A CONCEPTUAL FRAMEWORK FOR MACRO PRUDENTIAL POLICY Jean-Charles ROCHET (IDEI, Toulouse University, France) PREPARED FOR THE IADB-ATLANTA FED Conference “Toward Better Banking in Latin America” Washington D.C., Sept 30, 2005

1-INTRODUCTION Safeguarding financial stability has become a major preoccupation of public authorities Macro-prudential regulation (how to deal with systemic banking crises) is considered to be a fundamental element of this financial stability Academic literature has so far focused on micro-prudential regulation (how to deal with financial problems of individual banks): deposit insurance, capital requirements, lender of last resort

1-INTRODUCTION (2) This paper proposes to extend the conceptual framework to include as well macro-prudential regulation We develop a stylized model of a banking industry where banks collect deposits and invest in industrial projects that need to be monitored Deposits are insured by a Deposit Insurance Fund (DIF), financed ex-ante by actuarial premiums Banks are regulated ex ante by a Financial Service Authority (FSA) who imposes a minimal capital requirement

1-INTRODUCTION (3) For micro prudential purposes, liquidity shocks can be managed optimally by an ex-ante liquidity requirement and a system of multilateral credit lines commitments between banks. If liquidity shocks have a common component (macro shock), the CB is needed as a LLR and its collaboration between the FSA, the DIF and the Treasury has to be carefully designed.

PUNCH LINE OF THIS PAPER: deposit insurance and capital requirements are not enough regulatory/supervisory systems should be reformed, so as to deal properly not only with individual bank failures (micro- prudential regulation) but also with systemic crises( macro-prudential regulation)

PUNCH LINE(2): Central bank independence for monetary policy should be extended to lender of last resort activities Liquidity assistance to the banks in trouble should be provided under the strict control of independent supervisory authorities

PROPOSITIONS (1): The main reason behind the frequency and magnitude of recent banking crises is not deposit insurance, bad regulation, or incompetence of supervisors. It is the commitment problem of political authorities, who are likely to exert pressure for bailing out insolvent banks and delay crisis resolution. The remedy to political pressure on banks supervisors is not to substitute supervision by market discipline: market discipline can only be effective if absence of government intervention is anticipated.

PROPOSITIONS (2):. Instead the way to restore credibility is to ensure independence and accountability of bank supervisors The other key reform is to restrict liquidity assistance by the central bank to the banks with low exposure to macro shocks, that are backed by the independent supervisors (alternative: cap on macro exposure). Supervisors should be in charge of selecting these banks, who then would face a capital requirement and a deposit insurance premium that both increase with their macro exposure

PROPOSITIONS (3): By contrast, banks with a too high macro exposure should not be backed by the supervisors and should not receive liquidity assistance in case of macro shocks Central bank loans should be insured by the DIF.