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What data are needed for financial stability analysis and implementing macroprudential policy?

Is there a need for reprioritisation of FSIs?

IMF-FSB User ConferenceBernd Braasch

Financial Stability DepartmentDeutsche Bundesbank

The views expressed in this presentation are those of the author and should not be attributed to the Deutsche Bundesbank.

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Overview

I. Data for financial stability analysis What are the main future challenges for financial stability analysis? To what extent has the financial crisis revealed new fields for financial

analysis … … underlined identified priorities?

II. Financial Soundness Indicators Objectives Did FSI fail to indicate the crisis and why? Reprioritisation of FSIs

III. One of the main objectives of the conference Prioritised list of main issues for financial analysis and associated data needs

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I. Data for financial stability analysis

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Important to distinguish fields with information from data gaps – also to isolate priorities

Challenges

Data

needs

Financial stability analysis

Monitoring/early warning system

Financial soundness indicators

Surveillance …

I. Case by case

(for example special reports)

Capital flows of EMEs

Institutional Investors

II. Regular data

(for example)

Capital flows of non-bank fin. inst.

Balance sheet approaches

Financial innovations

Systemic risk

Global capital flows

Financial innovations

Measuring systemic risk etc.

International comparability

Reprioritisation

Market indicators

III. Data and analytical tools

(for example)

Centralised securities database

Risk map (Issing Report)

Globalised securities database

Risk map (Issing Report)

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“…, in order to achieve improvements in the financial architecture that substantially strengthen financial stability, an in-depth analysis of the underlying reasons for the crises is essential.”

(Axel Weber, Dinner speech at the joint Bundesbank-CEPR-CFS conference: “Risk transfer: challenges for financial institutions and markets”, Frankfurt am Main, 11 December 2008, BIS Review, 158, 2008, page 1 ff)

• Bundesbank will further deepen financial stability analysis …

• … in its newly created financial stability department

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Objectives of this conference – very ambitious

Financial stability

analysis

Priorities

Related

data needs

Available data• Market indicators• Official data

Remaining data gaps

Main issues

1. Cross-border linkages

2.

3 …..

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Different initiatives to take stock of information and data gaps

• Inter alia

Conference on implementing G8 Action Plan: Financial Globalisation, Vulnerabilities and Data Needs (Frankfurt, January 2008)

Co-hosted by the Bundesbank and the German Federal Ministry of Finance

Results have contributed to the Future Work Programme for broadening the database

And in particular for the reconvened Working Group in Securities Databases

http://www.bundesbank.de/presse/presse_aktuell.en.php

Roundtable meetings, working groups (MCM) to enhance collaboration in financial stability analysis

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Financial stability analysis – objectives and tentative priorities against the backdrop of the financial crisis

1. Analyse implications of changing global financial transmission mechanism

2. Institutionalisation of saving

3. Cross-border financial linkages of banking systems

4. Contributions to better understanding of changing interdependence between financial and real spheres

5. Deepening analysis of systemic risk approaches, as an element of early warning systems

6. Developing operational financial stability framework

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Financial stability analysis – objectives and tentative priorities against the backdrop of the financial crisis

6. Financial stability implications of financial innovations (new instruments; securitisation etc.)

7. Measurement of financial stability

8. Results of financial stability analysis contribute to furthering the development of macroeconomic models

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Cross border linkages

Recommendations of the „Issing Committee“

• Interconnectedness and shadow banking system, comprising off-balance sheet entities and risk transfer instruments (CDOs; CDS)

Risk map❙Global database of the global financial interconnectedness is needed❙… and of major risk drivers❙IMF and Inter-Agency Task Force should develop a proposal for „global risk map“

Global credit register❙Work efficiently on national level❙Gobal credit register could enhance risk management (firm and systemic level)

Global securities register ❙Would add the international capital market dimensions❙Proposal: Working Group on Securities Databases

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Cross border linkages

Recommendations of the „Issing Committee“

Hedge Funds• Data to enhance direct regulation

Structural data (including identifier; domicile; ownership structure; investment objectives)

Including balance sheet information on a quarterly base• Data to enhance indirect regulation

Systemic oversight risk directed at major banks which provide funds Monitoring counterparty risk management by prime brokers (including

leverage ratios)

Procyclicality Build up of systemic exposures Macrosystemic indicators and microsystemic indicators

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What are best practices in monitoring systemic risks arising from hedge funds and other large unregulated non-bank financial institutions?

• Main focus: Better oversight of potential systemic risks. • Public databases do not provide adequate data on HF; reports by primary

dealer about their exposures useful but not sufficient to get an appropriate insight.

