Don Kohn offers advice on macro-pru under uncertainty

Don Kohn gave advice to macro-prudential policy-makers on handling uncertainty during remarks on May 15, saying the Bank of England could still do more to improve its financial stability work.

The BoE financial policy committee (FPC) member said that while experience with macro-prudential policy is still limited, the central bank has managed to identify “sufficient empirical regularities tied to financial stability in historical experience” to allow it to act.

A key input to the committee’s work is stress-testing. The BoE’s tests are designed to increase in severity as financial conditions loosen, while easing off during downturns.

“[The tests] tell us directly about the capacity of the banking system to absorb losses in the stress and remain well enough capitalised to meet the hurdles we have set, which are designed, also in light of experience, to be high enough to assure continued access to funding and the ability to lend,” Kohn said.

As well as using the tests to inform the setting of the countercyclical capital buffer, the BoE also uses them to judge the appropriate level of capital held against particular risks. For instance, when the BoE found “deficiencies” in some banks’ modelling of risks from consumer credit, the FPC stepped in, said Kohn.

The BoE conducts annual stress-testing of major banks, but the FPC must also set policy during the gaps, when less information is available. Kohn said policy-makers turn to several key indicators for judging risks under uncertainty, paying “particular attention” to credit growth relative to income, as rapid credit growth has tended to be a precursor to crises.

Other useful indicators include spreads of bank loan rates over base rates, and rates on risky bank loans over safer loans, which can help policy-makers gauge shifts in credit supply, Kohn said.

Policy-makers ask for more detailed reports from BoE staff in key areas. This year, the focus is on exchange-traded funds, fintech, “fast markets” and the provision of cloud services to the financial sector, Kohn said.

Room for improvement

For all the progress in recent years, Kohn said there was still “considerable room” for the BoE to improve its ability to identify risks and build resilience.

He recommended making stress tests “more macro-prudential”, paying particular attention to asset classes or business lines that are growing suspiciously fast or making outsized profits. “We should also be looking for correlated positions and important interconnections among stress-tested banks that could amplify shocks,” he said.

Expanding the list of indicators would also help, he added, including more work to understand the “size and shape of the tails” of the distribution of possible outcomes. Relatedly, new metrics and techniques are needed to identify and analyse risks in the non-bank sector, he said.

Lastly, aggregate indicators of risk can be a “useful check on the overall state of the financial sector”, said Kohn. He added his voice to the several policy-makers who have recently backed the “growth-at-risk” metric. Both the BoE and the International Monetary Fund have been working on the metric, which indicates how much growth could be lost in a worst-case scenario.