14 June 2012

ECB/Constâncio: Financial stability – measurement and policy

From a broader financial stability perspective, it is not sufficient to be able to monitor systemic risks and their potential spillover effects within the financial system were they to occur. Financial stability analysis, and macro-prudential policy actions, is as much about assessing the implications of ruptures in the financial system on the wider economy. From this viewpoint, the development of macro-financial models linking financial instability and the performance of the economy is of the essence.

I would like to highlight concerns the interactions between macro-prudential policies, including financial regulation, and other policies such as monetary policy, as well as the impact these policies might have on the financial system and the real economy. Monetary policy impacts in a fundamental way financial stability: it affects asset prices, influences liquidity conditions, and has a bearing on risk-taking since low, short-term interest rates lead directly to expectation of profitable exploitation of a steeper yield curve, and consequently tend to increase leverage with more risk. What is significant in this “risk-taking channel” is that the short-term interest rate has a direct effect on monetary and financial conditions, not waiting for the indirect effect on medium-term rates.

The major challenges facing stress-testers today range from dealing with the inevitable subjectivity related to scenario building, to how to model and integrate in a consistent way within the framework elements, such as endogenous bank responses, interbank spillover and macro-economic feedback effects. Many of the available models also have difficulties capturing well the often non-linear tail risk effects that the scenarios are typically meant to reflect. Finally, stress test results are only as good as the data available, which in particular for central banks and other macro-prudential authorities without supervisory access is a key deficiency.

Finally, let me add that even though our top-down stress-testing framework is far from perfect and suffers from many deficiencies, it has proved a useful tool to challenge the more granular bottom-up approaches, such as the EBA EU-wide stress tests, and especially to detect outlier responses by individual banks in the latter case.

The last broad element of ECB financial stability analysis is the rapidly burgeoning literature on contagion. I reviewed some ECB work in this area in a speech last October. In that speech, I mentioned several analytical perspectives we use to examine contagion in all its forms relevant for the ongoing sovereign crisis in the euro area – highlighting models capturing the interaction between sovereigns, as well as that between sovereigns and banks. Such models make use of multiple techniques to uncover contagion – namely, multivariate frequency decompositions, regime-switching approaches and exploiting generalised measures of risk aversion in entity-specific frameworks. Clearly, the issue of contagion is not distinct from that of network analysis. While work in this area is broad, I can point to some recent ECB work featured in our latest Financial Stability Review – in which tools and results are presented regarding applications of network analysis both for actual collateral holdings and simulated interbank networks. Ultimately, work in this field remains still relatively nascent and I am sure more highly relevant applications will follow with time.

Full speech

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