Chapter 12:

Financial
Stability:
Intervention
Tools
Macroeconomy
⬡ Ex Ante

⬡ Ex Post

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Concept between ex ante and expost

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Possible Tools to Address Financial Stability
Areas of Focus Ex ante
Macroeconomy Monetary policy
tightening,Macroprudential
measures
Financial institutions Supervisory actions, Capital
adequacy requirements,
Coordination with
regulators of nonbank
financial institutions
Financial markets Regulations on market
players under central bank
supervision ,Coordination
with market regulators
Ex post
Conventional monetary
policy easing,
Unconventional easing,
Macroprudential measures
Lender-of-last-resort
facilities, Special resolutions
for troubled financial
institutions
Lender-of-last-resort
facilities ,Direct market
interventions (e.g., asset
purchases) 4
The Debate on the Use of Monetary Policy for the
Maintenance of Financial Stability
Some argued that monetary policy should be used to help lean on asset price
bubbles while they were still in the early forming stage so they would not grow
excessively large.
Others, however, suggested
that monetary policy should
be used instead to help
clean up the aftereffects
once the bubbles had burst.
Those in this camp argued
that monetary policy should
only be used to stabilize the
economy after asset price
bubbles had actually burst
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The arguments against the
use of monetary policy in
addressing the buildup of
bubbles included

(1) the belief, especially prior to the crisis,

that in a market economy prices should
reflect all relevant information, and thus
the central bank would not know any (2) that since monetary policy is a rather
better than the public if rising asset blunt tool, its use would affect the cost of
prices were beyond what was warranted money across the economy, not just in
by fundamentals and were actually the sectors where bubbles were forming,
bubbles,

(3) that placing financial stability as an additional objective of monetary policy could
place too much burden on monetary policy and compromise its credibility.
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Sustaining Financial Stability: Dealing with
Threats Against the Macroeconomy Ex Ante
⬡ To maintain financial stability, the central bank might want to deal with arising
threats early, before they lead to a full-blown crisis. After the 2007–2010 crisis,
it became increasingly recognized that the central bank could use monetary
policy as well as macroprudential measures as the main instruments to address
those threats ex ante.

⬡ Monetary policy is a potent but blunt instrument that affects all sectors of the
economy. Macroprudential measures are more precise, and can be used to
address specific pockets of the economy. The central bank could also consider
using both types of instruments in a complementary manner

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2007-2010 Crisis

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The Use of Macroprudential
Measures
to address risk buildups in specific
areas that, if remain unchecked,
could affect systemwide stability.
Although there is no single
definitive set of macroprudential
measures as yet, they can broadly
be classified into those that are
credit-related, liquidity-related, and
capital-related

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 Ceilings on ⬡ Debt-to-
Limits on Loan-to-
Value Ratios Credit Income Ratio
⬡ Growth
could help reduce
⬡ Limits on LTV ratios amplification effects from the ⬡ address risk
are used to address business cycle in general buildups in the
risk buildups in the household
⬡ By putting ceilings on credit
housing market.11 sector.
growth for specific sectors,
LTV ratios limit
on the other hand,
households’
regulatory authorities can
borrowing capacity
address risk buildups in a
through the amount Caps on Unhedged
more targeted way
of the down payment
required for a
Foreign Currency
housing purchase. Lending
can be used to limit exposure to the unhedged foreign
exchange rate risk that comes with external
borrowingnhedged Foreign Currency Lending
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Sustaining Financial Stability: Dealing with Risks within
the Macroeconomy Ex Post
⬡ Monetary Policy Easing

⬡ Conventional Monetary Policy Easing

⬡ Unconventional Easing

⬡ Macroprudential measures

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FINANCIAL INSTITUTIONS
⬡ Dealing with Threats to Financial Institutions Ex Ante

To safeguard financial stability against risks that may come from financial
institutions ex ante,a central bank with bank supervisory role to take both a
micro- and macroprudential perspective. For example, the use of
microprudential supervisory tools could be used to ensure that individual
banks comply with regulatory requirements, and that their management is
safe and sound, while macroprudential supervisory tools could be used to
ensure the resiliency of the banking system against risks amplification by
business cycles, as well as by cross-sectional risk concentration within the
system.

