Financial stability risks and macroprudential policy in the euro area
Speech by Vítor Constâncio, Vice-President of the ECB, at the ECB and Its Watchers XIX Conference, Frankfurt am Main, 14 March 2018
Ladies and Gentlemen,
I am grateful for the opportunity to address you at the nineteenth edition of the ECB’s Watchers conference, which has become a reference point over these first two decades of the ECB.
As interest rates across the globe have remained at very low levels for an extended period of time, supported by very accommodative monetary policies, possible related financial stability concerns came increasingly to the fore. In particular, the question of whether monetary policy should “lean against the wind”, countering a build-up of possible imbalances, has been debated once again, harking back to similar discussions held in academic and policy fora in various waves over the past decades. However, contrary to some critical comments on our monetary policy, financial stability in the euro area has been preserved all along.
In my remarks today I will briefly recall the academic debate and revisit the arguments that led to the understanding that macroprudential policies are best placed to address financial imbalances. I will then illustrate how the use of macroprudential policies can be welfare-improving, in particular in a monetary union where the single monetary policy is not well-suited to deal with financial imbalances that typically arise at national level. I will conclude with a review of the current situation in various asset markets, which, apart from some pockets of vulnerability, do not signal any credit-fuelled bubbles that would justify wide-spread policy action at the moment.
Monetary policy, “leaning against the wind” and macroprudential policies
The debate on “leaning against the wind” – using monetary policy to curb financial imbalances and overvaluations in asset prices – intensified in the late nineties. The practice implies increasing policy rates pre-emptively, above what would be adequate, for attaining the goal of price stability. The BIS composite asset price index, relating asset prices with the evolution of credit, as in Borio, Kennedy, and Prowse (1994) raised the possibility of using monetary policy interest rates to contain credit increase and avoid overstretched asset valuations. However, later in the decade, Bernanke and Gertler (1999) argued forcefully that monetary policy should only respond to fluctuations in asset prices, to the extent that they affect forecasts of inflation or the output gap.
The authors highlighted that, in normal times, convergence of price and financial stability objectives usually holds, relating financial stability to the absence of excessive movements in asset prices. In their view, when targeted inflation is assured or below target, monetary policy should not become over-restrictive just to pre-empt possible asset bubbles due to two main arguments. First, the early identification and precise measurement of price bubbles in real time was difficult, if not outright impossible; second, even if such price misalignments were observed, it was argued, monetary policy would not be able to deal with them adequately. This was because the interest rate adjustments necessary to contain asset price bubbles could not be easily calibrated based on theory. Furthermore, the increase of rates needed to curb an asset price bubble could be significant with substantially negative impact on growth and inflation, thus compromising the mandatory goal of monetary policy and affecting its credibility.
Contrasting this view, Cecchetti et al. (2000 and 2001) and Borio et al. (2002 and 2003) called for a more active role of monetary policy in addressing financial stability risks. They argued that if expected inflation were to remain unaffected by an asset price bubble, which would be the case if the bubble was not too long lasting, then reacting only to expected inflation would not prevent bubble-induced macroeconomic volatility.
In this first stage of the debate, the arguments hovered around a view of financial stability associated with asset price behaviour and concentrated on whether monetary policy rates, viewed as the only monetary policy instrument, should be used to serve the two objectives.
The financial crisis changed the terms of the debate. The notion of systemic risk, referring to impairments in the financial system with material consequences for the real economy, substituted the narrow concern of overvaluations in asset prices, while naturally also including them.
The second change relates to the emergence of a new policy area – macroprudential policy – with its dedicated set of policy instruments that have been intensely researched. In all major jurisdictions at least some instruments have been granted, in different degrees, to central banks and constitute a clear alternative or complement to monetary policy. This development has allowed monetary policy freedom to pursue its own purposes.
At the same time, the 2008 crisis confirmed that private credit booms are responsible for most of the financial crisis as shown by Schularick and Taylor in a series of papers. Several research papers, have however, shown that increases in interest rates may even increase rather than decrease credit and the debt-to-GDP ratio. In fact, higher interest rates also increase the debt service burden and lower the income of the borrowers, who then borrow more to smooth consumption as shown by Alpanda el al. (2014), Gelain et al. (2015) and Korinek and Simsek (2016). This reinforces the preference for the use of macroprudential policy to deal with financial stability concerns.
Accordingly, the main view became that two separate policy functions should be the norm, keeping the pre-crisis, price stability-oriented, monetary policy frameworks largely unaffected. Nevertheless, some alternative views go to the extreme point of advocating the full merger of monetary policy and macroprudential policy.
