Macro-prudential policy: Where do we come from and what’s next

Keynote speech by Stefan Ingves, ESRB 1st Vice-chair and Governor of Sveriges Riksbank, prepared for the 6th ESRB Annual Conference

Frankfurt am Main, 22 December 2022

Thank you very much for inviting me to the sixth ESRB Annual Conference, which in a sense closes a circle for me. I had the honour to speak at the very first Annual conference of the European Systemic Risk Board (ESRB). At that time as Chair of its Advisory Technical Committee, a position I held for six years, starting when the ESRB was launched in 2011. When it was more or less a blank page. I have been “wearing many different hats” in my international work over the years, besides being the Governor of Sveriges Riksbank. One as the Chairman of the Basel Committee on Banking Supervision (BCBS) and another when working for the International Monetary Fund (IMF) for a number of years. Within the ESRB community I have been a member of its decision making body, the General Board, and its so called Steering Committee. And for just short of three years, I have been the First Vice-Chair of the ESRB. This address will be coloured by all those experiences. What I learned along the way and the new perspective that more or less every new challenge added. It will also be the last time that I represent this organisation that I have had the great privilege to be deeply involved with during its almost twelve years of existence. I will step down as ESRB first Vice-Chair at the end of this year when I also end my tenure as Governor of Sveriges Riksbank. This is why it feels like I am closing a circle today.

When wrapping up after over a decade with the ESRB and macro-prudential policy in the European Union (EU), it is natural to think both about where we come from and what’s next. On how we can use what we learned along the road to navigate the challenges ahead and safeguard the stability of the EU financial system. I will give you my two cents on this, in particular on the institutional aspects and on why we need a strong ESRB, along with independent national macro-prudential authorities to succeed.

So where do we come from?

Looking back makes you realise just how far you have come. That certainly applies to macro-prudential policy in general, and the ESRB in particular. And while the rear-view mirror should not be our only compass, it can be very helpful in guiding you in the right direction and in navigating the challenges ahead. There are lessons to be learned from how both the ESRB and the EU macro-prudential framework overall emerged, developed and functioned over these years.

If we go back to the time before the Global Financial Crisis, macro-prudential analysis and policy were if not largely unheard of so at least not widely practiced. Supervisory quality varied across countries and coordination between countries was insufficient, at least in Europe. Few supervisors, or anyone else for that matter, could see the woods for all the trees. Nor did they see that the woods were connected across borders. The focus on individual institutions rather than the financial system as a whole became part of the perfect storm that lead to the Global Financial Crisis in 2008.

The macro-prudential framework was a game changer, but is still a work in progress

A main lesson from that crisis was that a system-wide, or macro-prudential, approach is needed to safeguard the stability of the diverse and interconnected EU financial system. In 2009 a report by a High Level Group chaired by Jacques de Larosière provided an outline for the European response to the crisis. And part of that was a blueprint of what would later become the ESRB. An EU level body that in a holistic way would bring together a representation and expertise just as broad as its system wide mandate. It would complement the three European Supervisory Authorities, responsible for oversight of banks (EBA); insurance and occupational pensions (EIOPA), and; securities and markets (ESMA). The ESRB was formally established in January 2011, with its intended broad mandate and composition. Its members include central bankers and financial supervisors providing both national and EU-wide perspectives as well as sectoral expertise; the European Commission and highly merited academics providing the academic perspective through the ESRB’s Advisory Scientific Committee.

For all the pain it caused, the crisis that started in 2008 also brought about a world-wide resolve for change. The developments in the EU reflected what was happening in the US and globally. On the US side, fifteen of the world’s leading economists produced the so-called Squam Lake Report, urging reformers to think about the financial system as a whole. In parallel, the G20 supported the foundations for a common macro-prudential framework at global level, building not least on work by the FSB and the Basel Committee. In September 2010 the Basel Committee's governing body announced higher global minimum capital standards for international banks. Later that same year it agreed to the design of a capital and liquidity reform package that we now call Basel III.