• Information should be regular and timely (preferably monthly, at least quarterly).

• Main items on asset side broken down by asset classes: Equity, bonds, commodities. Liabilities side: Investment by investors and debt (including collateralized debt).

• Also, use of derivates (according to risk categories) and short sales.• Information requirements should encompass single hedge funds as well as

Fund of HF. Global approach. • For discussion: Additional indicators for HF liquidity risk? Market risk?

(E. Brandt)

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Global financial factors of growing importance for national financial markets – Some empirical evidence

Global capital flows reflect growing importance of financial market channel:• Quantum leap in quantity and quality • Significant changes in the structure and composition of capital flows

Spreads gaining in importance as a leading indicator of real economic growth

Spreads in EMEs are more and more driven by global financial factors, and less by national fundamentals; global liquidity and risk appetite

Empirical evidence: • Around 50 % of the variance of the spread level in EMEs is determined by few global

factors, in particular risk appetite and global market liquidity - Martín González Rozada and Eduardo Levy Yeyati, Global Factors and Emerging Market Spreads, Inter-American Development Bank, Research Department, Working Paper No. 552

• “… that a single common factor is able to explain a large part of the co-variation in emerging market economies’ (EMEs) spreads observed in the last 4 years” - Alessio Carlione, Paolo Piselli, and Giorgio Trebeshi, Emerging markets’ spreads and global financial conditions. In: Journal of International Financial Markets, Institutions & Money, 19 (2009)

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Global financial factors of growing importance for national financial markets –Some empirical evidence

• Widening of the spread levels in current turmoil in EMEs mainly caused by lower risk appetite, less by fundamentals

• “… the search for yield has meant that investors have differentiated less in recent years between EMEs of different credit quality. In other words the dispersion of sovereign bond spreads across EMEs has fallen by much more than that of sovereign credit rating.” Guillermo Felices et al., BoE, Quarterly

Bulletin, 2008/Q1

• Three to four global factors can explain 80% to 90% of all rating changes in EMEs. What does it mean for costs of refinancing; country specific developments sufficiently considered? - Andrew Powell and Juan Francisco Martinez, On Emerging Economy Sovereign Spreads and Ratings. IADB Research Department Working Paper, No. 629, January 2008

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Growing importance of global financial factors – further noteworthy implications

• Dynamically changing interdependence between financial and real spheres

• Rebalancing effects and portfolio strategies of global players of increasing importance for global financial and real cycles

• Little differentiation between asset classes and country risks

• One of the main explanations of why even countries with a stable macroeconomic framework stronger regulation and an efficient market infrastructure

• … have been severely affected by this financial crisis

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Changing interdependencies between financial and real sphere of the economy

National financial system

Global financial factors

National determinants

Growing importance of

financial indicators

as predictor of national business cycles

National business cycle

200 bp increase in spread levels in EMEs dampens world economic growth by around 0,9 % compared with baseline scenario in the following year

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Better understanding of key drivers of financial globalisation is of key importance – for early warning systems and monitoring

Globally acting institutional investors

• Better data coverage of institutional investors’ behaviour, strategies and global capital flows, generated by international rebalancing of portfolios

Without a deeper knowledge of the behaviour of globally acting investors no substantial progress in understanding❙changing market dynamics ❙response patterns of financial markets, ❙contagion and spillover effects

is possible• Moreover, better data on portfolio strategies are key to enhancing progress

in early warning systems in monitoring implications of financial globalisation in financial soundness

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Better understanding of key drivers of financial globalisation is of key importance – for early warning systems and monitoring

Globally operating banks

Management of internationally allocated credit portfolios and liquidity management

Financial stability properties of different banking structures

“Portfolio” of mainly globally acting and financial market oriented big banks

“Mixed portfolio” of large globally acting banks, savings banks and cooperative banks

Empirical study on Bank ownership and financial stability in GermanyThorsten Beck, Heiko Hesse, Thomas Kick and Nataly von Westerhagen, Bank ownership and stability:

Evidence from Germany, March 2009

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Shift of risks to sectors where data coverage is weak or information non-existent

Central banks

Banking sector

Non-bank financial inst.

Firms Households

Central banks

Banking sector

Non-bank financial inst.