My own view is that the two policies are different and should remain separate, as convincingly argued in Svensson (2015), implying that monetary policy should not respond to financial stability concerns. The new main justifying argument for this stance is that macroprudential policy is now available and is the most effective tool for safeguarding financial stability. This is because policy instruments directly address excessive leverage behaviour and do not have the same cost or negative spillovers of a “leaning against the wind” policy.
Costs and benefits of “leaning against the wind”
Contributing to this debate, I want to investigate three points. First, what are the costs and benefits of “leaning against the wind” by monetary policy in the euro area; second, how does it compare with macroprudential policy and third, how do macroprudential policy and the financial cycle interact with regards to the cost and benefits of “leaning against the wind”?
The analysis is based on a simple theoretical framework brought forward by Svensson (2016, 2017). The model includes a flexible inflation-targeting central bank. The cost of “leaning against the wind” is measured by the increase in unemployment following a monetary policy pre-emptive tightening, and benefits are related to a lower probability and severity of financial crises. The empirical results are based on a monetary policy shock in a calibrated DSGE model for Sweden and several empirical studies that help to calibrate some of the effects considered.
Svensson argues, that “leaning against the wind” not only has a cost in terms of a weaker economy if no crisis occurs but, in addition, the costs of a potential crisis would be even more substantial if such a policy was used, by means of a second round of unemployment cost. Contrary to all previous studies, it takes into account that the severity of a crisis depends on the situation prevailing before the crisis eclodes. In turn, this is dependent on the effects of the pre-emptive increase in interest rates, above what was necessary to control inflation.
The empirical analysis of Svensson concludes that the marginal costs of using monetary policy to “lean against the wind” by far exceed the benefits. In other words, the cost of higher unemployment as a result of the monetary policy tightening far outweighs the benefits of the reduced probability and severity of financial crises.
Svensson’s conclusions have been criticised by Adrian and Liang (2016) and by several BIS researchers for not properly accounting for systemic risks and the persistence of the financial cycle, which risks ignoring the long-lasting effects on the real economy that financial crises may have. Accounting for these elements, it is argued, would create a case for a more active use of monetary policy to lean against the financial cycle.
Svensson (2016b and 2017c) has responded forcefully to these criticisms and to shed further light on this debate, two of our researchers have recalibrated Svensson’s model for the euro area using a DSGE model. Figure 1 shows that the direct recalibration comes to the same conclusion for the euro area as Svensson’s result does for Sweden; namely, that a monetary policy that tries to “lean against the wind” is associated with substantial net marginal costs (though slightly lower than the original Svensson result as shown in the second bar from the left).
The result also holds when the key financial variable in Svensson’s model (debt-to-income ratio) is replaced by a more broad-based and persistent financial cycle variable along the lines argued by some of Svensson’s critics. In order to establish the link between the financial cycle and the probability of the start of a crisis, a composite indicator for cyclical systemic risk is included and its value overtime is an outcome of the DSGE model used.
Considering now macroprudential policies, for illustrative purposes, we introduced a macroprudential policy measure of a 1 pp. increase of the capital buffer requirements. When modifying the model in this way, we observe (Figure 1, third and fourth bars from the left) that this measure is more effective in reducing the probability and severity of financial crises (marginal benefits) and that the negative impact on unemployment (marginal cost) is somewhat lower, than a monetary policy that tries to “lean against the wind”. Overall, the marginal benefits of macroprudential policy outweigh the marginal costs; especially also in the case where the financial cycle (fourth bar) is taken into account.
In the euro area context, the relative effectiveness of macroprudential policy to tackle the build-up of financial stability risks is even more pronounced owing to the fact that, in a monetary union, a single monetary policy is not well-suited to deal with financial imbalances emerging at national level. Such imbalances are indeed better tackled with targeted national macroprudential measures.
To illustrate this point, we consider a situation of a country-specific gradual rise of 10% in house prices over a two-year horizon, fuelled by strong demand and loose credit conditions. For simulation purposes, we used a two-country DSGE model calibrated to euro area countries with a single monetary policy and the possibility to conduct country-specific macroprudential policies.
The baseline simulation assumes that monetary and macroprudential policies are unchanged for two years. Against this background, two policy responses to mitigate the housing market imbalances are contrasted.
In the first scenario, we assume that a cap on loan-to-value ratios (i.e. a macroprudential measure) is introduced in the booming region, while monetary policy is kept constant. In the second scenario, the monetary policy rate is raised in the spirit of “leaning against the wind”.