All in all, the macro-prudential framework that emerged contributed to that the financial system overall was in a much better shape to cope even with a massive idiosyncratic shock like the Covid-19 pandemic. Admittedly, the crisis in 2020 was not generated by the financial system itself. And broad support measures on an unprecedented scale helped us handle its effects. But we shall not underestimate the importance of that banks entered that crisis with more and better quality capital and the regulatory frameworks that provided the basis for that. We also have far better data, and monitoring capacity than in 2008. And we have a much better capacity to identify and analyse risks to the financial system as a whole, and in most areas relevant authorities also have tools to address them.

But while the macro-prudential framework in its current shape and form has been a game changer, plenty of work remains to be done. Not least in extending the framework to non-banks, bridging data gaps and tackling new types of vulnerabilities. I will get back to that. But it is not only the building blocks related to information, analytical capacity, and the risks and vulnerabilities as such that matter for how well we will manage the challenges ahead. Much also comes down to the institutional set-ups, mandates and other factors that affect the decision making power of macro-prudential authorises.

So how do we tackle “what’s next”?

With the right set-up, different perspectives and expertise are a main strength

At that first ESRB Annual conference, I argued that “it takes all sorts …”, or at least plenty of different sorts, to make a functional macro-prudential body. In particular one at an international level like the ESRB. I also argued that, with the right set-up, differences in perspectives and expertise enrich our assessments and become a strength. At the beginning there were certainly some doubts about the ESRB’s slightly complex set-up. Could such a large and diverse crowd around the meeting table function well in practice and get things done? The ESRB’s track record since its launch in 2011 proves that it does. The ESRB was instrumental in operationalising macro-prudential policy in the EU and has contributed to safeguarding financial stability in the Union. There is a rich supply of reports, consultation responses, occasional papers and other outputs covering issues spanning the whole range of the ESRB’s mandate. There is also, by now, a long list of so called ESRB warnings and recommendations - identifying and warning against a broad spectrum of risks to the financial system, and, when called for, recommending measures to mitigate those risks on an “act or explain” basis.

It is important to note that several of the warnings and recommendations have been addressed to individual countries. The country based analysis and peer pressure are major strengths, and in my view a necessity, for fulfilling the mandate as the EU’s macro-prudential watchdog.

A main factor behind the ESRB’s good track record with policy decisions and publications and that it tends “to get things done” lies in its set-up. Its decision making body, the General Board, can vote and take majority decisions. This allows the diversity around the ESRB’s meeting table to become a strength and not an impediment. That the ESRB has managed to issue warnings and recommendations targeting individual countries is a good example of that. I think the blueprint for the ESRB was a good one in this respect and hopefully it will inspire the design of the structure of other international bodies. But decision making power and the ability to act in a timely manner are just as important at the national level as for international bodies.

Macro-prudential authorities need the capacity to act timely and effectively

So what do we need for a national macro-prudential framework to be successful? I think we can agree on some of the general features. First, the macro-prudential authority needs a clear political mandate to act, and a well-defined and sufficiently large toolbox that can be updated. Second, the mandate should have well-defined objectives, partly to ensure that macro-prudential policy is not used for purposes that it is not suited for. Third, macro-prudential oversight should also be transparent and accountable, not least to prevent inaction bias and to allow public scrutiny. Fourth, and perhaps stating the obvious, a macro-prudential authority needs the full capacity to identify and assess systemic risks and how to best mitigate them. This includes data, as well as analytical and methodological capabilities. It also needs to account for cross-border aspects in different shapes and forms.

