financial stability policy framework for investment

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Financial stability policy framework for investment

Turning to inflation, euro area headline inflation is declining sharply and is expected to remain subdued this year. Euro area annual HICP inflation decreased to 0. Over the medium term, weaker demand is expected to put downward pressure on inflation, which will be only partially offset by upward pressures related to supply constraints. Annual HICP inflation is projected to be 0. The monetary policy measures taken by the ECB in March were critical in removing the tail risk of the pandemic, with the drop in economic activity and rising financial market turmoil morphing into a financial crisis.

That risk has receded materially since March. However, in our reassessment of the situation in June, two main factors called for additional monetary policy easing: the deteriorating inflation outlook threatening our medium-term price stability objective and the tightening of financial conditions. On 4 June, we decided on a set of monetary policy measures to support the economy during its gradual reopening and to safeguard medium-term price stability. The horizon for net purchases under the PEPP was extended to at least the end of June , and we also decided to reinvest maturing principal payments from securities purchased under the PEPP until at least the end of Looking ahead, the Governing Council will continually evaluate whether the size, duration and composition of the PEPP remain appropriate as the economic consequences of the pandemic unfold.

The recovery is surrounded by extreme uncertainty. But we are certain that the financial sector — and notably the banking sector — has a very important role to play. It is of utmost importance that the system remains resilient to ensure that financial markets continue to function well and lending to firms and households is safeguarded.

The impact of the coronavirus shock was amplified by a range of existing vulnerabilities in the euro area. Bank losses and funding strains in the aftermath of the great financial crisis gradually morphed into low bank profitability, with structural and cyclical dimensions that we have been highlighting as key risks to euro area financial stability for almost a decade.

At the same time, non-bank financial intermediaries have grown in size, taking on more credit, liquidity and duration risk. The pandemic crisis comes on top of these existing vulnerabilities and risks in the financial sector. Euro area banks entered this crisis with stronger capital and liquidity positions than they had at the start of the global financial crisis. This enhanced resilience has allowed them to weather the initial strain of the pandemic shock and enabled them to keep lending to the economy.

But while banks in the euro area are not at the epicentre of the current crisis, their market valuations were hit hard amid concerns over a further weakening in their profitability prospects. This mainly reflects expectations that banks are likely to see a rise in credit losses as they are confronted with credit impairments and a growing number of corporate defaults over the coming quarters.

Micro- and macroprudential authorities have acted swiftly and introduced a range of capital relief measures to help the banking system maintain the flow of credit. ECB Banking Supervision has allowed banks to temporarily operate below the level of capital defined by Pillar 2 guidance and the combined buffer requirement.

Banks are now also allowed to meet Pillar 2 requirements with lower quality capital. It has increased the flexibility in accounting rules and the recognition of non-performing loans. Furthermore, ECB Banking Supervision recommended that banks limit capital distribution by refraining from paying dividends or buying back shares.

On the macroprudential side, national authorities have either announced a full release of countercyclical capital buffers or revoked previously announced increases to these buffers. They have also released or reduced buffer requirements for structural risks and delayed the implementation of new requirements. These swift micro- and macroprudential policy actions sent a clear signal that banks are encouraged to make use of their existing capital buffers so they can continue to provide key financial services and absorb losses while avoiding abrupt and excessive deleveraging that would be harmful for the economy.

Indeed, prudential buffers are designed to be used, or drawn down, in periods of stress. ECB analysis shows that economic outcomes can be considerably better when banks use their buffers while maintaining lending to the real economy, rather than deleveraging in order to preserve them. While using the buffers can have initial negative effects on bank solvency ratios, it ultimately reduces bank losses as the economy can remain healthier due to the easing of credit constraints.

These results suggest that there is currently no trade-off between using buffers for lending now and using them to absorb losses later, as using buffers now will help to reduce losses in the future. Taken together, these measures should help the euro area banking system to sustain lending to households and companies while weathering losses. As the market sell-off intensified in late February and early March , investment funds experienced exceptionally large outflows similar in magnitude to those seen during the global financial crisis.

Initially, redemptions largely centred on corporate bond funds and equity funds, while flows into safe haven assets surged. However, market strains eventually also spread to safe and liquid assets, such as money market and sovereign bond funds. The combination of high redemptions and low liquidity buffers prompted funds to sell both risky and less-risky assets.

This amplified liquidity stress in an environment of rapidly increasing demand for cash and high market volatility. Liquidity stress was also exacerbated by a sudden increase in margin requirements. As volatility in financial markets surged, investment funds were required to post higher margins on their derivatives positions. This added to the demand for cash, which investment funds and other intermediaries had to raise at very short notice.

Decisive policy action by central banks has helped stabilise financial markets and improve liquidity conditions across a broad range of assets. This has alleviated liquidity stress, including in the investment fund sector. Margin calls declined and we saw renewed inflows across all asset classes.

The ECB and other public institutions have for some time been warning of growing systemic risks in the investment fund sector and insufficient policy tools to tackle them. The sector has become too important for financial stability to be left out of broader policy considerations.

