Margins and haircuts as a macroprudential tool
European Central Bank
Directorate General Communications
Sonnemannstrasse 20, 60314 Frankfurt am Main, Germany
Tel.: +49 69 1344 7455, E-mail: media@ecb.europa.eu
Website: www.ecb.europa.eu
Remarks by Vítor Constâncio, Vice-President of the ECB, at the ESRB international conference on the macroprudential use of margins and haircuts, Frankfurt am Main, 6 June 2016
Ladies and Gentlemen,
It is a pleasure to speak here today at the ESRB conference on macroprudential margins and haircuts. In my view, macroprudential margins and haircuts have the potential to become tools for controlling the build-up of excessive leverage in the financial system. Importantly, these tools would reach beyond the banking system and also address the build-up of leverage and liquidity risks in parts of the financial system, where we have seen rapid growth in recent years. Before I elaborate further on the specific need for macroprudential margins and haircuts, possible tools and how to implement them, allow me to set a more general stage for the important discussions we will be having and briefly touch upon a key lesson from the history of financial crises.
In recent years, convincing evidence has been provided showing that excessive leverage, credit booms and subsequent de-leveraging episodes were at the heart of recurrent episodes of financial instability since the late 19th century.[1] Let me single out two major crises where the build-up of leverage and the subsequent de-leveraging played a key role.
First, the stock market bubble of 1927–1929 and the subsequent “Great Crash” of 1929 were accompanied by an extraordinary growth followed by contraction of leveraged trading in stock markets, amplified by margin calls.[2] The ensuing Great Depression brought real, severe economic consequences. While there is still debate on its ultimate causes, the Great Crash is widely considered as a major factor. Notably, the Great Crash motivated the establishment of the so-called “Regulation T” which allowed the Federal Reserve Board to set minimum margins for partially loan-financed transactions of stocks. And from 1947 until 1974, the Federal Reserve Board frequently changed these minimum margin requirements. The evidence on the success of this macroprudential tool in curbing excessive credit in securities transactions and stock market volatility is at best mixed.[3] Importantly, however, the limited scope of Regulation T – which allowed investors to avoid its impact by substituting other forms of borrowing for margin loans – has been identified as a key flaw.[4] I will return to this issue later on in this talk.
The second major crisis – the 2007-2009 global financial crisis – is still fresh in our minds. The build-up of excessive leverage and subsequent deleveraging in the banking sector[5] and within financial markets more generally[6], is widely viewed as one of the main causes of the global financial crisis. Notably, an important conclusion of this literature is that leverage and liquidity were closely interlinked and reinforced the stress in the financial system.
One of the key lessons from the history of financial crises is that the negative externalities of excessive leverage and associated liquidity risks that give rise to systemic risk provide a fundamental rationale for macroprudential policies. These limit the build-up of leverage in the financial system in a pre-emptive manner. In pursuit of excess returns, market participants engage at times in excessive leverage without internalizing systemic costs of their risk-taking behaviour. These comprise spillovers to counterparties and financial networks[7] or asset price declines triggered by fire sales.[8] A large and growing literature[9] supports the conclusion that these systemic externalities of excessive leverage call for macroprudential policies that restrict the use of leverage pre-emptively, as a way to improve general welfare.
The next crisis will likely come in a different form and perhaps involve different markets and entities, but history tells us that it is a fair bet to say that excessive leverage will again play a major role. To the extent that derivatives and securities financing transactions (SFTs) are the main means to create leverage, in particular in the non-bank financial sector, this calls for pre-emptive regulatory action in these markets. Let me now explain in more detail why I believe we should equip macroprudential authorities with the power to set margins and haircuts.
Directorate General Communications
Sonnemannstrasse 20, 60314 Frankfurt am Main, Germany
Tel.: +49 69 1344 7455, E-mail: media@ecb.europa.eu
Website: www.ecb.europa.eu
page source http://www.ecb.europa.eu/
