The aftermath of the Italian referendum sheds an insightful light on the latest financial stability report of the ECB.

We suggest that the ECB – and central banks in general – are using their supevisiory position to justify additional policy actions. This leads to acute governance questions that we continue to address in this post (macro-prudential supervision, financial stability) and the next one (micro-prudential supervision, banks).

We challenge the conclusions of the ECB by inverting the causation of its rationale: most of the financial stability risks identified in the report, in particular the risk repricing that is currently taking place, have been speeded up by unconventional monetary policies.

Much more than a free license to pursue them, we argue that financial stability risks can be seen as the cost of weird public policies.

Please consider ‘Global risk repricing endangers financial stability’, the latest Financial Stability report of the ECB, or its ‘press briefing’ for a quicker take.

The ECB identifies 4 main risks to financial stability:
(emphasis ours)

  • Global risk repricing leading to financial contagion, triggered by heightened political uncertainty in advanced economies and continued fragilities in emerging markets
  • Adverse feedback loop between weak bank profitability and low nominal growth, amid challenges in addressing high levels of non-performing loans in some countries
  • Re-emerging sovereign and non-financial private sector debt sustainability concerns in a low nominal growth environment, if political uncertainty leads to stalling reforms at the national and European levels
  • Prospective stress in the investment fund sector amplifying liquidity risks and spillovers to the broader financial system

Before digging into the report, a look at the supevisiory mission of the ECB seems necessary:

The European Central Bank is responsible for the prudential supervision of credit institutions located in the euro area and participating non-euro area Member States, within the Single Supervisory Mechanism, which also comprises the national competent authorities. It thereby contributes to the safety and soundness of the banking system and the stability of the financial system within the EU and each participating Member State.’

As we all know the ECB is also in charge of maintaining price stability by running its monetary policy, a responsibility that can be conflicting with its supervisiory mission:

‘We at the European Central Bank are committed to performing all our tasks effectively. In so doing, we strive for the highest level of integrity, competence, efficiency and accountability. We respect the separation between our monetary policy and supervisory tasks. In performing our tasks we are transparent while fully observing the applicable confidentiality requirements.’

Here we are:
– what separation?
– under which control ?
– what is the adequate level of transparency? Why not a straight full transparency?
– who sets the applicable confidentiality requirements?

We claim that this set of responsibilities is fundamentally conflicting. We argue that central banks face moral hazards when financial markets, banks or credit institutions under their supervision hinder monetary efficacy. As evidenced by numerous stress tests, stability reports and policy statements, this leads to poor or biased information that can ultimately contradict with financial stability.

 

That’s precisely how we understand the latest stability review.
Let us look at some of the issues listed in the report:


“Global bond yields, in particular, have remained low in the past six months, benefiting from accommodative monetary policies and less anxiety about the likelihood of a sharp economic slowdown in emerging economies. In the latter part of the review period, bond yields in advanced economies increased somewhat against the backdrop of expected fiscal stimulus in the United States. In an environment of overall subdued yields on debt instruments, investors have gradually been taking on higher credit and duration risk in their portfolios. This has been the case not only for investment-grade bonds, but also riskier segments of global fixed income markets, which have benefited from the recovery in oil and other commodity prices from the very low levels recorded in early 2016.
The prices in some equity markets are showing signs of stretched valuations. Valuation measures – including the cyclically adjusted price/earnings ratio (CAPE), arguably the best indicator of valuation based on earnings – are in some regions hovering at levels which, in the past, have been harbingers of impending large correctionsRisks of further asset price corrections remain high and may be amplified by high correlations between asset classes.”

We couldn’t agree more. Or maybe yes: to a large extent these risks have been engineered by unconventional policy measures themselves.

Here is how the ECB plans to tackle them:


Macroprudential policies are best placed to tackle challenges that could pose threats to financial stability, not least given their country and sector-specific characteristics. 
Such policies can bolster systemic resilience and curb financial excesses that may occur, thereby allowing monetary policy to focus on its primary objective of maintaining price stability – also to the benefit of financial stability. Determining the need for macroprudential action targeting the residential real estate market involves the review of a broad set of indicators including prices and valuation indicators, trends in mortgage credit growth, household indebtedness, the economic outlook and banks’ exposure to real estate markets.

Macroprudential policies, while powerful counter-cyclical strategies, should not be used as an additional monetary justification.

Assuming UMPs have contributed to systemic risks – a view that is obviously not shared by policy makers – this approach could be spiralling down instead of supporting financial stability and monetary policy.

 

We suggest:
– Macroprudential supervisiory objectives, while powerful counter-cyclical strategies on their own, should not be used as an active policy weapon.
–  By doing so, the ECB is making a severe governance failure …
– … that will ultimately spiral down into renewed ‘unexpected consequences‘.
– Most of the financial stability risks listed in the report have been generated by public policies themselves.

By trying to dampen past problems with newer tools the ECB is simply doubling down.

Again.

 

Jacques

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