resort to instruments that may also be used for other purposes or from different perspectives. For instance, in a boom, bank supervisors may see no need to tighten regulatory requirements, because individual institutions may look solid enough when viewed in isolation; but at that very same time, macroprudential authorities might be observing the same scene and be more worried about procyclicality in the financial system and aggregate risk-taking, and thus would want to tighten prudential instruments. Conversely, in a generalised downturn, macroprudential authorities may wish to release buffers to smooth the impact on the real economy, while bank supervisors may prefer that institutions preserve as much capital as possible so as to better weather their losses. Tensions can also arise between macroprudential and monetary or fiscal authorities. Resolving such conflicts requires rigorous governance and collaboration amongst public authorities as they seek workable compromises – while noting that the conversation alone is extremely useful for heightening awareness of the health of the financial system.

Third, it is difficult to identify financial vulnerabilities early enough and with sufficient certainty to take action. In some cases, it may be hard to disentangle the development of financial imbalances from welcome financial deepening and innovation. Vulnerabilities may also build up over many years, without leading to acute stress. The system may appear stable in the interim, especially since signs of low risk (for example, compressed spreads) may simply reflect high risk-taking – hopefully well assessed risk-taking by the parties engaging in it. And, tightening measures when the financial system is already vulnerable could trigger the very destabilisation one is striving to prevent.

Fourth, a bias towards inaction could result from the costs to the economy of taking preventive measures, combined with difficulties in the timely identification of systemic risk. For one, policymakers are usually wary of sounding a false alarm, preferring to wait and see whether a development is actually harmful – even though prompt intervention would usually be more effective. Further, the near-term costs of preventive actions are quite visible to society, but their long-term benefits, while large, are harder to discern: policymakers and their policies are rarely given much credit for a crisis that did not happen (!). Indeed, preventive measures may be understandably unpopular, as they may hamper access to credit precisely when the general picture looks good. In this context, the temptation can be strong to argue that ‘this time really is different,’ and that no action is needed.

Finally, the impact of macroprudential measures can be hard to measure, given the plethora of potential instruments, their complex interactions, and, frequently, the scantiness of evidence about their effectiveness. And this may be the case even when the objective is well defined. The way in which monetary policy and macroprudential measures may interact only adds to these challenges. In fact, despite recent progress, models that link the financial sector to the real economy tend to be highly stylised. It is best for policy-makers to admit, and the public to understand, that the calibration of macroprudential measures is more art than science.

Central banks on macroprudential approaches to capital markets activities

Current macroprudential measures focus mainly on banks, with the risk they may be inappropriate and so ineffective in dealing with risks arising from the market-based financing that has become yet more prevalent since the global financial crisis of 2007-2009. Bank balance sheets are indeed constrained, as these same central bankers have been striving to do for several decades now. Similarly, financial innovation and the application of new technology to the financial industry may shift the nature of risk, requiring a new set of policy responses and an expanded toolkit. In this context, how can macroprudential approaches help address systemic risk arising from the normal business activities of public funds management and the work of other institutional investors, such as insurers and pension funds?

Correlated and procyclical trading by asset managers can destabilise markets, as we saw a decade ago, resulting in large losses that propagate throughout the financial system. Such effects are possible, even if each market participant acts with apparent prudence on a standalone basis, given the interactions between market dynamics and the collective actions of individual market participants. Yet current regulation on the asset management fund industry is geared mainly towards microprudential and consumer protection objectives, and thus fails to incorporate how actions by one player can affect the health of others via changes in asset prices, exchange rates, and rapid variations in secondary market liquidity.

The macroprudential perspective should be extended to all segments of asset management to address these concerns. Authorities have a number of options to address these risks. For example, minimum liquidity requirements for asset management funds may allow them to meet redemptions without selling relatively illiquid assets in a rush. If so, such requirements could help increase the resilience of market liquidity.

In January 2017, the US Securities and Exchange Commission implemented new rules requiring open-end mutual funds and exchange-traded funds to establish liquidity risk management programmes. Amongst other measures, the rules require these funds to consider current market conditions and establish appropriate liquidity risk management policies and procedures in light of both normal and reasonably foreseeable stressed market conditions. Such requirements incorporate a macroprudential perspective in that they recognise that liquidity is adversely affected by market stress.

Liquidity stress tests for asset management of various types of funds have also been implemented by others. For example, in 2015 the Bank of Mexico assessed liquidity risk in domestic mutual funds. The French market supervisory authority has also published a guidance document on stress testing for asset management. But in these exercises, the authorities took a mainly microprudential approach by focusing on fund-level liquidity risks. By contrast, in February 2018 the European Systemic Risk Board published a recommendation on action to address systemic risks related to liquidity mismatches. In particular, it explicitly considered an amplification channel whereby mismatches between the liquidity of open-end investment funds’ assets and their redemption profiles could lead to fire sales to meet redemption requests in times of market stress, potentially affecting other financial market participants holding the same or correlated assets. And in 2018, the world’s public markets have a historically high level of correlation.

To deal effectively with systemic risks stemming from public funds and other institutional investors, close cooperation among the various authorities involved is crucial – central bankers, bank regulators, insurance regulators, and securities regulators. Here, differences in perspectives can complicate matters, but everyone must be at the table to iron out a common policy. For instance, securities regulators with responsibility for asset managers put prime emphasis on investor protection, while central banks and bank regulators focus more on financial stability, and hence are more inclined to apply macroprudential approaches.

National authorities are currently making the very first steps towards a macroprudential perspective on capital market activities, as compared with the progress already made in introducing macroprudential frameworks to the banking sector. The enormous and still growing importance of asset managers and other institutional investors in both domestic and cross-border financial intermediation requires national authorities to monitor potential systemic risks from these activities at both the national and global levels, and to consider how best to employ macroprudential approaches to deal with such risks.

Concluding thought from Thomas Murray

Though the firm’s clients are mainly focused on the post-trade questions of market infrastructure usage and custody services for safeguarding assets, they would do well to be aware early on of changes in the offing for the buy-side which they service. Their clients can expect to have to respond to new market-wide liquidity requirements, liquidation period requirements, some forms of stress testing in terms of ability to close out positions in rough market conditions, and perhaps other versions of the sort of macroprudential basic ratios – but adapted to their segment. In the capital markets, we have already seen versions of this applied to public funds. Whatever forms it will take clearly, macroprudential regulation of the world’s capital markets is in the offing, as adapted from what the authorities have grown comfortable with in bank supervision.


The author, Thomas Krantz, is Senior Advisor, Capital markets, in the firm of Thomas Murray; and served as Secretary General of the World Federation of Exchanges (2000-2012). The views expressed are his own, and not necessarily those of the firm.

Tags: macroprudentialBank for International SettlementsBISRegulationcrypto-currenciesmacroprudential regulationFinancial Stability BoardInternational MonetaryFundG20financial stabilityCentral Bankgovernancefinancial vulnerabilitiesmonetary policyCapital MarketsAsset ManagementSECliquidity riskstress testingbuy-side