A final feature that is essential is independence. But this is also a balancing act, as we need both independence as well as some degree of coordination with other policies. I would like to elaborate a bit on this, together with the first point about mandates. Optimally, the macro-prudential authority has a mandate and sufficient independence to allow it to act as it deems best to safeguard financial stability, doing so in a timely manner. In other words, the macro-prudential set-up must ensure that the authority is able to withstand pressure from, for instance, the financial industry and politicians. Groups that may try to push the authority to pursue their own agendas and short term goals, at the expense of the longer term financial stability objective. In this area we also have a communication issue that may enhance the pressure on the authority when trying to explain, and to gain acceptance for macro-prudential policy. It is much easier to estimate and explain the short term costs of a policy action, or lack thereof, than the benefits of avoiding a financial crisis much further down the road, or of having capital buffers to release in troubled times just to provide another example.

The ESRB recommendation[1] in 2011, on the macro-prudential mandate of national authorities, mentions independence and among other things notes that “pressures can be put on macro-prudential policy makers not to tighten policies in a boom or to loosen them in a bust. In order to safeguard policy credibility, macro-prudential authorities should be shielded against outside pressures through independence”.

So do national macro-prudential authorities have enough freedom of manoeuvre?

As the ESRB member countries got their macro-prudential frameworks and mandates in place, they chose different solutions regarding how to place, or set up the decision making body. In some cases macro-prudential policy decisions are taken by a committee. In others it is the central bank, noting that financial supervision is part of the central bank’s mandate in many countries. Then there are examples where the macro-prudential mandate lies with the supervisory authority. My impression so far, is that it can be difficult to find a good balance between independence on the one hand, and cooperation with other policy areas, or rather, influence from the political system on the other. To which degree this has been a problem so far is bound to vary with the mandate and set-up chosen, but also with other factors including if there has actually been a need to act to mitigate emerging vulnerabilities. My concern is rather a forward looking one. We need institutional set-ups that are robust over time.

A common example of macro-prudential instruments that are often subject to political pressure and debate, is borrower based tools. Their aim is to ensure sound lending standards for new loans, contributing to higher resilience of both borrowers and lenders. These tools often limit the size of a loan or how much debt can be granted, in relation to factors such as the value of the real estate used as collateral or the borrower’s income. Another example are tools that impose requirements related to a loan’s amortisation scheme. Borrower-based tools tend to have distributional effects and may be politically sensitive, not least for that reason. These tools are also not harmonised under EU law and what tools are available depends on the national legal framework. Some tools may therefore be missing from the toolbox.

My own country is no exception when it comes to debating borrower-based measures. There has been pressure on the Swedish Financial Supervisory Authority, Finansinspektionen, which is the macro-prudential authority, to at least temporarily relax the amortisation requirement that is currently in place. The Government tasked Finansinspektionen with assessing whether this would be appropriate. However, Finansinspektionen found that relaxing the current measure would not be an efficient way to target those households that are under the most pressure in the current economic situation. Few of those own their own house or apartment and subsequently have no mortgage. Finansinspektionen also noted that relaxing the measure would work against monetary policy. I agree with that assessment, noting that a loosening that would contribute to higher inflation could lead to higher interest rates than would otherwise have been needed to maintain price stability. On a related topic, it is worth noting that the Government also has the right to veto any proposal to introduce new borrower-based measures in Sweden.

It is to an extent understandable that politicians may have a desire to exert some type of influence over macro-prudential tools that may have significant effects for instance on certain types of households, and have distributional effects. But that does not mean that they necessarily should. So how can we ensure that macro-prudential authorities are able to do their job efficiently?

Can we learn something from monetary policy in this respect?

For monetary policy, independence is often enshrined in law. In the EU this is captured in Article 130 of the Treaty[2]. Generally, the task of conducting monetary policy is delegated to the central bank by the Government or Parliament, but can be formulated in different ways. A common example is an inflation target, but it may also be an operational mandate, which was more common in the past. There may be a specification of the toolkit available to the central bank and the conditions for its use, along with various conditions regarding oversight and accountability. The idea is that monetary policy should not be affected by direct political influence. Many central banks seem to have landed in a reasonably well-functioning set-up, with a monetary policy independence paired with transparency, checks and balances to hold the decision makers accountable. But this was not achieved over-night. The balance between independence on the one hand, and oversight by public officials and the degree of political influence on the other, has been debated for many years. It will probably continue to be debated for many more to come.

