Changing Pro-cyclicality for Financial and Economic Stability Zhou Xiaochuan   Much has been discussed on the root causes for the current financial crisis, including but not limited to lessons on monetary policy, financial sector regulations, accounting rules. This note aims to stimulate debate and discussions on some of the pro-cyclical features in the system, possible remedial measures, and how monetary and fiscal authorities can play their professional roles at times of severe market distress. It also touches upon China´s financial sector reform and macroeconomic policy to counter slowdown in economic growth. The major points here were presented at the G20 Meeting of Finance Ministers and Central Bank Governors in San Paulo, Brazil on November 15, 2008.   1.    The built-in pro-cyclical features in financial architecture   When we discuss system stability, we can borrow some concepts from electronic engineering or control theory. In a complicated system, there are usually many feedback loops, some of them are positive, some of them are negative. A positive (plus) feedback loop enlarges amplification (like multiplier), tends to create oscillation (like boom and bust pro-cyclicality) and zero-point shifting (like a reference of bubble). While a negative (minus) feedback loop can reduce amplification, help for system stability and self-correction of zero-point. In economic and financial systems of recent years, we have too many positive feedback loops on macro and micro levels, and a small number of negative feedback loops. Thus the system shows a strong pro-cyclicality. What we need to do is not to totally rebuild the system, but to add a few negative feedback loops, which are able to sufficiently change the characteristics of our system.   Financial crises normally originate in the accumulation of bubbles and their subsequent bursts. Usually, economists pay a lot of attentions to pro-cyclicality on the macro level. However, on the micro level, there are quite a number of notable pro-cyclical features embedded in the market structure today, which should be addressed as we deal with the current crisis and reform the financial system. In the current market structure, more counter-cyclical mechanisms or negative feedback loops on micro-level should be put in place to sustain a more stable financial system.   1)    Rating problems and herding phenomenon arising from outsourcing   The global financial system relies heavily on the external credit ratings for investment decisions and risk management, giving rise to a prominent feature of pro-cyclicality.  The rating industry is dominated by a few large players, which provide practically all important rating services. Specific ratings from the big three tend to be highly correlated and they are combined to form a strong cyclical force. Economic upswings produce euphoria and downturns generate pessimism.  Many market players adopting ratings from the three agencies and using them as the yardstick for operations and internal performance assessments clearly result in a massive "herd behavior" at the institutional level. Moreover, the rating process is filled with conflicts of interest by virtue of the issuer-paying business model (issuers also pay for the rating agencies´ advisory services on structuring their products, which leads to more problems). Moreover, the rating models for mortgage-related structured products are fundamentally flawed. During the current crisis stemming from the subprime mess, the high ratings assigned to many subprime products and the massive downgrades of them within short period were unprecedented, which drove the massive write-downs by financial institutions, and exacerbated downward spirals.   Herding phenomenon can also be explained as too many positive feedback loops to cause an oscillation. In investment area, we always preach on the virtue of diversification. Portfolio diversification means when you bet for upside in some products, you should also place protection elsewhere for downside. Investor diversity and heterogeneity is predicated on the notion that market needs both optimists and pessimists. Thus the system should not encourage all investors and their portfolios to behave in the same way. However, too many financial institutions outsourced the development of their internal control systems and the technical models used by their bankers and traders in internal assessment and risk control, including the program trading models that had been widely adopted at an earlier time. Outsourcing of system technologies at such a prevalent scale contributed to high degree of homogeneity in the financial system, which strongly added to pro-cyclicality. For complex financial products, most institutions use models built by a handful of quantitative analysts that get widely adopted throughout the industry. Such models tend to produce similar directional results at the same time when certain conditions prevail. In other words, outcomes from such models are highly correlated. When they are used by the whole financial industry world-wide, asset price boom is made much stronger and bust much more damaging. And due to high synchronizations of market participants´ behaviors as a result of using the similar models, systemic risk arises. Regulators should require systemically important financial institutions to complement external pricing models with internally developed capabilities to exercise judgment. In addition, to give issuers of structured products more incentives to better assess their risks, regulators should ask them to retain a meaningful share of the underlying assets on their balance sheets in order to alleviate the myriad of problems associated with the "originate-to-distribute" business model, including moral hazards and fraudulent loan underwritings.   On the users´ side of ratings, there is the long-standing moral hazard issue. Various rules have required investment management decisions and risk management practices to be benchmarked on financial instruments attaining certain ratings from the so-called Nationally Recognized Statistical Rating Organizations (NRSRO). This practice has enabled industry practitioners to piggyback on the external ratings and not to worry about the inherent risks once the instruments have achieved the threshold ratings.  Over time, the financial industry has become accustomed to the practice and become complacent of the ratings they rely on so heavily. Some market players seem to have forgotten that the ratings are no more than indicators of default probabilities based on past experiences but were never meant to be guarantees for the future. Along with complacency, there is inertia and sloppiness on the part of investment managers to ask tough questions about the inherent risks of instruments sitting in their portfolios. Once problems take place, as we have seen during the current crisis, fingers are pointed to the rating agencies. The institutional users (e.g., the money managers and financial institutions) of credit ratings should be ultimately accountable to their customers and shareholders and should exercise their own judgment of risk, not just outsource risk assessment duties to the rating agencies. To the extent they have to use external expertise, internal and independent judgment has to be deployed as a complement.  