Macro-prudential Regulation as an Approach to Contain Systemic Risk: Economic Foundations, Diagnostic Tools and Policy Instruments

Speech by Jean-Claude Trichet, President of the ECB, at the 13th conference of the ECB-CFS Research Network, Frankfurt am Main, 27 September 2010

Ladies and Gentlemen,

It is a pleasure to welcome you to the European Central Bank (ECB) for this conference on macroprudential regulation, particularly as it is taking place just a few days after the European Parliament passed important legislation on this very issue. I would like to thank the Centre for Economic Policy Research in London, the Center for Financial Studies at the University of Frankfurt and our staff here at the ECB for organising this conference. As we begin the implementation of macroprudential supervision at both, the EU and national levels, all inputs from academia and the private sector are most welcome.

The ECB will continue its open and transparent debate with the main stakeholders concerned with economic and financial policies related to our competences. Our research conferences are intended to serve this purpose.

The topic of the conference we are hosting over the next day and a half is extremely timely because apart from many national initiatives to implement macroprudential supervision, the new European Systemic Risk Board (ESRB) will be set up. The ECB as an EU institution will be entrusted with the task of supporting the new body – analytically, statistically, administratively and logistically, drawing on technical advice from national central banks and supervisors and in close cooperation with all ESRB members. As you know, the ESRB includes all EU national central banks, the heads of the three new European Supervisory Authorities (ESAs) and the European Commission, national supervisory authorities and the chair of the Economic and Financial Committee.

Today, I would like to share a few thoughts with you about how the ECB and the ESRB relate to one another.

The ESRB is a body that is quite distinct and separate from the ECB. The ESRB will not change in any way the mandate and the functioning of the ECB’s statutory role. The ESRB and its macroprudential policies will have three main tasks: to identify and prioritise systemic risks; to issue early warnings when significant systemic risks emerge; and to issue policy recommendations for remedial action in response to the risks it identifies.

Systemic risk can be defined as the risk that financial instability becomes so widespread that it impairs the functioning of a financial system to the point where economic growth and welfare suffer materially. The crisis that we have experienced over the last three years is an overwhelming case of the materialisation of systemic risk. Whereas many of the risks that played a role in the crisis were identified by central banks and official international financial institutions, not enough attention was paid to the ways in which these risks could combine and reinforce each other so as to lead to a severe systemic crisis.

The ECB thus welcomes the agreement to create the ESRB, a body designed precisely to deal with risks that develop and interact in a way that can endanger the financial system as a whole. The ESRB will start its operation in January next year. The core of the ECB’s policy support will be undertaken by a new unit to be established, the ESRB Secretariat. This new unit will be closely connected with the ECB, the Directorate General Financial Stability and other business areas. But at the same time, the Secretariat will have its own status and operate under the guidance of the ESRB. As I have made clear, the ESRB, together with its governance and sub-structures, is a body of its own.

The ESRB is complementary to other institutions. It does not replace the functions of any existing institution, be it a supervisory organisation or a central bank. The task of macroprudential oversight of the EU financial system is a new one, and the ESRB will have to interact very fruitfully with other competent authorities in the area of financial supervision and regulation. To this effect it is part of the European System of Financial Supervision (ESFS), together with the new ESAs and the national supervisory authorities.

The orientation of the ESRB’s policy actions is also new in terms of early warnings and recommendations to contain systemic risk. Systemic risk analysis and macroprudential policy have to consider all elements of the financial system and how they interact with each other and with the economy as a whole.

This is an important point about the scope of the new body, which I could not stress more. One lesson from our experience of the crisis is that there should not be any “pockets” of financial systems that are not considered and understood for their implications for financial stability. Another lesson is that we have to understand better how regulatory instruments act at the level of the system as a whole, beyond their effectiveness at the level of the individual intermediary or market.

For the ESRB to be effective, the quality of the analytical input – an area to which this conference intends to make a contribution – and the clarity and specificity of the strategy to issue and follow up on warnings and recommendations will be essential.

Accordingly, we at the ECB, in collaboration with other future ESRB member institutions, are working intensively on further developing the conceptual and analytical underpinnings for macroprudential policies. Several analytical approaches for the identification, prioritisation and warning about systemic risks are available. We have systemic risk indicators and early warning models, macro-stress testing approaches and contagion or spillover models. We are continuously trying to improve them and keep them at the frontier of research knowledge.

But we also need to be conscious that the economic models we – and other policy authorities – have at our disposal do not necessarily capture all the relevant dimensions of systemic risk. The research community can make a significant contribution to rectifying this. Existing approaches should not only be improved gradually, but also some fundamental gaps should be filled.

Let me give you three examples. First, many standard macroeconomic models do not have well developed financial sectors and are mostly linear in nature. Therefore, they cannot easily capture widespread financial instability. As a consequence, they were not able to predict the drastic downward revision of growth figures we experienced during the crisis.

Second, a greater understanding is needed of how financial regulations act at the aggregate level, both in containing systemic risk and in affecting the growth potential of economies. This would allow a more precise “calibration” of policy recommendations that would have to been made in the ESRB context, for example.

Third, the systemic importance of non-bank financial intermediaries is not explored as well as systemic banking risk. But we do need to include the roles of large and complex insurance corporations or highly leveraged financial players and their interactions with banks in our overall judgements about relevant system-wide interactions. For example, the impact of a large pool of “hyperliquid funds” that can shift allocation in global markets in real time is not yet fully understood, and it would be valuable to see it captured in financial models.

A considerable intellectual and policy challenge lies before us. We have to re-evaluate our understanding of the nature of risk of market disruptions. We have to re-evaluate our understanding of the role of financial markets in our economies and our societies. And we have to re-evaluate our understanding of the very nature of financial markets, which have shown themselves at times to be far less efficient and far less atomistic than they are often perceived. Herding, leverage cycles and oligopolistic structures in some important market segments are all issues that would be fascinating to be seen captured in models and theoretical approaches to finance.

In all these areas research can support us significantly and will help meet the challenges of macroprudential policy.

Obviously, we and other central banks are also investing in research and analysis ourselves. This conference marks the start of a major research effort by EU central banks. The European System of Central Banks (ESCB) has launched a macroprudential research network, called MaRs. Many researchers from all EU central banks are contributing to its main work areas over the next two years. We will report on its main results in 2012 and until then occasionally exchange notes with researchers outside central banks in events like this conference. At the conference dinner tonight, Vice-President Vítor Constâncio will share further thoughts with you about how your and our research can contribute to the development of macroprudential policy in the months and years ahead.

I wish you a very stimulating conference.