Although systemic risks are understood much better today, the search for appropriate regulatory actions has not ended – far from it. The latest developments in some highly indebted industrialised nations and the massive capital inflows in some emerging economies make it clear just how important it is to take a macro-economic view of systemic risks.

Global and European level

At the global level, the International Monetary Fund (IMF) and the Financial Stability Board (FSB) have assumed the task of overseeing the situation and development of risks within the global financial system. In this context, the IMF’s primary focus is on identifying macro-financial risks, i.e. especially on the interaction between the real economy and the financial sector.

In the European Union, macro-prudential oversight is the task of the European Systemic Risk Board (ESRB), which took up its work at the beginning of 2011. It brings together the expertise of the European central banks and supervisory authorities with the aim of identifying and measuring systemic risks, issuing warnings as appropriate, and recommending which measures should be taken to avert risks posed to financial stability.

At the beginning of 2012, the ESRB proposed the establishment of macro-prudential authorities or bodies at the national level, arguing that for efficient national macro-prudential supervision there needs to be a clearly defined scope for action; the ESRB therefore recommends a legislative basis for this. It is to define the aims of macro-prudential supervision, appoint one or more competent authorities and specify transparency and accountability obligations.

Act on the oversight of financial stability

Germany has implemented this ESRB recommendation with the Financial Stability Act (Gesetz zur Überwachung der Finanzstabilität – FinStabG). This Act is mainly concerned with strengthening co-operation of the Deutsche Bundesbank, BaFin and the German Ministry of Finance (BMF) in the area of financial stability. The establishment of the Financial Stability Commission (FSC – see info box) in particular marks an institutional integration of ongoing macro-prudential oversight carried out by the Bundesbank with the micro-prudential supervision carried out by BaFin.

The FSC is made up of members from the German Ministry of Finance, the Bundesbank, BaFin and – without a voting right – the Financial Market Stabilisation Agency (FMSA). The key task of the FSC is to regularly discuss the matters of decisive importance for financial stability based on analyses of the Deutsche Bundesbank, to issue warnings of risks when these are identified and to make recommendations on how to avert such risks.

Cross-Sectoral Risk Committee of BaFin

To fulfil the new tasks arising for BaFin under the Financial Stability Act, the Authority at the beginning of 2013 grouped the (until then directorate-specific) risk committees into a BaFin-wide Cross-Sectoral Risk Committee. This better underscores the cross-sectoral view of integrated financial services supervision. With the help of the Cross-Sectoral Risk Committee, macro-prudential system supervision is to be more closely interwoven with micro-prudential supervision of individual market participants. In addition, the Cross-Sectoral Risk Committee is to facilitate forward-looking and risk-oriented control by BaFin.

The BaFin Cross-Sectoral Risk Committee is primarily involved in the task of identifying, measuring, monitoring and managing risks of the supervised undertakings or of the financial sector of relevance to all BaFin directorates. Such risks are to be identified by BaFin-internal and external analyses, for example by the Bundesbank and by auditors, as well as by cross-comparisons of the companies. The objective is to assess the relevant risks and to take them into account in ongoing supervision.

Moreover, the Cross-Sectoral Risk Committee supports the work of the BaFin Executive Board by identifying and presenting supervisory issues as well as preparing the meetings of the Financial Stability Commission together with the Bundesbank.

The Cross-Sectoral Risk Committee is made up of representatives from all BaFin directorates and meets quarterly. The permanent members of the Committee also include representatives of the Bundesbank from the central business areas Banking supervision as well as Financial stability. A secretariat located close to the President’s office serves as an interface between the Executive Board, the Cross-Sectoral Risk Committee, the secretariat of the FSC at the Federal Ministry of Finance and the Bundesbank.

Co-operation between institution or company supervision and macro-prudential system supervision by the FSC is as follows: As a rule, institution or company supervision is responsible for gathering data and for staying in contact with the supervision subjects. It monitors the risks of the individual companies and ensures that they adhere to the provisions of supervisory law. The FSC also gathers and analyses data, but from a system-wide perspective. By issuing recommendations, it indirectly exercises an influence over the use of macro-prudential instruments; in Germany and in many other jurisdictions, these instruments are in the hands of institution supervision.

Comprehensive view of financial system

In order to judge in what areas the financial system is susceptible to crises, a comprehensive view of financial risks is needed. Its assessment depends to a great extent on the quality of the underlying data and how up-to-date such data are. Particularly in the shadow banking system, gathering such data continues to be difficult. This area includes companies pursuing banking-related business activities, such as lending or liquidity transformation, but which are not subject to banking supervision.

Providers of market infrastructure and services, i.e. payment systems, clearing and invoicing companies as well as central counterparties are also of key importance for the functioning of the system and can become a source of systemic risks. That is why a comprehensive assessment of weaknesses within the financial system should include non-bank financial institutions as well as private households and companies.

Macro-prudential instruments

Efficient macro-prudential supervision requires not only a clear regulatory framework but also effective and efficient instruments. Depending on the degree of intervention, macro-prudential instruments can generally be divided into soft (communication), moderate (warnings and recommendations) and hard (intervention) instruments.

As a soft instrument, public communication does not directly interpose in the business operations of market participants but especially has an influence on their expectations. It is therefore appropriate at an early stage of risk build-up. However, public communication will likely no longer suffice when a risk to financial stability becomes more acute. In that case macro-prudential supervision can resort to the instruments of warnings and recommendations that are relevant for the FSC and ESRB. Instruments of intervention such as additional capital buffers or higher risk weightings for certain loan receivables make up the category of hard instruments.

Differentiation by type of systemic risk

Alternatively, macro-prudential instruments can be classified in terms of the type of systemic risks. Here, a distinction is made between systemic risks of the time dimension and those of a cross-sectional dimension. The time dimension refers to the development of risks over time (reduction of procyclicality), whereas the cross-sectional dimension describes the distribution of risks at a given point in time or risk concentrations within the system.

At the international level it is being discussed what measures could be used to reduce the cyclical component (time dimension) of systemic risk. Some of the possibilities under discussion here include time-variable capital and liquidity requirements, introducing a cap on indebtedness, possibilities of increasing risk weightings for specific classes of receivables, adjusting the requirements to be met by loan collateral, and providing for a dynamic component in credit risk provisioning. Instruments aimed at systemic risks of the cross-section dimension notably include additional capital add-ons for systemically important financial institutions (SIFIs), key liquidity ratios to promote stable sources of refinancing as well as measures relating to market infrastructure.

Outlook

The macro-prudential regulatory framework will change significantly over the next few years. This will also affect the work of the FSC and the Cross-Sectoral Risk Committee. For example, the recently adopted CRD IV package, consisting of a directive (Capital Requirements Directive – CRD IV) and a regulation (Capital Requirements Regulation – CRR), will transpose, among other things, Basel III in Europe and thus once again expand the set of macro-prudential instruments in the EU.

Oversight of the entire financial system is a new element of the supervisory regime that is still being established. How successful the newly created authorities and bodies are will depend to a decisive extent on the institutional strength of the supervision, the effectiveness of its instruments and the quality of its analyses.