Policy and Research Agenda on Prudential Supervision Simone Manganelli (ECB) SYRTO Final Conference, Paris - February 19, 2016

1. Policy and research
agenda on prudential
supervision
Final SYRTO conference
Paris, 19 February 2016
Simone Manganelli
European Central Bank
Disclaimer: Any views expressed are only the author’s own and do
not necessarily reflect the views of the ECB or the Eurosystem

2. Rubric
www.ecb.europa.eu ©
• Modern economies need well-functioning financial systems.
– Transfer resources when and where they are most needed.
– Allow entrepreneurs to finance project with positive NPV.
– Enhance the growth potential of the economy, creating job and wealth.
– Large literature on causal relationship b/w finance and growth.
– Dating back to Schumpeter (1912), King and Levine (1993).
• Well-functioning financial systems are necessary for central banks
to perform their functions.
– Monetary policy is implemented by steering short term interest rates.
– Via expectations and no arbitrage relationships, this affect the whole term
structure and therefore the cost of funding of the economy.
– In exceptional times, when the lower bound is reached, non-standard
measures affect directly the longer end of the term structure, via forward
guidance and QE.
• ECB (and other central banks) attempt to bypass a malfunctioning
financial system by means of non-standard measures.
2
Motivation – Why effective supervision is important

3. Rubric
www.ecb.europa.eu ©
Composite Indicator of Systemic Stress
3Source: BCE e Hollo, Kremer, Lo Duca (2012), ECB WP No. 1426
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
Sep2000
Mar2001
Sep2001
Mar2002
Sep2002
Mar2003
Sep2003
Mar2004
Sep2004
Mar2005
Sep2005
Mar2006
Sep2006
Mar2007
Sep2007
Mar2008
Sep2008
Mar2009
Sep2009
Mar2010
Sep2010
Mar2011
Sep2011
Mar2012
Sep2012
Mar2013
Sep2013
Mar2014
Sep2014
Mar2015
Sep2015
CISS EA (monthly average) SovCISS EA (GDP weights)
Subprime
crisis
Forward
guidance
QE start
Lehman
Start Greek
crisis
Draghi
speech
Terrorist
attacks
WorldCom
bankruptcy
3y
LTRO
AQR
and CA
QE

4. Rubric
www.ecb.europa.eu ©
• ECB measures have been successful in fixing a malfunctioning
financial system.
• But it should be clear that these measures have dealt only with the
short term symptoms of the crisis.
• To improve the long term efficiency of the system requires
addressing the deep causes of the crisis.
• Many initiatives have been taken. My focus today is on the
Banking Union.
4
The road ahead

5. Rubric
www.ecb.europa.eu ©
1. Market failures
2. Narrow banking
3. Banking Union
a) Single Supervisory Mechanism
b) Single Resolution Mechanism
c) Common Deposit Insurance
4. Really big questions:
a. Interaction between monetary and prudential policies
b. Shadow Banking
5
Overview

6. Rubric
www.ecb.europa.eu ©
Government intervention is justified on the basis of market failures:
• Negative externalities
– Panic run (Diamond and Dybvig)
– Bank-sovereign nexus
– Too-big-too-fail
– Systemic risk
• Asymmetric information
– Opacity and complexity of banks’ balance sheets
– Deposit insurance, government interventions and moral hazard problems
6
1. Market failures

7. Rubric
www.ecb.europa.eu ©
• In its most extreme form, “narrow banks” issue deposits which are
fully backed by cash.
• Financing of the economy is left to “investment funds”, which are
financed with equity and long-term debt.
• The classic Chicago plan goes back to Douglas et al. (1939).
Recent contributions are Kotlikoff (2010) and Benes and Kumhof
(2012).
But not so fast:
• The transition from the current system is not trivial.
• The maturity transformation function of the banking system is lost.
• The new “investment funds” could also be subject to run (‘fire
sales’) with unpredictable consequences for the financing of the
economy.
• Prohibiting short term debt in the regulated banking system will
push it to the unregulated shadow banking sector.
7
One extreme solution: Narrow banking