As a matter of fact, the problem has become so serious that regulators need to encourage financial institutions to enhance internal rating capability to rely less on external ratings, and that central banks and regulators should impose requirement whereby use of external ratings should not exceed 50 percent of business activities, at least for systemically important financial institutions. Internal capabilities should be developed to exercise independent judgment on credit risks at such organizations.   2)    Fair value accounting, mark-to-market and mark-to-model   Both IFRS and GAAP require mixed value measurements of different type of assets and liabilities according to their features and the management´s intentions of holding them, i.e. assets on the trading book and available-for-sale assets should be measured on the fair value basis, while hold-to-maturity assets, loans and liabilities without an objective fair value should be recorded at historical costs.   GAAP and IFRS define fair value in a similar way, which is a price at which an asset and liability can be traded with a willing counterparty in an orderly manner. Both accounting frameworks provide measurement approaches at differentiated levels. Level 1: prices can be observed on active market, which are used to measure the value of assets and liabilities, a practice called mark-to-market. Level 2: when there is no active market, prices are assessed by using models with observable parameters as inputs, a process called mark-to-model. Measurement approach used on level 3 is similar to the mark-to-model approach, but it involves unobservable parameters and model assumptions as inputs.  Both IFRS and GAAP require disclosure of the adoption of fair value approaches and specific assumptions as well as risk exposures and sensitivities.   The problems of fair value accounting have been exposed by the current crisis. First, compared with the historical cost approach, fair value accounting intensifies market fluctuations. While the fair value approach is more dynamic and can better reflect the real time value of assets and liabilities, it also magnifies the changes in their values and increases the volatility of returns through the profit and loss account as a consequence. As a result of the massive collateralized securities they held, financial institutions registered mounting unrealized losses which actually involved no cash flow under the fair value rule. Though these losses were only meaningful in accounting, such astronomical book losses distorted investors´ expectations and formed a vicious cycle of prices tumbling - asset write-down ¨C panic selling ¨C further prices slumps. Second, the poorly guided adoption of fair value in non-active markets exacerbated market volatility. As defined, the using of fair value approaches must be based on the prerequisite of orderly trading. At times of crisis, as a large number of institutions were forced to liquidate their assets, prices developed under this situation did not meet the prerequisite for fair value measurement. However, due to the lack of specific guidelines on dealing with such circumstances, reporting entities had to conduct fair value measurement on the basis of unreasonable market prices, which magnified book losses and exacerbated the vicious cycle.   We could say, in a normal situation or in a low frequency band, mark-to-market is a negative feedback loop. However, in an extreme situation or high frequency band, mark-to-market mechanism can not catch the changing phase. When phase lag is larger than 90º, a negative feedback loop can become a positive feedback loop in characteristics. In this situation, what we need to do is to cut off this loop, thus we need a circuit breaker. We can resume the system when it returns to normal condition. In economic system, we need to put into place a sort of circuit-breaker mechanism to stem the pro-cyclicality caused by mark-to-market and fair value accounting in specific situations.   3)    Internal rating based (IRB) approach under Basel II   The New Basel Capital Accord (Basel II) released in 2004 improved the capital adequacy ratio framework, shifting from singular requirement on capital adequacy to highlighting the importance of risk-based banking supervision, and including minimum capital as one of the three pillars of banking supervision (regulatory capital requirement, regulatory responses, disclosure and market discipline). Under Basel II, the minimum capital requirement of 8 percent was unchanged, but the notion of risk weighted asset was improved to reflect not only credit risks, but also market risks and operational risks. Following the release of the Basel II, major economies have outlined steps and the timetable for its implementations, and major European countries have basically implemented the new Accord. China is also making preparations for implementing it.   The Basel II framework allows financial institutions to apply internal rating-based approach in pricing and assessing risk of complex products.  Risk weights for purpose of capital adequacy calculation are derived from internal modeling.  Such weights are generally low and lead to high capital adequacy ratio (CAR) during economic upswing, and are high and lead to low CAR during cyclical downturn, everything else equal.  As a result, financial institutions tend to have high leverage ratios during good times and have to deleverage during bad times. This amplifies bubble buildup during upswings and leads to credit squeeze and asset dumping during downturns, thus increase cyclical volatilities. This reflects a strong pro-cyclicality. We took notice that FSF has formed working groups to cooperate with BCBS in studying ways to strengthen Basel II framework, and to address its weaknesses revealed during the crisis including its pro-cyclicality.     2.    Give full play to the professional role of authorities of overall financial stability and establish a counter-cyclical mechanism for capital requirement   Among the supervisory requirements on financial institutions, banking institutions in particular, capital adequacy ratio is one of the most important prudential requirements. The current financial crisis suggests that a sound capital buffer is critical for banks´ resilience to risks and financial stability in a broader sense. Effectively addressing the pro-cyclicality elements in the existing capital requirement framework is essential for avoiding a repetition of serious financial crisis. The on