Macro-prudential policy is much “younger” as a field. Perhaps it will take a few more years of learning by doing until we will find solutions similar to what has been achieved for monetary policy. But this is something we need to prioritise. We can probably learn from the monetary policy experience and I think that macro-prudential policy would benefit from the same type of independence that keeps monetary policy at arm’s length from the political system. This could be facilitated by putting the macro-prudential authority under the umbrella of the central bank, where anything that falls under the Article 130 of the Treaty is already shielded from undue influence. I will get back to this shortly.

Independence is essential, but so is cooperation across policy areas

But at the same time as macro-prudential authorities need to be able to withstand pressure from both politicians and the financial industry, some degree of coordination with other policies is desirable too. The example with Sweden and the amortisation requirement that I just mentioned illustrates that. The need to cooperate, share expertise and information that I spoke of earlier within the ESRB community, also applies to economic policy more broadly. In fact, it even includes other fields beyond economic policy, where drawing on medical expertise during the Covid-19 pandemic is a recent example. At least as far as cooperation and exchange of information goes. Whether you deal with monetary, fiscal or macro-prudential policy, you will at least need to take the full policy mix into account if you are to get the results that you are striving for in an efficient manner. The pandemic showcased this very clearly. While it in many ways put a spanner in the works of global interactions, it also demonstrated just how necessary cooperation across borders and fields of expertise really are. From a macro-prudential perspective I am thinking of the unprecedented and broad economic policy response where the design, coordination and eventual phasing out of fiscal and monetary policy support measures were, and to an extent still are, key for financial stability. The same holds true for the situation that we are currently in, with economic developments and geopolitical tensions providing different challenges for different policy areas.

There are strong complementarities and interactions between monetary policy and macro-prudential policy. For instance, a strong macro-prudential framework can create more room for manoeuvre for monetary policy, by tackling undesired side effects of monetary policy in a targeted way. One example is addressing vulnerabilities that spring from the dynamics between real estate prices and indebtedness in a low interest rate environment. However, as macro-prudential policy is not likely to be able to fully mitigate such developments, monetary policy needs to account for financial stability aspects as well. As I already alluded to, also fiscal and structural policies are very important from a financial stability perspective. This applies to issues such as sovereign debt, to tax policies that incentivise indebtedness or to dysfunctional housing markets just to name a few. Other examples are the support measures during the pandemic. As for the dynamics between micro- and macro-prudential policy, these areas are intimately linked and there is normally less potential for conflict, especially in normal or good times. But there are obvious overlaps and a need for cooperation.

A report by the ESRB’s Advisory Scientific Committee[3] argues that the macro-prudential authority should be allocated to the body where the overall balance of synergies between policy objectives over conflicts and the required expertise are the largest. While the authors recognise that macro-prudential and monetary policies have both synergies and conflicts, they find that allocating macro-prudential powers to a central bank is most likely to maximise synergies between policy objectives under most circumstances. Other studies come to similar conclusions, and like the ESRB in the recommendation on macro-prudential mandate of national authorities, find that the central bank should play an important role in macro-prudential policy.[4]

Overall, the cooperation and exchange of information between macro-prudential policy and other policy areas have only increased in importance. We must accommodate that need while at the same time safeguarding the independence and credibility of macro-prudential policy. At the national level, fora where all relevant authorities are represented can serve that purpose. At EU level, the ESRB has made efforts to enhance such exchanges and provides a suitable forum for such efforts as we move forward.

Cooperation must also extend across borders and fields of expertise

Cooperation and information sharing must also extend beyond borders. Financial stability is in many ways both a national and global affair, not least as financial instability in one jurisdiction is very likely to affect other jurisdictions. Nationally or globally, if we want to safeguard financial stability we need to think past our own national borders at the same time as we are trying to mitigate the risks “at home”. The ESRB in many ways contributes to accomplishing just that for the EU. But we also need to strengthen global cooperation, including regulatory cooperation. A keystone in building a more resilient global financial system that can effectively support the real economy through the business cycle and financial cycle is to in a full, timely and consistent manner implement the Basel III accord - the financial reforms that started to take form in the wake of the Global Financial Crisis just like the ESRB.