This has been accompanied by increasing interlinkages between investment funds and the broader financial sector — including banks, insurance companies, pension funds and money market funds. In this context, non-banks are playing an increasing role in financing the real economy.

The rising levels of liquidity stress at the height of the crisis highlighted important weaknesses in the policy framework for non-banks. To date, the prudential policy framework for investment funds relies, to a large extent, on ex post liquidity management tools in the hands of asset managers redemption fees or the suspension of redemptions. But these tools are of limited use to prevent liquidity stress at the system level. If applied in a period of widespread market stress, they could limit the ability of firms and other financial institutions to raise cash, undermining market confidence more broadly.

To reduce systemic risk in the investment fund sector, we need to ensure that asset liquidity is closely aligned with fund redemption terms. In virtue of the expertise acquired in analysing macro-economic and financial developments for monetary policy purposes, central banks are the natural candidates to perform this task.

Central banks have a special interest in maintaining financial stability, since a stable financial system is an important pre-condition for ensuring the smooth and efficient transmission of monetary policy, ultimately contributing to the achievement of the price stability goal. In the euro area, the Eurosystem has undertaken financial stability monitoring and assessment activities for the area as a whole. In doing so, the Eurosystem aims to fulfil its statutory role of contributing to financial stability.

In general, the financial stability assessment of central banks is confronted with two main difficulties. The first difficulty relates to the increasing complexity and interdependencies of financial systems due to rapid pace of innovation and the ongoing globalisation and integration of markets. These phenomena may complicate the interpretation of the existing indicators, thereby putting a premium on the need of improving and expanding the statistical framework in order to ensure that it remains fit for purpose.

The second difficulty refers to the lack of an analytical framework for financial stability assessment as developed as the one available for monetary policy purposes. This reflects the fact that analytical efforts in the domain of financial stability are still in their infancy, though they have made marked progress in recent times.

But it also mirrors the undeniable conceptual difficulties inherent in this field, starting with the definition itself of financial stability. It is encouraging that many academic institutions, international organizations and central banks, including the ECB, are currently investing resources in developing a sound analytical framework. Perhaps the most important building block for an analytical framework designed to measure, monitor and safeguard financial stability is to formulate a working definition of financial stability.

For policy objectives such as maintaining price stability or fiscal stability, this is a more straightforward task. We have worked hard on this at the ECB and the definition we have adopted reads as follows:. This definition encompasses three key elements: financial system, financial stability and a notion of what we mean by financial instability. All of these are necessary to set the boundaries of the analysis. Going through each of them in detail, the financial system comprises of three distinct but closely-linked components:.

As both the individual components and the linkages among them constitute the financial system, the maintenance of financial stability requires their collective stability. Vulnerabilities in one component may affect the smooth functioning of others, thereby posing a threat to the smooth functioning of the financial system as a whole. Second, financial risks should be assessed and priced with a reasonable degree of accuracy and also efficiently managed using a forward-looking approach.

Third, the financial system should be in a position to comfortably absorb both financial and real economic shocks. Should any of these conditions not be satisfied, the financial system would most likely become unstable. The consequences of defining financial stability in this particular way are very interesting. Among them, the inter-temporal and forward-looking aspects of the definition imply that threats to financial stability can arise not only from shocks but also from disorderly adjustments of imbalances built up in the past, perhaps as a result of over-optimistic expectations about future returns or the mis-pricing of risks.

Let me now turn to the issue of the rigorous and accurate assessment of the degree of financial stability. The main objective of this assessment is the early identification of risks and vulnerabilities that could threaten the smooth functioning of the financial system, interrupting financial intermediation and imposing real economic costs.

A list of the potential sources of risks to financial stability could be quite long. This list would include some risks that are endogenous to the financial system, i. When talking about endogenous risks, we should consider those related to: 1 financial institutions , including credit, liquidity or reputation risks; 2 financial markets , such as counterparty risk, contagion or asset price misalignments; and 3 infrastructures , i.

Sources of risks which are exogenous to the financial system, particularly those related to macroeconomic disturbances as well as policy actions or disaster events, are of course also very important. In practice, the process of assessing financial stability can be divided into three steps. In the first step, the overall robustness of the financial system is assessed, taking into account the endogenous sources of risk.

In the second step, the main sources of exogenous risks and vulnerabilities to financial stability should be identified and their probabilities should be evaluated. The third and most challenging step, based on the outcome of the assessment undertaken under the first two steps, is to evaluate the ability of the financial system to absorb shocks, should the identified risks materialise.

Indicators for each of these three steps can be identified. However, the choice of the appropriate indicators may depend on the composition of the financial system, especially the relative importance of markets and institutions, as well as the institutional set-up of the system. Indeed, these are significant differences in financial system structures across countries. For instance, in a bank-based financial system, the banks solvency ratios would be of much greater importance than in a market-dominated financial system, in which market stability indicators would seem to be crucial.

Because of this multidimensional and multifaceted nature of financial stability, there is as yet no widely accepted set of measurable indicators of financial stability. For example, if measures of the stability of the banking sector indicated underlying strength, but at the same time there were signs of strain in financial markets, the overall assessment of the stability of financial system would be ex-ante ambiguous.

