Back to the fundamental questions when designing macroprudential policy
Since the financial crisis a lot of progress has been made in strengthening the financial system. In order to plan for an effective macroprudential policy – policy that focuses on promoting the stability of the financial system - one cannot do without a deep understanding of the underlying relationships between various factors, insists Michel Heijdra, Deputy Director of Financial Markets Directorate at the Ministry of Finance.
In a complex environment full of uncertainties, one should always ask the fundamental questions, he urges.
When it comes to macroprudential policy, sitting back is not an option for Heijdra, who also heads the ministry’s Financial Stability department. One example is the housing market debate. ‘House prices are rising substantially right now. It’s important to monitor that.’
Various parties have mentioned a possible further reduction of the maximum loan-to-value (LTV) on new mortgages. ‘A comprehensive look at the LTV, the amount of compulsory contributions by young people to pension funds and the accessibility of the rental market is indispensable’, Heijdra emphasises in an interview in the run-up to a workshop at the University of Amsterdam on financial stability and supervisory frameworks.
For years, there have been calls for a further reduction of the maximum mortgage in relation to the value of the house purchased, beyond the current 1%-point reduction a year to 100% by 2018. Both the Wijffels Commission and the IMF earlier pleaded for a reduction to 80% and last year, the Dutch Financial Stability Committee advised to continue the reductions at the current rate after 2018 until the LTV-limit has been reduced to 90%. Heijdra, former head of Financial Risk Management Banks at DNB, is tight-lipped on the issue, pointing to analyses by various parties, including the Bureau for Economic Policy Analysis CPB and DNB, identifying the widespread areas a further reduction of the LTV-limit might affect: some effects include putting pressure on house prices, increase demand for rental homes, and have an impact on household consumption levels. ‘It shows how far-flung the various aspects of macroprudential policy and macro-economic policy intertwine.’
Fundamental questions in the field of economics:
o How to draft monetary policy in an environment where interest rates appear to be structurally low?
o How to find a balance between stability and innovation when regulating the financial sector?
o How should regulators deal with unknown unknowns?
Heijdra has always had a broad perspective. He studied physics, philosophy and epistemology and obtained a PhD in applications of Darwin’s theory outside the field of biology. ‘I’ve always wanted to understand well how things work, in different areas. And I want to ask the fundamental questions. In the domain of nature, this comes down to physics; in that of the mind, it comes down to philosophy. ’ He is also intrigued by the complexity of economic issues. ‘It is interesting to ask the fundamental questions about that.’
The parallels with physics are numerous. Don’t many economists dream of finding causal laws and being able to make predictions based on mathematical models? But as it turns out, that ideal often does not entirely apply even in physics. And since the financial crisis it cannot be denied: in economics too, not everything can be explained by statistical correlations. Heijdra: ‘Suddenly, there was a black swan, which changed the way we look at economics and risks: how to build a healthy financial system that can handle unknown unknowns and is stable and agile at the same time?’
This requires a combination of thorough analysis and rules of thumb. And, as is the case for resilience in natural ecosystems, it is essential to find the right balance between diversity and central players. ‘The financial system also has crucial nodes that need extra protection, such as banks and central clearing parties’, Heijdra draws the parallel.
Coming up with a macroprudential policy to strengthen the financial system remains a learning process. The transition from bail-out to bail-in – where instead of taxpayers, investors must foot the bill in case of a bank collapse – is still far from complete, and many doubt whether authorities will stand firm in case of an emergency. Nevertheless, Heijdra considers this one of the major chances since the crisis. ‘The diabolical loop between banks and authorities is broken down more and more.’
He is satisfied with the steps taken so far to structurally improve stability. The Netherlands was, in his view, was ‘fairly early’ in drafting resolution plans for banks getting in trouble, in imposing additional capital buffer requirements on the financial sector and in introducing legislation to prevent banking risks from being passed on to the State. The required leverage ratio for Dutch systemic banks of 4% in 2018 may be below that in the United States and the United Kingdom, but it is higher than many banks on the continent. Pointing to the repayment obligation for the mortgage interest tax deduction, the reduction of this tax deduction, the lowering of the LTV-limit and the tightening of the loan-to-income requirement: ‘A substantial package of measures has been taken in the housing market, even in a in time of crisis.’
A lot remains to be done, such as defining the criteria for bail-in related debt on a European level. A thorough understanding of the correlation between the various factors is essential when crafting effective macroprudential policy. Heijdra: ‘Interacting with the sector provides me with new insights, which I hope to be able to transfer into policy.’
Give and take
Heijdra ‘s position as assistant professor Risk Management Financial Organisations at UvA comes in handy. One of the places Heijdra teaches is at the recently launched Academy for Banking and Insurance, a partnership between the UvA’s faculties of Economics and Law and the Financial Services chair founded by the educational institute for the Dutch banking, insurance and investment sector NIBE-SVE. With the participants – probably mostly lawyers, economists and business administration professionals – he wants to return to the fundamental questions. ‘Don’t look only at financial aspects, but also: “What kind of incentives does a certain packages of regulations create? What does this imply for the channels along which a product is being sold, for the financial landscape, for the form of potential cooperation between institutions?” One needs solid, broad knowledge to be able to answer such specific issues.’
A cross-sector and cross-border perspective is crucial, he continues. National regulations can conflict with the EU-framework and conversely, harmonisation within the EU, for example of the risk weight of certain assets for a particular sector, can promote fair competition from an international perspective but create an imbalance between sectors on a national level. Heijdra therefore regularly checks his thoughts with various parties, including Dutch banks and insurers. ‘I can use that knowledge and those evaluations to react in a substantiated manner to EU measures so that they won’t have a disruptive impact nationally.’
He is not under the illusion that he is working on a system that is ideal for all those involved: ‘One always seeks a balance between transparency and simplicity of the law versus arrangements that are tailored to individual parties with slightly different business models.’
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