To safeguard the stability of the EU financial system we also need cooperation in a broad sense - across borders, sectors and areas of expertise. And we should not limit this to economic policies. For instance, it is clear that our economic forecasts have benefitted plenty from assessments by national health authorities or by branches of the military reporting on the war in Ukraine. As I mentioned in that speech at the first ESRB Annual Conference, it really does “take all sorts”. And we need to approach the future challenges for macro-prudential policy with part of that mind-set.

Some of the challenges we face are “new” to us in one way or the other. Some of them are driven partly by technological change. Our world, not least the financial system, is becoming more and more interconnected, with linkages between the growing non-bank financial sector and banks as well as non-financial corporates and sovereigns. The dash-for-cash episode in 2020 as well as more recent developments have showed weaknesses in the non-bank sector where the macro-prudential framework is still incomplete. Tackling vulnerabilities and increasing the resilience of non-bank financial institutions and market-based finance must be a priority as we move forward. Then there are issues such as the liquidity and funding strains for non-financial corporates participating in energy derivative markets, and their interaction with central clearing parties. These are issues that must be addressed, but in doing so we should make sure not to relax the prudential requirements for central clearing.

We are faced with broad, cross-cutting issues like climate change and transition risks, as well as cyber threats, not least in the wake of increased digitalisation. The whole approach to payments is changing, with a shift from the use of cash and factors such as the emergence of digital currencies and crypto assets. We have a growing FinTech sector that is reshaping some areas of financial services, providing opportunities for financial inclusion but also presenting risks to financial stability. All these issues in their own way require us to work together. We need highly specialised experts to work together with other highly skilled experts, along with those who can connect all the dots. A setting like the ESRB, with a broad and diverse membership already at the outset, is well suited for taking on such challenges.

The more near term challenges

We also have a combination of old and new types of risks and vulnerabilities to handle in the more near term. Looking at the past few months, the global economic outlook has deteriorated. Central banks are combating the highest levels of inflation in decades. One factor behind the sharp rise in the prices of several important commodities and inputs is the global supply and demand imbalances that evolved during the pandemic. The Russian invasion of Ukraine has pushed up prices even further. One example is the price of food, but it has also created serious disruptions to the European energy market. Electricity prices have been very volatile and have, during some periods, hit very high levels.

The combination of high inflation, rising interest rates and deteriorating growth prospects poses a number of challenges for the stability of the global financial system, not least in the EU. We have had many years with low inflation and very low interest rates, paired with increasing asset prices and rising indebtedness. And over time, vulnerabilities have been building up in different corners of the financial system. The situation underlines the importance of both vigilance and of good resilience, as tougher times may wait around the corner. Against this background it was natural for the ESRB General Board to decide to issue a warning on vulnerabilities in the financial system of the EU, which it did on 22 September this year.[5] The Board concluded that risks to financial stability in the EU and the probability of tail-risk scenarios materialising have increased. The latter basically means that very adverse scenarios that we do not think are the most likely to happen, have become a bit less unlikely. The risks that the ESRB highlights in its warning in very broad terms concern: (i) the deteriorating macroeconomic outlook, (ii) risks to financial stability stemming from a (possible) sharp asset price correction, and (iii) how such developments would affect asset quality.

The ESRB General Board was careful to point out that the resilience of the EU financial sector is already being supported by the actions of both micro-prudential and macro-prudential authorities. But the warning also calls for these authorities to preserve or enhance resilience. This is fundamental if we are to ensure that the financial sector will have the capacity to continue supporting the real economy, if and when financial stability risks actually materialise. The General Board also pointed out that it is necessary for private sector institutions, market participants and relevant authorities to continue preparing for scenarios in which tail risks materialise. In addition, the General Board called for close coordination between relevant authorities and for prudent risk management practices across all financial sectors and market participants. These are key factors if we are to address vulnerabilities effectively, and at the same time avoid market fragmentation and negative externalities for other EU Member States.