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Microprudential
Supervision

⬡ would aim to ensure that individual banks do have enough capital and
liquidity to cover any emerging shocks, and that the banks are managed in a
safe and sound manner. It is often associated with bank examinations and
their associated actions, including enforcement of regulations and laws to
ensure bank compliance

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Macroprudential
Supervision

⬡ macroprudential supervision puts more emphasis on

the resiliency of the banking system as a whole.
Macroprudential measures, especially those that are
capital-related and liquidity-related, are used to
safeguard financial institutions against systemic risks

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Capital-Related
Macroprudential Measures
⬡ Capital requirements are a key tool that the central
bank can use to help ensure resiliency of the banking
system against systemic risk, by requiring that banks
hold enough capital to deal with multiple types of risks.
Capital requirements can be used to guard against
systemic risk that might arise from (1) risk
amplification through the business cycle, and (2) risk
concentration and distribution within the system.

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CONCEPT: INTRODUCTION TO BASEL I, II, AND III

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The Basel Accord (Basel I)
⬡ issued in 1988, assets of financial institutions were classified into
five categories according to their perceived riskiness. Banks were
required to hold capital as reserves against the assets at 0, 10, 20,
50, or 100 percent, depending on their perceived riskiness
⬡ Basel I deemed corporate bonds to be very risky and assigned them
a risk-weight of 100 percent. This meant that for corporate bonds
held as assets on their balance sheets, the banks would have had to
hold capital as reserves equivalent to the full amount

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 Basel II
⬡ Basel II was an attempt to make improvements upon
Basel I through the use of the three pillars approach

⬡ Pillar 1 put emphasis on making capital requirements more

comprehensive and responsive with respect to risks that financial
institutions might be facing
⬡ Pillar 2, known as supervisory review, stressed the importance of a
banking supervisor making risk-weight adjustments to truly reflect what
the supervisor sees as the underlying risks faced by a bank.
⬡ Pillar 3, market discipline, emphasized the ability of market forces to
discipline the bank’s management to be vigilant about risks that the
bank might take

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 Basel III
⬡ it became apparent that Basel II itself
needed revision in many areas. The
revisions ultimately led to the
issuance of Basel III in late 2010,
which improved upon Basel II with
respect to the three pillars and laid
out minimum global liquidity
standard as well as additional capital
buffers for SIFIs

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 Improvements to the Three Pillars
⬡ In learning from the 2007–2010 crisis, the Basel
Committee made considerable adjustments in Basel III
that improved upon the three pillars of Basel II.
⬡ Pillar 1 aimed to improve the quality and quantity of capital, as well as
the coverage of risk and limits on the banks’ leverage.

⬡ Pillar 2, introduced supplemental requirements for supervisory review by

addressing issues relating to (1) bankwide governance and risk
management practices, (2) off-balance sheet exposures and securitization
activities (3) the management of risk concentration within the bank, (4)
compensation and valuation practices, (5) accounting standards for
financial instruments, and (6) supervisory colleges
⬡ Pillar 3, suggested revisions to disclosure requirements for all banks

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Dealing with Threats to
Financial Institutions Ex Post
⬡ The Discount Window
As a provider of liquidity, the discount window can be used as another
channel to either inject liquidity into financial institutions that are under extreme
liquidity pressures, or to redistribute liquidity—through the borrowing financial
institutions—to other parts of the economy where it is needed.

It is the principal instrument of central banking operations where the central

bank provided funds to financial institutions that needed them.

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 ⬡ Special Resolutions for Troubled Financial Institutions
and Living Wills
There is always a possibility that a bank might still fail. To ensure financial
stability, the central bank and related authorities might need special resolutions to
ensure that a troubled bank does not fail in a disorderly manner.

