The Road to Macroprudential Policy in Latin America: Institutional Considerations
There is increasing recognition that the absence of macroprudential policies allowed financial vulnerabilities to grow unchecked, eventually contributing to the global crisis. In response, several countries in Latin America and elsewhere are reviewing their framework for financial stability to build stronger foundations for the implementation of macroprudential policies.
While most countries in the region have made substantial progress over the last decade to increase the soundness of their financial systems and their resilience to real and financial shocks, more might be needed in light of the lessons from the recent crisis. The latter shows that financial sector risks interact strongly with macroeconomic developments. Moreover, the experience in advanced countries shows that the distribution of risks can shift quickly, not least in response to existing and static regulatory constraints. Macroprudential policy is precisely aimed at addressing the resulting buildup of systemic risk.
This essay identifies the key issues that Latin American countries could take into consideration when building the institutional foundations for an effective implementation of macroprudential policies. Our analysis draws on Jácome et al, (2012) and on the conceptual analysis laid out in Nier et al, (2011). It focuses on two models for financial stability that exist in most Latin American countries. We call them the “Pacific” model (Chile, Colombia, Peru, and Mexico, among other countries) and the “Atlantic” model (Argentina, Brazil, and Uruguay).
While Latin America went through the recent global financial crisis relatively well, helped by strong terms of trade and the build-up of policy buffers ahead of the crisis, Latin America has historically been prone to large and recurrent financial crises. During 1970 to 2007, as many as 28 systemic banking crises occurred in the region and no large country remained immune to this disease.* In some countries banking crises occurred more than once, with Argentina leading this group with four episodes (1981, 1989, 1995, and 2002). In half of these events, a currency crisis also took place, and in nine of them a sovereign debt crisis occurred as well. From a worldwide perspective, Latin America is a region particularly prone to banking crises, only surpassed by Africa when measured in absolute numbers (see Figure below), and the region most affected on a crisis per country basis. Therefore, strong macroprudential policy frameworks are desirable in the region, just as much as in those countries that were hit harder in the most recent global crisis.
In the Pacific model, financial supervision and most regulations are performed by separated agencies other than the central bank, leaving the latter exclusively in charge of monetary policy, with limited regulatory powers. The level of integration of financial regulation and supervision into the various agencies varies across countries. Yet, in many cases, the central bank is responsible for specific financial regulations; for instance, licensing and registration of financial institutions and regulating their foreign currency positions. In addition, central banks are invariably in charge of reserve requirements.
The main characteristic of the Atlantic model is that banking supervision and regulation is conducted under the roof of the central bank. Surveillance of other areas of the financial system, such as insurance and securities markets, is typically performed by one or more other agencies, except in Uruguay where all financial regulation and supervision is fully integrated at the central bank.
Until recently, none of these two models had explicitly incorporated a mandate for preserving systemic financial stability, but some countries have introduced new legislation to strengthen the institutional underpinnings for the implementation of macroprudential policies.
By issuing an executive decree, Chile, Mexico, and Uruguay created financial stability committees with macroprudential responsibilities and, implicitly or explicitly, also with crisis management powers (see Box below). In turn, an internal regulation by the Central Bank of Brazil (BCB) created a financial stability committee within the BCB, comprised by all the members of its Board.
A strong macroprudential framework should be based on mechanisms to: (i) achieve effective identification, analysis, and monitoring of systemic risk; (ii) ensure timely and effective use of macroprudential policy tools, by creating appropriate mandates and assuring strong powers and accountability; and (iii) ensure effective coordination in risk assessments and mitigation, so as to reduce gaps and overlaps, while preserving the autonomy of separate policy functions.
At the same time, the establishment of a strong macroprudential policy function needs to work within the existing institutional environment and take key aspects of the structure as given. Since countries present different starting points for the development of a strengthened macroprudential policy function, a different set of priorities may be applicable in advancing the institutional foundations for macroprudential policy. We provide some suggestions below for countries organized under the Pacific and the Atlantic models.
The institutional separation that characterizes the Pacific model poses challenges for the successful identification and mitigation of systemic risk. This is because the relevant information, expertise and regulatory powers are distributed across agencies rather than being available to one organization. Moreover, accountability for the success of macroprudential policy is harder to establish when success depends on the cooperation of several agencies. This institutional structure finally confronts additional difficulties in devising arrangements that ensure cooperation while respecting the operational autonomy of the separate agencies.
The response to these challenges emerging across the region is the establishment of dedicated financial stability councils that bring together all relevant agencies, including the central bank, the prudential regulator of banks, potentially separate insurance and securities regulators, the deposit insurance institution (when it exists) and, typically, the government (i.e. The Treasury). While these arrangements are likely to be useful in fostering the exchange of information and facilitating cooperation in risk mitigation, a number of issues deserve closer consideration.
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In some cases, the council is given a function, to promote financial stability, which is not matched with adequate formal decision-making powers. A lack of legal powers makes it harder to hold the council formally accountable for the maintenance of financial stability. As a result, de facto, responsibility remains distributed across agencies. In order to address this, it will be useful to introduce, if possible, formal powers of direction in regards to specific macroprudential tools, such as the dynamic capital buffer introduced under Basel III. These would complement current powers to issue nonbinding recommendations to constituent agencies. To strengthen the force of such recommendations and to ensure follow-up, recommendations should be public and subject to a comply-and-explain mechanism.