My two cents

Let me sum up very briefly. Looking back at the years with the ESRB, and with macro-prudential policy as a more widely understood and used concept, I am glad to see just how much has been achieved. The resilience of banks during the pandemic, although support measures naturally played a main role, is to some extent evidence that we did something right. We still have plenty of work to do, with expanding the macro-prudential framework to non-banks, bridging data gaps and developing methodologies and new macro-prudential tools. One area where there has been significant progress but where we must continue our efforts, is stress testing. Not only stress testing of banks but of all parts of the financial system, and addressing very broad issues such as climate-related risks or cyber threats. Some of the challenges ahead are very complex and require that we break new ground, like those I just mentioned. Some are “old” problems that just re-emerge in slightly different shapes and forms but may still need to be tackled in new and more efficient ways. Some keys to successfully navigating through all these challenges are cooperation, bringing different types of expertise together and ensuring that macro-prudential authorities have the full capacity and independence needed to act timely to safeguard financial stability. In essence, we need to see to that we have the right set-ups to be able to do our job.

That the ESRB has managed to get things done did not only come down to hard work but also to its mandate to take majority decisions through voting. This has been a major strength not least in managing to issue ESRB warnings and recommendations addressed to specific countries. As I mentioned, country-based analysis and peer pressure are in my view necessary for fulfilling the mandate as the EU’s macro-prudential watchdog. It is clear that the ESRB has made substantial progress in this area. But I hope that we will progress even further in the years to come. Since 1999, the IMF has been operating the Financial Sector Assessment Program (FSAP), which is a very comprehensive assessment of a country’s financial sector. While not going all the way to the equivalent of fully fledged FSAPs, I hope that the ESRB will take a few more steps in that direction. This is naturally also a question of resources.

A final observation is that the ESRB over the years has become an important sounding board for other institutions, such as the European Commission. The big and diverse meeting table of the ESRB provides a forum for discussion where ideas can be kicked around and different standpoints debated, most of the time resulting in us eventually converging on something that we can all agree on. So while the ESRB only possesses soft tools, and maybe even partly because of that, it has an important role also in helping other European institutions to get things done, influencing decisions and legislation under the umbrella of macro-prudential oversight.

There are many challenges ahead. But looking back at how far we have come I also have good faith in what we all, not least a strong ESRB, can achieve. After all, we did not “come this far, to only come this far”.

[1]Recommendation of the European Systemic Risk Board of 22 December 2011 on the macro-prudential mandate of national authorities (ESRB/2011/3)
[2]Treaty on the Functioning of The European Union, Part Three - Union Policies and Internal Actions, Title VIII - Economic And Monetary Policy, Chapter 2 - Monetary Policy, Article 130 (Ex Article 108 TEC), Official Journal of the European Union
[3]Schoenmaker, Dirk, Gros D., Langfield S. and Pagano M., “Allocating macro-prudential powers”, Reports of the Advisory Scientific Committee: No 5/November 2014, European Systemic Risk Board, Frankfurt am Main, Germany 2014.
[4]E.g. Recommendation of The European Systemic Risk Board of 22 December 2011 on the macro-prudential mandate of national authorities (ESRB/2011/3); Restoy F. “Central banks and financial stability: A reflection after the Covid-19 outbreak” BIS, Financial Stability Institute, FSI Insights on policy implementation No 16, Financial Stability Institute (FSI), August 2020; Key Aspects of Macroprudential Policy, IMF, June 2013
[5]Warning of the European Systemic Risk Board of 22 September 2022 on vulnerabilities in the Union financial system (ESRB/2022/7) (2022/C 423/01)