30 April 2013

Dirk Schoenmaker: An integrated financial framework for the Banking Union - Don't forget macro-prudential supervision

This essay reviews the sequencing of the functions of supervision, resolution, deposit insurance and the fiscal backstop in the Banking Union, and puts forward a concrete proposal for conducting macro-prudential policy in the prospective Banking Union.

This paper was prepared as part of the DG ECFIN research project on the Future of EMU.

This essay reviews the sequencing of the functions of supervision, resolution, deposit insurance and the fiscal backstop in the Banking Union. All these functions deal with the soundness of individual banks. In the run-up to the 2007-2009 financial crisis, the bigger picture of the stability of the wider financial system was overlooked. This essay puts forward a concrete proposal for conducting macro-prudential policy in the prospective Banking Union.

The authors suggest giving the lead on applying macro-prudential tools in the Banking Union to the ECB to foster a coherent approach, with important input from the national competent authorities to allow for much needed differentiation at the national level. Next, they argue that the ECB should separate the macro-prudential and micro-prudential functions. Otherwise, we may again be bogged down by the details of individual banks (micro), while losing sight of emerging imbalances in the wider financial system (macro).

Concluding remarks

At the national level, there is a risk of group think which may lead to an inaction bias on the macro-prudential front. A good example of group think is Ireland, where the build-up of the real estate bubble was not recognised as such by the relevant policy-makers. Another example is the Netherlands, where the warnings of the IMF about the impact of the tax relief of mortgage interest rate payments on retail housing prices were ignored. National authorities may be more subject to the “This time is different” syndrome, described by Reinhart and Rogoff (2009), while supranational authorities are by their nature more detached from the local situation and have often experience with similar situations in other countries.

Macro-prudential should thus be a euro-area-wide, or even broader Banking-Union-wide, responsibility. The ECB (and participating NCBs) would get a financial stability mandate in addition to its existing monetary policy mandate. That would be consistent with the authors' support for central banks combining monetary policy and financial stability. While the ECB may design a common set of macro-prudential tools (such as countercyclical buffers, LTV and LTI ratios, funding ratios, and margin requirements), these tools need to be differentiated at the national level, as the national financial systems differ (e.g. the institutional design of the housing market varies across the euro area). So, local input via the national competent authorities (NCAs) is crucial for an effective conduct of macro-prudential policy. Nevertheless, the pro-active use of the macro-prudential tools should be monitored and controlled at the ECB.

A final word on the interaction between macro-prudential and micro-prudential policies. There is a tendency to mix these policies, as they are all ‘prudential’. But there is a clear difference between the macro- and micro-prudential perspectives. If there is a conflict between these objectives, the authors suggest that the macro-prudential concerns should override the micro-prudential concerns. The stability of the financial system is more important than the stability of individual institutions.

Full article

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