Covid-19: Financial Stability Committee and its macroprudential tools and objectives

All opinions are solely mine and not institutions I am affiliated to.

In my recent article I have presented some basic information about the Financial Stability Committee. As I promised today we will go through tools and objectives of this part of safety net. The FSC has two important roles: (i) macroprudential guardian and (ii) financial and economic crisis manager. Let’s take a quick look on the first role and available tools and see whether we should expect the FSC in its crisis management role. 

According to the article 1 of the Act a macro-prudential supervision covers the identification, assessment and monitoring of systemic risk arising in the financial system or its environment and actions aimed at eliminating or reducing this risk with the use of macroprudential instruments. As we will see further this means that the FSC may recommend a target level of various capital buffers, i.a. countercyclical buffer. 

One may ask how the FSC should achieve stable financial system and economy. The act does not include a list of intermediate objectives of the macro-prudential policy. Such objectives are “required” by the ESRB according to the Recommendation ESRB/2013/1[1]. Such goals can be, however, found in the FSC’s strategy (click) and basically reflect those approved by the ESRB. The macroprudential authority should: 

1. Avoid and prevent risk arising from excessive growth or level of debt or leverage (mainly – countercyclicality);
2. Avoid and prevent risk resulting from excessive mismatch (assets versus liabilities plus liquidity)
3. Avoid and prevent risk resulting from excessive concentration of exposures and linkages (interconnectedness); 
4. Avoid and prevent risk arising from misaligned incentives (excessive risk-taking or moral hazard – including good remuneration policies); 
5. Avoid and prevent risk arising from insufficient resilience of the financial infrastructures. 

The FSC has four tasks (article 5) that are aligned with the objectives described above. 

Systemically Important Institutions

Taking into consideration that macro-prudential supervision is aimed at protecting financial system, one of the FSC’s tasks is to identify financial institutions which may pose a significant systemic risk for the financial system, as such institutions are potentially dangerous due to the existing interconnectedness[2] between banks, as the case of Lehman Brothers showed in the past[3]. Therefore, the FSC issues the opinions on identification of the global systemically important institutions and other systemically important institutions. Such opinions are important and mandatory requirement for the Polish Financial Supervision Authority that wish to adopt a decision whether to assign entity to one of the groups (Global-Systemically Important Institutions + VI categories or Other-Systemically Important Institutions). The full list of institutions can be found here.

Macro-prudential supervision requires effective tools to achieve its goals. Therefore, the FSC are equipped with some macro-prudential instruments, e.g. official positions and recommendations. This is the second task. 

As a third task the Act provides a close cooperation with the ESRB, other European Union institutions, macro-prudential supervision authorities and international organization. In that context the FSC will be responsible for notifying the ESRB and the European Commission on various matters, like the capital buffer rates or reciprocity measures. 

The FSC is also responsible for providing sufficient exchange of information between members of itself (during its meetings and on a daily basis. 

Macro-prudential supervision instruments at hand – primacy of the soft law?

Effectiveness of the macro-prudential policy depends on various factors. It requires internal and external coordination[4] and cooperation, even if is conducted only on a national level. One of the preconditions for effective macro-prudential authority is sufficient set of instruments which authority may use to influence the market and its participants (and of course other institutions and bodies). As IMF noticed “country authorities have used a variety of policy tools to address systemic risks in the financial system”[5]. To reach macro-prudential objectives authorities use not only typical instruments such as capital buffers or LTV indicators, but also fiscal and monetary tools. 

Today’s global market forces macro-prudential authorities to use non-standard measures which have to be adopted and implemented without a delay. Typical “hard law ordinarily gives rise to enforceable obligations and therefore has to be reasonably certain and predictable so that people can determine what is expected of them”[6]. The main constrain of the hard law is that process of adoption is time-consumable and burdensome in an administrative sense and what is really important – it generates significant costs[7]. Therefore soft law becomes “(…) accepted as being important for sound, stable and well-functioning financial systems”[8].