⬡ Liquidation: Closing of a Bank

Liquidation is often the preferred option in cases in which regulatory authorities
feel that the closure of the bank would not lead to contagion effects. The bank’s
assets would be sold over time to repay its liabilities to depositors and other creditors

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 ⬡ Conservatorship: Temporary Administration
In a conservatorship, preexisting shareholders may be removed from ownership
of the bank or their rights might be temporarily constrained. The administration team
would reform the bank’s operations to improve its financial health, with the goal of
possibly selling or merging the bank with another financial institution at a later date.

⬡ Purchase and Assumption: Facilitating an Acquisition by

Another Party
This approach essentially aims to transfer the troubled bank’s operations to
another healthy bank. Regulatory authorities withdraw or cancel the license of the
troubled bank, terminate shareholders’ rights, facilitate the assumption of the
troubled bank’s good assets and deposits by the other bank, and take over the
troubled bank’s problem assets so they can be managed and sold afterward
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 ⬡ Nationalization: Assumption of Ownership by the
Government
In such a case, all assets and liabilities of the troubled bank are transferred to
the government in exchange for cash injection and ownership. The government might
appoint new management or it might let current management continue to improve
the bank’s financial health, such that the government would either be repaid over
time or would sell the bank to a private party at a future date.

⬡ Living Wills
it has been recognized that modern financial institutions can be very large with
very complex ownership structures and contractual obligations.

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FINANCIAL MARKETS
⬡ Since the central bank is normally not the direct
regulator of financial markets,* it is often the case that
the central bank will take a hands-off or a very selective
and very cautious approach in dealing with those
markets. As it is not a direct regulator of financial
markets, the central bank might not have adequate
regulatory tools to mitigate risk buildup among
financial market players, except possibly in cases in
which players are banks under its supervision

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Dealing with Threats to
Financial Markets Ex Ante
⬡ A central bank is normally not the lead regulator of
financial markets. Still, with its monetary policy
fundamentally affecting prices and cost of funds in
financial markets, its extensive operations in the
financial markets, and its regulatory power over banks
that are key financial market players (in cases in which
the central bank is also a bank supervisor), a central
bank has the ability to deal with threats to financial
markets ex ante.

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Using Monetary Policy to
Address Risk Buildups in the
Financial Markets
⬡ the central bank might target
⬡ a central bank could choose to
tighten monetary policy in order to
prevent the buildup of risk in
financial markets. A tightened
monetary policy stance raises the
cost of funds among players in
financial markets, which
discourages them from undertaking
more speculative activities.
Regulations on
Market Players
regulations to financial
market players under their
supervision (i.e., banks).
Examples of such regulations
include limits on net currency
positions, limits on currency
mismatches, and limits on
maturity mismatches of
banks under the central
bank’s supervision
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Dealing with Threats to
Financial Markets Ex Post
⬡ Given the central banks’ control of monetary policy,
and their lender-of-last-resort status, the central banks
also are in a good position to deal with threats to
financial markets ex post

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Monetary Policy and Liquidity Liquidity Provision to
Risk Institutions Not Supervised
by the Central Bank

If those with excess liquidity become very
worried and refuse to lend or demand excessively
high interest rates for loans, even those players
who are solvent (the value of their assets exceeds
their debt) but need liquidity urgently (possibly to
pay for their own transaction obligations, for
example), might also fall into trouble, which
could create a trail of liquidity shortages that
runs through the whole system
⬡ As financial markets have grown in
importance, however, it could be
hazardous for the central bank to
ignore liquidity shortages of
systemically important players just
because they are outside its direct
supervision

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Federal Reserve intervened in the financial
markets ex post in three nontraditional
ways:
the provision of
liquidity to
1
institutions and
firms not
the expansion of supervised by
types of the central bank
collateral taken 2
in lieu of the provision of
liquidity nonrecourse loans
provisions, of longer maturities
3 in certain cases
normally outside
traditional liquidity
provision
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Thanks!
Any questions?

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