8. Rubric
www.ecb.europa.eu ©
Manage overall risks of the financial system, building on regulatory
requirements, together with well-designed supervision and resolution
mechanisms.
The Banking Union rests on three pillars:
1. Single Supervisory Mechanism – Operational as of November
2014
2. Single Resolution Mechanism – Operational as of January 2016
3. Common Deposit Insurance – Details yet to be agreed
8
A more balanced solution: Banking Union

9. Rubric
www.ecb.europa.eu ©9
Why a Banking Union?
The Banking Union has been essentially created to break the bank-
sovereign nexus.
• Fragile banks undermine government finances and weak
government finances undermine the banking system.
• This has an impact on the real economy, by reducing lending and
further aggravating the positions of banks and government.
• Within a monetary union, this bank-sovereign nexus can only be
broken if banks are supervised and recapitalized at European
level.

10. Rubric
www.ecb.europa.eu ©10
The case for macro-prudential policies
From ‘VaR’ to ‘VAR for VaR’: safety of individual banks does not
guarantee safety of the financial system as a whole.
Long standing issue of whether to use monetary policy to deal with
asset price misalignments and financial stability risks.
Important emerging research on measurement of business cycle
and financial cycle:
• If the two cycles are synchronized, monetary policy can be also
used to lean against the wind.
• However, financial cycles tend to have larger amplitude and
lower frequency than business cycles.
• When the objective of price and financial stability are not
synchronized, monetary policy should be accompanied by a
suitable macro-prudential policy, with a differentiated set of tools.

11. Rubric
www.ecb.europa.eu ©11
SSM: The Single Supervisory Mechanism
SSM started its operations in November 2014.
It is governed by a Supervisory Board of 25 members, similar to the ECB
Governing Council.
Its main aims are to:
• ensure the safety and soundness of the European banking system
• increase financial integration and stability
• ensure consistent supervision
The ECB directly supervises the 129 significant banks of the participating
countries. These banks hold almost 82% of banking assets in the euro
area.
• Supervision of the significant banks is carried out by Joint Supervisory
Teams, comprising staff of the ECB and the national supervisors.
• Banks that are not considered significant continue to be supervised by
their national supervisors, in close cooperation with the ECB.

12. Rubric
www.ecb.europa.eu ©12
Prudential tools of the SSM
SSM has both micro and macro prudential powers:
- Lender-based instruments:
- Capital requirements
- Capital buffers for systemically important institutions
- Countercyclical capital buffers
- Liquidity requirements
- Borrower-based instruments (available at national level):
- Loan-to-value
- Loan-to-income
- Debt service-to-income

13. Rubric
www.ecb.europa.eu ©13
Effectiveness of prudential policies
Key research and policy questions:
• How to resolve the tension between micro and macro
perspective?
• What is the effectiveness of these measures?
• How do they interact among themselves?
• Are there spillovers across national borders and how to best
coordinate these instruments?
• What is the optimal design of stress tests and the optimal
amount of disclosure?

14. Rubric
www.ecb.europa.eu ©14
Single Resolution Mechanism and bail-in
When all of the above measures fail, in the absence of orderly
resolutions, governments may have to bail-out banks to avoid
contagion and severe impairment of the financial system.
But:
• Bail-outs strain public finances
• Bail-outs fuels moral hazard behaviour and distorts incentives
Since bank failures are inevitable (even under optimal supervision),
it is important to have resolutions mechanisms in place.
Questions:
• How is bail-in affecting the cost of funding of banks?
• Optimal resolution strategy?

