1. Micro and Macro Prudential Perspectives of Financial Stability Mario Bergara Managing the Capital Account and Regulating the Financial Sector: A Developing Country Perspective UNDESA – IPD - IPEA, Rio de Janeiro, August 23, 2011

2. The relevance of Financial Stability in a context of Macroeconomic Stability Price Stability Sound financial system Well-functioning payment system They contribute to generate credibility and long term perspective, allowing a better decision-making on savings, credit and investments. A healthy financial sector channels those decisions more efficiently. A proper Financial Safety Net reduces the system’s vulnerability. They complement social policies, by protecting the poor: lower income population has less ability to fight the effects of high inflation and financial crisis. Micro and macro prudential perspectives of Financial Stability

3. The importance of economic and financial stability No experiences showing economic and social development in contexts of macroeconomic and financial disorder. The largest declines in production and the largest rises in poverty are linked to bank runs and macroeconomic crises. Disconsidering price and financial stability is disconsidering their impacts on: Production Employment Income of households Poverty Inequality Consolidation of proper values in society Micro and macro prudential perspectives of Financial Stability

4. The need for consistency among macroeconomic policies Financial Stability Micro and Macroprudencial Regulation Monetary policyFiscal Policy Identifying relevant systemic risks and addressing externalities Monetary and fiscal policies can help to mitigate costs of aggregate weaknesses and individual failures The ability to use monetary policy is limited in countries facing short term currency appreciation pressures Micro and macro prudential perspectives of Financial Stability

5. Some lessons from the financial crisis: What are we discussing? Current discussion influenced by the situation in developed countries The lack of a macro-systemic approach was clear, but was the microprudential regulation working properly? Failure of the regulatory approach and of the organizational design of financial regulation The decentralized governance failed as well as the “light supervision” approach The focus on the macroprudential issue will be fruitful only if it does not imply that the microprudential regulation was doing its job Micro and macro prudential perspectives of Financial Stability

6. Some lessons from the financial crisis: What are we discussing? A possible (dangerous) lesson from the crisis: “Everything was right except that the macroprudential approach was lacking” Supervision was poor and the organization of the Financial Safety Net was inaccurate in some places and chaotic in others From Financial Safety to Financial Stability: both micro and macro prudential perspectives are essential Regulation should be determined by the assessment of risks, avoiding arbitrage incentives Risks include those derived from externalities: micro and macro-systemic risks have to be taken into consideration Micro and macro prudential perspectives of Financial Stability

7. Some lessons from the financial crisis: What are we discussing? The discussion about the governance of macroprudential policies might be “smuggling” a more transparent debate about the failure of the decentralized regulatory approach and the need to move towards a more centralized fashion This process might be determined by political economy considerations, but it is relevant to pose the right questions on the table Governance implications could be wrong if we think that the only problem is to “add” the macro perspective In order to revise that, we need to get back to the conceptual determinants of the optimal Financial Safety/Stability Net: conflict of objectives, incentive structures and organizational design Micro and macro prudential perspectives of Financial Stability

8. Fundamental objectives of financial regulation Financial Safety/Stability Net Adverse Selection Representing uninformed agents Mitigating systemic risks / externalities Moral Hazard Costly State Verification Micro and macro prudential perspectives of Financial Stability

9. Preventive tools Corrective tools Lender of Last Resort Resolution Mechanisms Control and Supervision Prudential Regulation Financial Safety Net Micro and macro prudential perspectives of Financial Stability

10. Monetary Policy Lender of Last Resort Prudential Regulator and Supervisor Deposit Insurer and Resolution Agency Explicit conflict of objectives and coordination Financial Safety Net: Governance Micro and macro prudential perspectives of Financial Stability

11. The decision-making of some crucial issues Liquidating financial institutions Mergers and acquisitions Short term financial assistance Intervening financial institutions Financial Safety Net: Governance and Conflict of Objectives Micro and macro prudential perspectives of Financial Stability

12. Separation/Unification of the Financial Safety Net agencies Relative institutional strenght Reputation and credibility Expertise and capacities Make explicit the conflict of objectives Institutional Determinants of the Financial Safety Net Design Micro and macro prudential perspectives of Financial Stability

13. The necessary consistency in supervision and regulation across markets and agents Capital markets Insurance markets Pension fund administrators Financial intermediaries and non-intermediaries Degree of Centralization of Financial Regulation Micro and macro prudential perspectives of Financial Stability

14. More centralized Efficiency due to specialization Lower power concentration Economies of scale and scope Lower bureaucratic costs Less centralized Conglomerates logic Degree of Centralization of Financial Regulation Micro and macro prudential perspectives of Financial Stability Lower regulatory arbitrage

15. Monetary Policy Lender of Last Resort Prudential Regulator and Supervisor Deposit Insurer and Resolution Agency Coordination and contribution for all agencies to comply with their respective mandates Financial Stability Net: Governance Micro and macro prudential perspectives of Financial Stability Ministry of Finance/ Treasury

16. The complementary roles of micro and macro perspectives Both micro and macro perspectives have to be considered in order to set the optimal governance structure to the Financial Safety/Stability Net The contribution of both approaches should be transversal to all the Financial Safety/Stability Net agencies Micro and macro prudential perspectives of Financial Stability Financial regulationPerspectives Micro-prudencial Macro-prudencial Mitigating systemic risks Representation of uninformed agents

17. The complementary roles of micro and macro perspectives Sound risk management are needed not only of individual institutions but also of the financial system as a whole Both approaches should help to make agents to internalize externalities in both static and dynamic dimensions of financial stability All proposals (capital buffers, counter-cyclical provisioning, caps on Loan-to-Value ratios, liquidity requirements) require more understanding for implementation and impact evaluation Rules vs. Discretion: equilibrium between flexibility and reputation Corporate governance is also relevant: internal risk-management process and compensation schemes should be aligned with a reasonable risk-taking behavior Micro and macro prudential perspectives of Financial Stability

18. Implications of systemic risks on rules and institutions Systemic risks Rules Institutions Risk-based regulation Broad perimeter Financial Safety Net Financial Stability Framework Centralized Regulation Ownership/stockholding of non-financial entities Corporate governance Regulatory treatment of public entities Exposure to common and correlated risks Interconnectedness (players and markets) Financial and real sector conglomerates/ cross border New kinds of risks as markets develop Regulatory arbitrage across entities with different licenses Micro and macro prudential perspectives of Financial Stability

19. Mario Bergara Managing the Capital Account and Regulating the Financial Sector: A Developing Country Perspective UNDESA – IPD - IPEA, Rio de Janeiro, August 23, 2011 Micro and Macro Prudential Perspectives of Financial Stability