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