15. Rubric
www.ecb.europa.eu ©15
Common Deposit Insurance
This is the area where research can have the greatest impact, as
there is no agreement yet on its optimal design.
In general, public guarantees induce moral hazard and excessive
risk-taking problems, because:
- Creditors no longer have incentives to discipline banks
- Banks’ funding costs are artificially reduced
European Deposit Insurance Scheme (EDIS), building on national
deposit guarantee schemes.
Many issues to be clarified, related to:
- How to trigger the insurance
- How to ensure that national DGS manage their costs and risks
properly
- How to fund the Scheme

16. Rubric
www.ecb.europa.eu ©
1. Market failures
2. Narrow banking
3. Banking Union
1. Single Supervisory Mechanism
2. Single Resolution Mechanism
3. Common Deposit Insurance
4. Really big questions:
a. Interaction between monetary and prudential policies
b. Shadow Banking
16
Overview

17. Rubric
www.ecb.europa.eu ©17
Additional challenges: Interaction with monetary policy
Global inflation has been subdued for a few years.
Central banks have answered by injecting large amounts of liquidity
and with large scale asset purchases.
Low inflation can be a problem because
• higher real interest rates
• higher debt burden for borrowers
• slower adjustment of highly indebted households, firms and
governments
• low interest rates may induce excessive “search for yields”
BIS view that low rates present a threat to financial stability.

18. Rubric
www.ecb.europa.eu ©
-1
0
1
2
3
4
5
1999
2001
2003
2005
2007
2009
2011
2013
2015
Euro area inflation below its objective in the past few years…
18
Source: ECB

19. Rubric
www.ecb.europa.eu ©
-1
0
1
2
3
4
5
6
7
1999
2001
2003
2005
2007
2009
2011
2013
Deposit Facility Marginal Lending Facility MRO
… and interest rates have reached their lower bound
19
Source: ECB

20. Rubric
www.ecb.europa.eu ©20
Forward guidance and quantitative easing
• Interest rates cannot fall too much below zero: “Investing” in cash
gives a return of zero.
• Central banks can charge slightly negative interest rates,
because bank accounts are more convenient (to make payments
and to prevent theft).
• Once short term interest rates have reached their lower bound,
central banks use “forward guidance” and “quantitative easing”:
• The main objective remains to further stimulate the economy,
lowering long term interest rates.

21. Rubric
www.ecb.europa.eu ©
4 July 2013 – Forward guidance
The Governing Council expects the key ECB interest rates to remain at present or
lower levels for an extended period of time.
22 January 2015 – Expanded asset purchase programme
• ECB expands purchases to include bonds issued by euro area central governments,
agencies and European institutions
• Combined monthly asset purchases to amount to €60 billion
• Purchases intended to be carried out until at least September 2016
• Programme designed to fulfil price stability mandate
9 March 2015 – ECB starts purchases
21
Main announcements of the ECB

22. Rubric
www.ecb.europa.eu ©
Impact of announcement on term structure of interest rates
22
Soource: Andrade, Breckenfelder, De Fiore, Karadi, Tristani (2015), ECB

23. Rubric
www.ecb.europa.eu ©23
Impact of ultra low interest rates on banks
With negative deposit rates, banks are required to pay a tax to
deposit excess liquidity with the ECB.
• Retail deposit rates are constrained at zero, so further lowering of
interest rates may squeeze banks’ profitability and create
fragilities.
• Of course this neglects the macro channel: an accommodative
monetary policy should stimulate economic growth and
strengthen banks’ balance sheets, for instance by reducing non-
performing loans.
• In any case, interest rates are foreseen to remain low for a long
period of time, so any study which may shed light on the impact
on financial stability would be welcome.
• More generally, what is the optimal monetary/prudential policy
mix?

24. Rubric
www.ecb.europa.eu ©24
Additional challenges: Shadow banking
What is the best way to think about shadow banking? As banks
become increasingly regulated, some activities will shift outside the
banking sector.
Key issues:
1. Information on non-banking sectors is much more limited.
Studies should pull together data from different sources.
2. Understand the incentive structures and how the non-banking
and banking sector interact.
3. Indicators to detect new sectors in which risks are accumulating
and find ways of including them in early warning and stress-
testing frameworks.
4. Effective policy measures to increase resilience of non-bank
institutions and to mitigate risks in financial markets.