Occasional Studies Vol. 12 - 7 Putting Macroprudential Aerdt Houben, Rob Nijskens and Policy to Work Mark Teunissen Contents Foreword Klaas Knot 3 1. Introduction Aerdt Houben, Rob Nijskens and Mark Teunissen 6 2. Making macroprudential policy work Vítor Constâncio 17 3. Systemic risk and macroprudential policy Martin Hellwig 42 4. Macroprudential policy: what do we need to know? Claudia Buch 78 5. What should be the ambition level of macroprudential policy? Karolina Ekholm 94 6. Implementing macroprudential policies: the Korean experience Hyun Song Shin 104 7. How to deploy the macroprudential toolkit? Anne Le Lorier 110 8. Thoughts on how to use the instruments of macroprudential policy Lex Hoogduin 121 9. How does macroprudential policy interact with other policy areas? Christine Cumming 130 10. On the special role of macroprudential policy in the euro area Fabio Panetta 138 11. Central banks, monetary policy and the new macroprudential tools Avinash Persaud 159 12. The institutional setting of macroprudential policy Jan Brockmeijer 165 13. Allocating macroprudential powers Dirk Schoenmaker 178 14. The macroprudential voyage of discovery: no map, no specific destination in mind... no problem? Richard Barwell 196 About the contributors 218 Publications in this series as from January 2003 229 Foreword Klaas Knot In Europe, we are entering a new financial era with a centralised banking 3 union and a largely decentralised macroprudential policy. This reflects the need to promote strong supervision, while also addressing diverging financial cycles between countries. This era is by any measure a challenging one. In recent years, we have learned that not addressing systemic imbalances can have high costs. Now that we know that we should employ macroprudential policy to address these imbalances, we are faced with the difficulty that we only have limited practical experience to go by. Policy making in the coming years will thus inevitably be a process of ‘learning by doing’. Moreover, the situation in Europe is perhaps even more complex than in other parts of the world, as there are several layers of decision making in macroprudential policy. While the mandate rests predominantly with national authorities, the ECB will soon be empowered to tighten national policy measures. Throughout this process, we will come across tough questions for which we have to find an answer. How ambitious should macroprudential authorities be? Which instruments should they use? When should they use them and in what measure? Who should be involved in the decision- making process? How do we deal with uncertainty and how do we counter the inaction bias? How does macroprudential policy interact with other policy areas? These questions were discussed at a high-level seminar hosted by DNB on 10 June 2014. The event brought together senior policy makers, supervisors and academics at the forefront of macroprudential policy implementation. Their contributions are bundled in this DNB Occasional Study. The various papers provide substance and inspiration on this essential new policy area, enriched with practical experiences in various parts of the world. 4 Let me illustrate the importance of macroprudential policy with an example close to home and dear to my heart: the Dutch mortgage market. Since the mid-1990s, mortgage debt in the Netherlands grew unabatedly to a level which now exceeds our annual GDP. The root causes of this tremendous mortgage growth are of a structural nature: a generous tax treatment of mortgages and supply-side rigidities in the housing market. Credit growth was further fuelled by lax lending standards. Notwithstanding clear signs that excessive credit growth carried large risks, policymakers were reluctant to take action. For instance, it was recognized that the preferential tax treatment of mortgages helped spur the boom. Nevertheless, tax deductibility remained intact. Loan-to-Value (LTV) restrictions were considered, but not applied. DNB suggestions to limit these ratios met fierce resistance. It was argued that public authorities should not intervene in private contracts between banks and their customers. In all fairness: DNB, in its capacity as a microprudential supervisor, did not push for LTV restrictions either. We believed our microprudential mandate did not empower us to address macrofinancial risks, such as those on the housing market. Even a proposal to limit the extension of interest only mortgages, coming from the banking industry itself, was rejected by the Dutch competition authority. It judged that such a limit would unduly restrict consumers’ freedom of choice. In sum: everybody cared, but nobody took action. The consequences have been unfortunate. House prices have fallen by more than 20% since the financial