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Careful design of the council’s macroprudential powers is particularly important where the primary objective of the regulatory agency is the protection of consumers (depositors) since this can result in conflicts with the objective of the council. In particular, such conflicts may strengthen the case for assigning to the council direct control over specific and well-designed macroprudential tools.
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This framework can then form the basis for a more clearly articulated accountability framework. Communications around specific actions can be supplemented by formal and regular reports on the risk assessments and activities of the council that could be issued and available to the legislature and the public at large. These reports should be prepared in coordination with the central banks’ financial stability reports.
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Another important issue is the appropriate role of the government. Participation of the government in macroprudential councils is useful to ensure the cooperation of the government when successful mitigation of systemic risk requires a change in the law (e.g. to expand the regulatory powers of prudential agencies, or when it requires a change in specific taxes or subsidies that foster the build-up of systemic risk.)
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However, a leading role of the government can pose risks, since macroprudential policy is subject to important political economy challenges that favor inaction or insufficiently forceful action in good times when risks are building up. A leading role of the government in the macroprudential council may also undermine the operational autonomy of constituent agencies or be seen to have the potential to reduce their independence, including the central bank’s (as in Chile).
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These difficulties can be mitigated when chairmanship of the council is given to the central bank, as it is the case in a number of countries outside of the region, such as Australia and the United Kingdom. As a second best option, the central bank may have a strong representation and concomitant strong voting powers in the council This is the case in Mexico, where the central bank has 3 seats on a 10-strong committee. A leading role of the central bank is useful not only to counter the adverse political economy pressures of macroprudential policy. It also harnesses the central bank’s expertise in systemic risk assessment as well as its strong incentives as the lender of last resort to promote financial stability and the mitigation of systemic risks.
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The government may claim a stronger role in committees whose function is coordination in times of crisis, since crisis management will often result in fiscal outlays. To square both demands, separating the arrangements for crisis prevention (macroprudential policy) and crisis management will be useful in many cases.
In countries where the starting point is the Atlantic model there is also room for improvement.
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It is important to clarify the legal mandates for macroprudential policy, establishing that the objective of monetary policy is price stability while the objective of macroprudential policy is financial stability. Where the mandate and its key objectives are not clearly defined it is difficult to assign strong regulatory powers, and to design a framework to hold the policymaker accountable for policy decisions. It would therefore seem desirable to introduce the pursuit of financial stability as the main objective of the central bank’s actions in supervision and regulation.
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A clear delineation of the respective objectives of the two policy fields can then help in developing strong, but separate, accountability frameworks for both monetary and regulatory policy. Because macroprudential policy manages a tail-risk, rather than a continuously observable outcome such as inflation, accountability frameworks for macroprudential policy will need to be different to some extent from those developed for monetary policy. Nonetheless, a number of key elements can be “borrowed” from those frameworks, including communicating key deliberations that led to particular policy decisions, issuing regular reports to the legislature and the public that assess the key sources of systemic risk, evaluating the effectiveness of past actions taken to manage systemic risks, and outlining the policy agenda to deal with new or remaining risks. A good vehicle to lay out this analysis and to better explain the decisions of macroprudential authorities is a (remodeled) financial stability report.
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Setting up a financial stability committee within the central bank structure that is distinct from the monetary policy committee can help further clarify the distinct roles of the central bank in maintaining price and financial stability. In addition, where the central bank does not have regulatory control over all relevant financial institutions and markets, such as when there are separate insurance and securities regulators, as in Argentina and Brazil, the separate agencies can be admitted as members of such a committee. This can help establish regular access to information on nonbank financial institutions and markets. It can also help risk mitigation efforts, allowing the authorities to develop a coherent macroprudential strategy that extends to nonbank-financial institutions as necessary.
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Participation of the government in a financial stability committee is useful. However, just as discussed for the Pacific model, a leading role of the government in such a committee (as in Uruguay and Brazil) poses risks since it could potentially undermine the independence of the central bank.
In sum, dedicated arrangements to underpin macroprudential policy are desirable and feasible both under the Atlantic and the Pacific models. They should combine a clear mandate that is distinct from both monetary policy and crisis management, with strong powers and appropriate arrangements to ensure accountability for macroprudential policy. While some progress has already been made, much remains to be done to establish such frameworks across Latin America. Crisis prevention can have substantial benefits; establishing strong frameworks should be made an important priority now.
*The authors borrow the definition of systemic financial crises from Laeven and Valencia (2008).
Disclaimer: Any opinion and conclusion expressed here are those of the author and do not necessarily represent the views of the International Monetary Fund.
References
Jácome, Luis I., Erlend W. Nier, and Patrick Imam, 2012, “Building Blocks for Effective Macroprudential Policies in Latin America: Institutional Considerations,” WP/12/183, (Washington: International Monetary Fund).
Laeven, Luc and Fabian Valencia, 2008, “Systemic Banking Crises: A New Database,” IMF Working Paper 08/224 (Washington: International Monetary Fund).
Nier, Erlend W. Jacek Osinski, Luis I. Jácome, and Pamela Madrid, 2011, “Towards Effective Macroprudential Policy Frameworks: An Assessment of Stylized Institutional Models,” IMF Working Paper 11/250 (Washington: International Monetary Fund).