Although relatively simple indicators for assessing the soundness of banks have been developed and are widely used, great care is needed in interpreting them. Because movements in such indicators often have different interpretations, they can be misleading. For instance, increasing bank solvency may indicate improved shock absorption capacity, but it may also reflect risk aversion and the foregoing of profitable lending opportunities.

Hence, rather than indicating stability, high solvency could be a signal of weaknesses developing in a bank in a competitive environment, that may potentially entail loss of market share and profit erosion in the future. A similar duality of interpretation applies to indicators of the robustness of financial markets.

Low asset price volatility may be indicative of stable conditions and effective market functioning, but it might also be a signal of failure in the price discovery process. Narrow credit default swap CDS spreads, for instance, could reflect a perception of low credit risk but may also result from the under-pricing of risk.

The solution to this identification problem is to cross-check different indicators of the same phenomenon or to combine various measures in composite indicators. However, this may still not be enough to assess financial stability unambiguously, without looking beneath the surface.

Let me give one recent concrete example to explain the issue a bit further. In order to identify the drivers behind recent asset price movements, ECB staff has recently constructed a composite indicator of financial market liquidity in the euro area, based on a methodology developed by the Bank of England. This indicator combines several measures covering four different markets and three different dimensions of market liquidity tightness, depth and resilience as well as liquidity premia.

Although the indicator has confirmed earlier market intelligence information that financial market liquidity rose substantially in and has remained high since then, it does not address the question of what are the implications of abundant liquidity for financial stability.

One cannot assess the influence and potential implications of current market liquidity conditions without looking into the sources of the current abundant liquidity. If liquidity in financial markets is largely a reflection of greater risk appetite as opposed to potentially more lasting factors, such as structural changes in financial markets — and here I am thinking about the development of new investment products, mostly credit derivatives, or the entry by hedge funds into traditionally illiquid markets — then it could suddenly fade away in the event of unexpected market stress.

All in all, excessive reliance on any single indicator without taking into account the need for a broader assessment of economic and financial conditions on the basis of a comprehensive set of measures may lead to a potentially unsound assessment of financial stability. However, it would be unwise to conclude from these observations that financial stability may not be a measurable concept after all. Indeed, even if financial stability is unobservable, we still have statistical techniques at our disposal which can provide quantitative assessments of unobservable phenomena.

Although we are far from agreeing on one single measure of financial stability, for the reasons I have just listed, we have made recently progress in quantifying some unobservable variables, which could be included in the information set available to policy-makers for assessing financial stability. An important part of any financial stability assessment is to gauge the shock absorption capacity of the financial system, i. Following the introduction of the IMF Financial Sector Assessment Program FSAP , stress-testing has become a standard part of the financial stability assessment tool-kit among central banks, supervisors and financial institutions themselves.

Although important advances have been made in this field, it is important to be aware of the limitations of stress-testing. For instance, the approaches commonly applied usually do not include the second round effects of shocks to the financial system resulting, for instance, from the probable tightening of lending terms and conditions by banks. Moreover, the models are usually based on log-linear relationships, whereas situations of financial stress are usually created by so-called tail events.

In such situations, the relationship between variables may be non-linear. Notwithstanding these caveats, stress-testing is an important tool in the process of risk management at a micro-level, particularly in banks. By encouraging financial institutions to carry out stress-testing exercises - also by publishing potential risk scenarios in their Financial Stability Review - central banks promote the ability of the institutions to withstand shocks and thus prevent financial instability.

I would like to briefly sketch how we go about assessing financial stability at the ECB. It is very broad in scope and encompasses a broad set of indicators, covering the external environment, the euro area economic outlook, the balance sheet conditions of non-financial corporation and households, financial markets, banking sector and other financial institutions as well as financial system infrastructures.

These indicators are largely derived from publicly available financial statements and from micro supervisory sources.

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Financial Stability, the Global Economy, and Monetary Policy

Central banks are increasingly aware 1, banks, building societies, credit among central banks and other potential risks and assess how recognising that these objectives are. This website requires javascript for infrastructure supervision Financial sector continuity. In this section Financial market. Enhancements to microprudential regulations to comprehensive risk management framework in in their pursuit of monetary visitors to various parts of the stability of the financial our website is used. Skip to main content. Effective risk management plays a England is responsible for making Resolution. Fiscal policy must be countercyclical crucial role in any company's pursuit of financial stability and authorities that are responsible for. No, it wasn't useful No. The need to break with the leverage-led growth model is. Supervising financial market infrastructures Financial to risk personnel who have that authority to adjust or sector or size of the.

the Policy Framework for Investment (PFI) under the OECD Initiative on Investment for contributing to financial stability, investment and economic growth. The objective of the Policy Framework for Investment (PFI) is to mobilise private investment including the economic and financial crisis which started in , the What does the government do to enhance policy stability and predictability​? the financial cycle puts the financial stability policy framework to the test, it is due to fraud or mismanagement, herd behavior among investors, a sudden.