Soft law

Soft law can be defined[9], as Senden suggests, as “rules of conduct that are laid down in instruments which have not been attributed to a legally-binding force as such, but nevertheless may have certain indirect legal effects that are carried out and may produce practical effects”[10]. Zerilli proposed to call soft law as “non-binding coercions” and this definition seems to be most proper[11]. Soft law does not have a direct effect and it cannot impose legally binding obligations on the addressees. Main purpose of soft law is to “force” the addressee to comply with the rule and to reach a particular objective without using a hard law enforcement. Such approach has useful advantages – it is less burdensome, cheaper and flexible, while hard law is strict and expensive. Its adoption usually takes time and effort. 

Global financial markets with all the innovations and financial engineering are not the same as 20-30 years ago. Nowadays, environment and in particular financial regulations changing rapidly. Authorities have to react in a line with such trends and reply properly (and predictably) as well. This is one of the reasons why significant number of macro-prudential authorities decide to apply soft law instruments instead of hard law. 

Macro-prudential soft law is very specific. It “could take the form of general guidelines or specific recommendations on the use of certain prudential tools – macro-prudential instruments”[12]. Indeed, for example at the EU level the ESRB issues recommendations on adjustment of capital buffer rates, reciprocity etc. which significantly supports micro-prudential authorities[13]. Such recommendations are also complementary to hard law provisions, like the CRDIV.   

Tools

In Poland, mainly due to constitutional constraints, the FSC has been “equipped” with two soft law instruments: positions (stanowiska) and recommendations (rekomendacje). The positions are rather general, while recommendations are more specific. 

The FSC may issue a position if the source of the systemic risk has been identified within the financial system or its environment. Such instrument has to include information about a type of risk, its range and expected consequences for financial system and is addressed to the FSC’s institutions or entities creating the financial system. Positions are not binding and should be treated as the “early warning” alert rather than legal instrument with potential to force any of the addresses to undertake a particular action. However, their role might be very important while such entities would be able to sufficiently prepare to potential shocks on the financial markets. 

Second FSC’s instrument seems to be more effective. Recommendations are solely addressed to relevant institutions comprising the FSC in the event that it is indispensable to undertake actions aimed at limiting systemic risk. Such recommendation may contain a deadline for the action if the FSC considers it necessary (one of the examples is recent recommendation to lower systemic risk buffer). 

To be continued… 

[1] Recommendation of the European Systemic Risk Board of 4 April 2013 on intermediate objectives and instruments of macro-prudential policy (O.J. EU 2013/C 170/1).

[2] IMF, Understanding Financial Interconnectedness, October 4, 2010. “Countries are financially interconnected through the asset and liability management (ALM) strategies of their sovereigns, financial institutions, and corporations. This financial globalization has brought benefits as well as vulnerabilities. In particular, the speed with which illiquidity and losses in some markets can translate into global asset re-composition points to the risks of interconnectedness”. 

[3] Wiggins, R. Z., Piontek, T., Metrick. A (2014): The Lehman Brothers Bankruptcy, Yale Program on Financial Stability Case Study 2014-3a-v1, Ooctober 1, 2014.

[4] IMF, Key Aspects…, op.cit., p. 1.

[5] IMF, Understanding Financial…, op.cit., p.8.

[6] Eilis, F., Kern A., Can Soft Law…, op.cit., p. 6.

[7] Shaffer, G. C., Pollack, M. A. (2010): Hard vs. Soft Law: Alternatives, Complements, and Antagonists in International Governance, Minnesota Law Review 94:706, p. 718.

[8] Manger-Nestler, C. (2011): Impacts of International Law on the Restructuring of the Global Financial Systems, Max Planck Yearbook of United Nations Law, Volume 15, p. 188.

[9] Mather, G. (2010): Is soft law taking over? The perils and benefits of non-traditional legislation, European Policy Forum, 20 October 2010, p. 4.

[10] Senden, L. (2005): Soft Law, Self-Regulation and Co-Regulation in European Law: Where do they meet?, Electronic Journal of Comparative Law Vol 9.1, January 2005, p. 22. 

[11] Zerilli, F. M. (2010): The rule of soft law: An Introduction, Focaal—Journal of Global and Historical Anthropology 56, p. 4.

[12] Głuch, D., Škovranová, L., Stenström, M. (2013): Central Bank Involvement in Macro-prudential Oversight, ECB, Legal Working Paper Series No 14, p. 6. 

[13] However, ESRB case is a bit specific since recommendations are generally addressed to the Member States or authorities.