The respective simulations are presented in Figure 2. It turns out that the macroprudential measure is able to contain the asset price increase in the booming region (“home country”) and to better shield the rest of the euro area (“foreign country”). By comparison, a tightening of monetary policy delivers significantly more cross-country heterogeneity and negative cross-border spillovers.
To sum up, there are synergies and trade-offs between monetary and macroprudential policy. These interactions may become even more pronounced in a monetary union where monetary policy, by definition, will be focusing on area-wide economic and financial conditions. In such circumstances, macroprudential policy targeting imbalances building up at the national level within the monetary union can help to achieve better policy outcomes in terms of price and financial stability.
Safeguarding financial stability in the euro area
Let me now turn to our actual experience. Our price stability mandate continues to require maintaining a very accommodative monetary policy stance which has been decisive for the economic recovery and gradual normalisation of inflation. Naturally, the resulting low interest environment in the euro area, similarly to all major jurisdictions, continues to generate a search for yield by market participants.
Nevertheless, contrary to some alarmist views, euro area asset prices currently do not point to signs of a general overvaluation in the euro area and certainly not of credit-fuelled bubbles. There are, of course, specific market segments that require close monitoring and there is margin for contagion if a significant financial price correction occurs worldwide. Let me go through the major asset classes in turn.
Euro area stock prices have been on an overall upward path but generally do not appear to be exceptionally elevated by historical standards. In particular, the cyclically adjusted price/earnings ratio remains moderate, in contrast to developments in the U.S. (see Figure 3, chart on the left).
However, developments in the U.S. are not irrelevant for the euro area: as seen in February, a sudden correction could, to some extent, spill over to euro area markets. More broadly, the sharp movements that took place in the U.S. equity market in February 2018 demonstrated how sentiment can change very quickly – and market participants should be well aware of this risk. In an environment characterised by search for yield and depressed volatility, technical factors can greatly amplify initial market movements. This reflects the fact the volatility itself has become an asset class on which investors take positions. However, following the peak reached during the correction at the beginning of February 2018, markets now expect a somewhat higher volatility in stock prices, up from the record-low levels seen during the past year (see Figure 3, chart on the right).
Turning to fixed income markets, euro area sovereign bond yields are hovering at very low levels and have stayed well-anchored throughout the recent repricing episode. Spreads across euro area sovereigns have remained narrow (see Figure 4), reflecting the significant fiscal consolidation and structural reform efforts made in the aftermath of the sovereign crisis and the significantly improved macroeconomic outlook.
While the ECB’s expansionary monetary policy has also undoubtedly supported bond prices, judging from forward rates, market participants expect a smooth adjustment in global monetary policy rates without much turbulence (see Figure 5, chart on the left). Nevertheless, term premia remain low and in fact still negative in the U.S. A possible normalisation of term premia towards historical averages would point to some scope for adjustment in bond yields (see Figure 5, chart on the right).
Corporate credit spreads have also remained at low levels in the euro area and yield compression has been particularly impressive for the riskiest, high-yield segments (see Figure 6, chart on the left). This has resulted in lower investor compensation than has historically been the case for the level of default risk embedded in the bonds, in other words, negative excess bond premia (see Figure 6, chart on the right).
This very sanguine pricing of corporate bonds is based on expectations of continued comfortable debt servicing burdens and vigorous earnings growth, what is sometimes called “pricing for perfection”. But this delicate investor sentiment can be quickly swayed. Furthermore, we have recently observed that in some high-yield markets, such as leveraged loans, the spread compression has sometimes been accompanied by higher borrower leverage and contracts with lower investor protection. Should this become more wide-spread, it could fuel vulnerabilities to financial stability. These developments, therefore, warrant close monitoring.
Finally, turning to real estate markets, our analysis suggests that, at the aggregate level, residential property prices may – at most – be somewhat more elevated than what would be justified by fundamentals (see Figure 7, chart on the left). Going into detail, we do see signs of overvaluation in certain areas and large cities, where housing prices have increased at a faster pace than household incomes.
The hunt for yield has also contributed to continued increases in the prices of prime commercial properties, which have already reached historical highs in many euro area countries. Indeed, there are indications that values may be stretched in this segment and investors need to be aware of the associated risks. Although potentially of concern for individual investors, we should place this market into perspective. Whereas residential mortgages constitute around 16% of the assets of euro area banks on average, the corresponding figure for commercial property loans is 7%. Moreover, prime commercial property constitutes only a sub-segment of this market and, consequently, is relatively small in size. Therefore, we currently do not see systemic consequences arising from the situation.
To sum up, apart from the few pockets of vulnerability I mentioned, the overall financial stability picture in the euro area reveals no signs of generalised asset market bubbles. Moreover, the crucial factor of private sector leverage fuelled by bank credit, does not seem to have markedly contributed to vulnerabilities, as asset price increases have not been accompanied by excessive credit growth overall(see Figure 7, chart on the right).