crisis erupted in 2008, and 30% of Dutch mortgages are currently ‘under water’. More than a million households are cutting their expenditures and raising their savings to bring their finances back in order, thereby amplifying the economic downturn. This experience in the Netherlands – but also similar episodes in 5 Ireland and Spain – has demonstrated the importance of addressing real estate imbalances early on. When remedial actions are not taken, the need for adjustment does not disappear, but actually becomes larger. Indeed, over the past two years, the Dutch government has taken several important steps to stabilize the mortgage and housing market. These include lowering the maximum LTV ratio step-by-step (by 1 % point a year, on current plans to 100% in 2018), stimulating mortgage debt amortization and gradually reducing the tax deductibility of interest payments on mortgages. But there is still quite a way to go. We need to ensure that next time will be different. It is encouraging that many countries have taken steps to bolster their institutional framework. Macroprudential authorities with explicit financial stability mandates have been created. In Europe, since the beginning of this year, these authorities have novel policy instruments at their disposal. Moreover, a recent ESRB survey reveals that more than 15 EU countries have employed or are about to employ one or more of these instruments. Indeed, countries like Belgium, Denmark, Sweden and the UK, who are currently confronted with rising household debt and sharply rising house prices, have taken initial macroprudential steps to dampen the financial cycle. These developments show that countries around the world are progressing in the operationalisation of macroprudential policy. I hope that this Occasional Study brings them inspiration in this challenging task. 1. Introduction Aerdt Houben, Rob Nijskens and Mark Teunissen 6 The great financial crisis of 2007-2009 again illustrated the enormous costs of financial imbalances. Since the crisis, advanced economies have suffered a cumulative output loss of 33% relative to its pre-crisis trend, an increase in public debt amounting to 21% of GDP and direct fiscal costs totaling around 4% of GDP.1 These losses demonstrate the need for macroprudential measures that reduce the incidence and impact of systemic crises. This need has been acknowledged by economists and policymakers alike, and much has been written on the theory of macroprudential policy. Now the time has come to put these insights to work. To bring together key players in this new policy arena, DNB organized a high-level seminar on 10 June 2014; the speakers’ contributions are bundled in this Occasional Study. In this introductory chapter, we first identify 10 key take-aways from the seminar. Subsequently, we zoom in on an important prerequisite for making macroprudential policy a success: establishing a clear bias for action. 1.1 Key take-aways (1) Macroprudential policy should be ambitious. It should smooth the financial cycle, besides enhancing the resilience of the financial sector. From a welfare perspective, relying on enhanced resilience and improved resolution regimes to weather a crisis is important but insufficient. Although the effects of macroprudential policy are uncertain, authorities should strive to smoothen the cycle in order to reduce the risk of large, systemic shocks that can trigger the need for lender-of-last-resort financing or other forms of public support. Moreover, macroprudential policy should target the financial cycle, not the business cycle. This contributes to macroeconomic stability by containing unsustainable credit booms and by reducing the impact of shocks on the provision of credit to the economy. Beyond this, macroprudential policies should not be overburdened with a broader role in macroeconomic management of the real economy, nor in correcting shortcomings in other 7 macroeconomic (fiscal, monetary) policy fields, as this would mix up policy responsibilities and create moral hazard. (2) Macroprudential policy is expected to be more important in the euro area than elsewhere, because Europe has a bank-dominated financial sector that is fragmented along national lines and that lacks common macroeconomic instruments to address diverging financial cycles. The euro area economy relies heavily on bank credit. As the macro- prudential toolbox operates predominantly through the banking sector, macroprudential policy will be more powerful than in economies which are more market-oriented (such as the US). European banks operate mostly in local retail markets, with distinct structural and fiscal characteristics, and cross-border bank penetration is relatively low. Because of this fragmentation, national macroprudential