Before the global financial crisis, financial regulation largely took the form of microprudential policies and centered on monitoring prudential risks to individual institutions. As such, financial regulation failed to consider the buildup of macroeconomic risks and vulnerabilities that could pose systemic risk by destabilizing a number of institutions simultaneously. The global financial crisis underlined an urgent need for financial regulatory authorities to identify and monitor early on the buildup of macroeconomic risks that could threaten the financial system. Such early detection and prevention requires strong macroprudential policy measures—for example, caps on the loan to value (LTV)ratio—designed to mitigate financial stability risks that stem from vulnerabilities building up in the broader financial system. More specifically, different types of macroprudential policies are more effective against different types of macroeconomic risks (Lee, Asuncion, and Kim 2015).
Arvai et al. (2014) acknowledges that several characteristics of the economies, financial sectors, and policy frameworks in the GCC countries make macroprudential policy a particularly important policy tool. Interest rate policy is constrained by the pegged exchange rate regimes. So fiscal policy—particularly government spending, given limited domestic taxation—is the main tool for managing economic cycles.
However, because of time lags in implementation and rigidity in expenditure, fiscal policy is not always flexible enough to prevent credit booms and the buildup of systemic risk in the financial sector. Other tools are also needed. Macroprudential policy needs to play a major role, supporting fiscal policy in managing financial cycles associated with oil prices.
The experience of 2008–09 demonstrates the vulnerability of the region to credit and asset price cycles. Higher oil revenues in that period led to large government fiscal surpluses, increases in government spending that boosted activity in the non-oil sectors of the economy (particularly construction), and increased liquidity in the banking sector. Credit and asset prices rose, moving closely with the oil price cycle, and consumer and business confidence increased. When these factors reversed, they caused considerable difficulties in some countries. The heavy reliance on volatile hydrocarbon revenues, the importance of real estate as a major asset class for investment, the underdeveloped fixed-income and derivatives markets that limit the range of liquidity and risk management tools, and the shortcomings in crisis resolution frameworks—all of these conditions underline the importance of having macroprudential policy in GCC countries’ toolkit to limit systemic risk in the financial system.
The GCC countries were ahead of many countries in implementing some macroprudential measures, but there is still scope for refining the existing macroprudential toolkit. More targeted prudential interventions are required that act directly to constrain excessive credit and leverage as well as exposure to aggregate shocks. Arvai et al. (2014) suggests actions in the following areas:
1) Alleviate pro-cyclicality in credit and asset markets by introducing time-varying loan-to- deposit and loan-to- value ratios could be introduced;
2) Limit the buildup of excessive exposure to specific sectors or categories of borrowers, sectoral exposure limits, particularly for real estate and personal loans;
3) Support liquidity management, the development of domestic inter-bank money and debt markets is important (GCC regulators are in the advanced stages of developing regulations on liquidity risks to comply with Basel III requirements); and,
4) The effectiveness of macroprudential policies would be enhanced by structural reforms, including modernizing the insolvency regimes and strengthening crisis management and resolution systems.
References:
Arvai, Zsofia, Ananthakrishnan Prasad, and Kentaro Katayama, 2014. Macroprudential Policy in the GCC Countries, IMF Staff Discussion Note, SDN/14/01, March.
Asuncion, R. Carlo, Jungsuk Kim, and Minsoo Lee, 2015. Effectiveness of Macroprudential Policy in Developing Asia: An Empirical Analysis, ADB Economics Working Paper Series, ADB, Mandaluyong City, Philippines, July. http://www.adb.org/sites/default/files/publication/162311/ewp-439.pdf
*Ruben Carlo Asuncion is a research economist/consultant with the Asian Development Bank. His research is in macroeconomics and finance, monetary economics, development economics, and applied econometrics.