The cross-country and cross-sector heterogeneity of localised vulnerabilities underlines the advantage of macroprudential policy in containing financial stability risks, namely, the possibility to activate policy instruments in a targeted manner.
National authorities in overall nine countries have decided the introduce Loan-To-Value (LTV) and Debt-To-Income (DTI) type of measures (see Figure 8). These measures influence the provision of credit and raise resilience by curtailing the tails in the risk exposure. Given their effectiveness, the ECB Governing Council called upon governments in all euro area countries to implement the legislative basis for borrower-based measures.
In addition to the borrower-based measures, some authorities have raised risk weights for exposures to the real estate sector to increase bank resilience. To further enhance resilience and to address potential cyclical systemic risks, Slovakia has activated the countercyclical buffer and Lithuania has announced the intention to do the same. Finally, as regards capital buffers to counter the “too-big-to-fail” problem, the decisions relate to eight globally important banks (in France, Germany, Italy, the Netherlands and Spain) and more than one hundred domestic systemically important financial institutions in all euro area countries (see Figure 9).
The capital- and borrower-based macroprudential instruments I just mentioned are targeting risks among the banking sector and the real economy. But given that the growing fraction of credit intermediation is conducted by non-bank financial institutions, they do not necessarily reach beyond the banking sector. Europe should thus expand the toolkit to cover maturity mismatch and leverage also in the non-banking sector. The ongoing review of the macroprudential framework in the EU provides an excellent opportunity to make these necessary tools available to macroprudential authorities on a common legal basis.
The secure financial stability environment has been fostered by a host of macroproprudential measures adopted by member states and not objected by the ECB that, as you know, has the competence to top up national measures and analyse their spillovers to neighbouring countries.
Let me conclude. The institutional setup in the euro area, with distinct roles assigned to monetary policy for the maintenance of price stability and to macroprudential policy for safeguarding financial stability, is well placed to achieve both of these objectives. In my remarks, I have shown that this is supported by the academic consensus and empirical evidence. In a monetary union with a single monetary policy, this set-up allows deploying targeted macroprudential policies wherever imbalances may be emerging.
In general, in view of the present international situation that may trigger financial market turbulence with contagion for the euro area, there is no margin for complacency and inaction. In this perspective, the European legal macroprudential policy framework needs to be enhanced by introducing new instruments, including for non-banks, and by allowing Member States and the ECB more flexibility to activate those instruments. Apparently the forthcoming review of the CRD IV/CRR will not deliver the comprehensive reform of the macroprudential framework which would be important in order to continue safeguarding financial stability in the euro area.
Thank you for your attention.
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 See Bernanke and Gertler (1999, 2001) and later, articulating the same arguments, Kohn (2006, 2008).
 See Cecchetti et al. (2000), Cecchetti, Goldberg and Wadhwani (2002), Borio and Lowe (2002) and Borio et al. (2003).
 Systemic risk can be defined as “the risk that the provision of necessary financial products and services by the financial system will be impaired to a point where economic growth and welfare may be materially affected.” It can arise from “(i) an endogenous build-up of financial imbalances, possibly associated with a booming financial cycle; (ii) a large aggregate shock hitting the economy or the financial system; or (iii) from contagion effects across markets, intermediaries or infrastructures”. For definitions see the ECB’s financial stability website.
 See Jordà, Schularick and Taylor (2013, 2015a, 2015b, 2016). See also Brunnermeier and Schnabel (2016).
 See Bean et al. (2010) and Svensson (2012).
 See Brunnermeier and Sannikov (2013).
 See Svensson (2015).
 See BIS (2016), Filardo and Rungcharoenkitkul (2016), Adrian and Liang (2016) and Gourio et al. (2017).
 See Kockerols and Kok (2018). To calibrate the Svensson model for the euro area, the DSGE model of Darracq Pariès, Kok and Rodriguez Palenzuela (2011) was used.
 The systemic risk indicator is based on the following four variables: 2-year change in bank credit-to-GDP ratio, 2-year growth rate of real total credit, 3-year change in residential real estate price-to-income ratio, and the 2-year change in the debt-service ratio. A logit model is estimated to establish the link between the lagged cyclical systemic risk indicator and the probability of a crisis start (using the financial crisis database presented in Lo Duca et al., 2017).
 See Darracq Pariès et al. (2018); see also the special feature entitled “Quantifying the policy mix in a monetary union with national macroprudential policies”, ECB Financial Stability Review, November 2015.