Firms

Households

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• Financial risks have been shifted to households and firms where data availability is weak or data non-existent, such as emerging market economies

• Financial activities expanded in fields where information and data are weak or non existent (IMF)

Off-balance sheet entities: shift of risks to off-balance sheet positions; lower risk weight; undervaluation of risks

New financial instruments; structured products Derivatives markets Non-bank financial institutions

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II. Financial Soundness Indicators

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Reprioritisation of financial soundness indicators

Rationale must answer the following important questions:

i. What are the main objectives of FSIs? – Different concepts (FSI; MPI; GFSR)

ii. Did FSIs fail to indicate the financial crisis and why?

iii. What necessary information is not captured by traditional FSIs?

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FSIs - Different objectives

Necessity and direction of reprioritisation depends on the main objectives of the FSIs

• Financial stability of banks and (national) banking systems

• Enhancing international comparability of financial data

• Part of early warning systems with regard to risk exposures and financial tensions

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FSIs – Limitations

• Backward looking indicators

• Are on average not “sensitive” enough to major shifts in market developments

• Financial innovations and globalisation of finance influence banks’ risk exposure … higher sensitivity to shifts in market developments which are insufficiently captured by FSIs

• Comparatively low frequency of data

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• Set of core indicators with only one indicator which reflects market risks: exposure to currency risks

• Recent empirical studies show that FSIs significantly fluctuate with the business cycle

Impairs international comparability Influence of boom and bust cycles?

• Changing financial environment – changing interdependencies of credit and market risks which are not captured by FSIs?

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• In particular CAR failed to distinguish between US banks that needed government intervention and banks not needing intervention, leverage ratios more informative (GFSR)

Reprioritisation: In a broader context, not a first priority for closing data gaps• First question: appropriate criteria or methods to single out relevant FSIs• Open for discussion

Leverage ratios Off-balance sheet positions Better regional data coverage Better coverage of global risks to balance sheet positions Liquidity positions

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FSIs as part of early warning systems

Two elements:

Early warning of financial tension (intermediaries) Early warning system with regard to contagion and spillover (financial system)

• In both cases, FSIs have little power to predict systemic risks

• FSIs fruitful in countries with less developed markets

• FSIs fail to reflect the complexity of modern financial systems and could lead to erranous conclusions without extensive background analyses (Deutsche Bundesbank, Financial Stability Review, Financial Soundness Indicators: a contribution to improving the worldwide availability of data for financial stability analysis. November 2006, p 103 - 122

• “Comparative advantages” of market indicator-based approaches for detecting systemic risks?

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Measurement of financial stability

• Macro stress tests failed to anticipate the financial turmoil as a potential relevant outcome. “The tests indicated that the capital buffers in the system were perfectly adequate, and yet they came under considerable strain once the turmoil erupted.” Borio and Drehmann, Towards an operational framework for financial stability: “fuzzy” measurement and its consequences. BIS Working Papers, No. 284, June 2009

• “The very fact that unusually large shocks are needed to produce any action suggests that the current generation of macro stress tests is missing essential elements of financial instability.” (Borio and Drehmann, 2009, p. 22)

• Should more emphasis be put on early warning systems and systemic risk approaches?

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Systemic risks

• Effective measurement of systemic risks of key importance in a more globally interconnected world

• Approaches for evaluating risks of individual financial institutions

• Contagion and spillover, regime shifts from high volatility to systemic risk

• Approaches to measure financial soundness based on market information

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Systemic risks

• Two key questions: Simultaneous defaults of large systemically relevant financial institutions Measurement of the vulnerability of financial systems

• Market-based indicators: forward-looking, daily availability CDS and equity prices Probability of default of individual banks and asset-return correlation For example: new indicator: price of insurance against large losses in the banking

sector in the coming 12 months (Xin Huang et. al.; A framework for assessing the systemic risk of major financial institutions, BIS Working Papers, No. 281, April 2009)

Credit risk and tail risk models: option implied probability of default (iPoD); forward-looking, provide early warning systems of distress. “When complemented with other market and non-market information, option-iPoD and option-leverage might become a useful tool for the daily surveillance of financial and non-FIs.” GFSR, April 2009

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Reliability of market indicators

• But, here is a big “if”:

• “If, as some analytical approaches suggest, excessive risk-taking is the source of financial instability, then estimates of risk derived from market prices would tend to be unusually low as vulnerabilities build up and would tend to behave more like contemporaneous indicators of financial distress.” Borio and Drehmann, 2009, p. 14

• Even more important, measures of systemic risks and early warning systems have to generate outcomes ─

which give reliable guidance? For globally coordinated measures – will there be agreement on one model of early warning systems?

Are these approaches sufficiently forward-looking to enable policy action? How do we assure that identified risks are translated into action?