[Course: Bank Management]

could you please help explain about Topic 6 from this research paper https://econ-papers.upf.edu/papers/1201.pdf

I don't understand much. and i need to present it to the class.

6. MACRO-PRUDENTIAL AND MONETARY POLICY 6.1 Macro-prudential regulation The link between business cycle and risk assessment with its implications on capital requirements is one of the key issues regulatory reform should address. Four aspects are critical.POST CRISIS REGULATION 14 FirstI as stated by Dewatripont and Rochet [BUM]. a mechanism to formally declare a systemic crisis would be required as it enables to redene the rights and responsibilities of both commercial banks and regulatory authorities once a systemic crisis is declared. This will allow dening regulatory miles that would apply only during a systemic crisis but that a bank in trouble cannot invoke in nonnal times. The decision can be based on a number of automatic thresholds being reached which limits the possibilities of lobbying by banks as well as political interference. Of courseI once the crisis is declared regulatory institutions independence will be limitedI as each bailout is a governmental decision. Second, as the crisis has highlighted the critical importance of bubbles. macroprudential policy should implement mechanisms for the identication of asset prices bubbles. This mandate should presumably be part of the central banks responsibilities, as this institution is equipped with the information required to identify a bubble. This information need not be public. but will be a critical input in both the banks internal rating models and their supervision by the regulatory authorities. This role of central banks in providing macroprudential information to supervisory authorities would be quite consistent with the monitoring of overall leverage in the banking and nancial industry, which absence during the current crisis has had a negative impact. Third. Adrian and Bannermeier [EDIE] consider the issue of banks' risk measurement from a perspective encompassing a wider view of the marketsI and so taking into account the contagion effects due to the distress of other banking institutions. Although value at risk {Vail} already reflects the variations in the business cycleI as the Basel II approach is based on the unique factor Merton {19?4] model. it does not take into account the interaction between banking risks and markets when banks are in distress. This has led Adrian and Brunnermeier to put forward a different risk measure. CoVoR as \"the value at risk [Vail] of nancial institutions conditional on other institutions being in distress". Using this concept. they show a signicant Co'v'aR increase among nancial institutions in the years before the crisis and important Juctuations in the wedge between Co'v'aR and VaR. This idea could be extended to cope with the illiquidity of the marketI which is neither contemplated by Basel II nor in the design of Jfair value accounting rules. Indeed a bank's liquidity mismatch that is considered of low risk and managed by accessing the interbank markets becomes a high risk when there is a generalized liquidity shortage. Fourth, to cope with the negative impact of banks' capital regulation through the business cycleI regulation should impose more stringent capital requirements during good times that could be lowered in bad times. This would take into account the fact that risks should be computed through the cycleI notjust at a point in time. lilepulloI Saurina and Tmcharte {EDIE} analyse this issue and compare different procedures to account for the capital procyclicality. Their empirical analysis shows that the best procedure is to use a simple multiplier of the Basel II requirements that depends on the deviation of the rate of growth of the lGross Domestic Product with respect to its longtun average. Capital requirements would be increased in expansions [or decreased in recessions] by 12% for a one standard deviation change in Gross Domestic Product growth. POST CRISIS REGULATION 15 til Monetary policy Three issues should he considered regarding monetary policy. First, a lax monetary policy during the pre-crisis period has been held responsible for nurturing asset price bubbles and macroeconomic fragility. Second, during the crisis period, monetary policy has changed course and has focussed exclusively on the provision of liquidity at low interest rates. Sustainable monetary policy A lax monetary policy could be compatible with low levels of ination if the excess liquidity is channelled into asset prices. This means that maintaining a lax monetary policy may come at a cost, as this represents a distortion with respect to the long term equilibrium that at one point will have to revert to its \"fundamental value". Of course, the existence of current account imbalance makes this issue more complex. Traditionally, monetary policy objective is price stability, as the European I[Central Bank's unique objective, or at a combination of price stability and economic growth, as it is the case for the US Federal Reserve. It is not clear that the current crisis will change the way monetary policy is conducted. Yet, the impact of interest rate deviations has been made clear. In the design and implementation of monetary policy, central banks should take into account that, with some probability however small, low interest rates imply higher macroeconomic fragility and nancial instability. This may have an impact on interest rates. Still, if nancial institutions take into account the risk of a bubble in their internal risk models, there is no need for monetary policy to take into account asset prices. Emergency liquidity management Regarding liquidity injection, the behaviour of central banks across the world has been quite consistent. They have injected as much liquidity as required by the nancial system. Of course, the difference between injecting liquidity and subsidising banks depends on the collateral that is used and the price that is set for the collateral. Here the policy of both the European Central Bank and the US Fed has been to lend against a large class of eligible collateral. By so doing, central banks have departed 'om their traditional cautious lending policy and have taken risks that may result in future losses. Still, central banks liquidity injection has limited the number of banks in distress, avoiding a worsening of the crisis. Perotti and Suarez (2009] suggest an alternative to the central bank intervention through the idea of mandatory liquidity insurance. During good times, the Emergency Liquidity Insurance Fund would receive the liquidity insurance premia and once a systemic crisis is declared it would use its \"prepackaged access to central bani: liquidity and government funds backing\". Thus the fund could not be used by a ban]: facing a liquidity shortage in normal times; such a bank would have to face market discipline. Yet the fund has the advantage of providing a \"guarantee on uninsured wholesale funding" thus preventing the nancial accelerator and contagion effects we have seen. As central banks have actually provided emergency liquidity provision, the di'erences should be emphasized: a private institution would be able to price liquidity insurance correctly and by so doing provide the right incentives for banks to keep more liquid assets {but notice that, as mentioned, liquidity is endogenous). Second, it would provide the market with certainty regarding POST CRISIS REGULATION l liquidity injection. Still, the problem of eligible collateral would remain to be solved: if its denition is too strict, say TBills. the md is useless; if it is too wide, say AAA mortgage back securities, it wncspuuda to capital, not liquidity injection. Interest rate policy. It has been often argued that monetary policy and prudential regulation were to be separated and implemented by diment agencies. The recent events seem to challenge this view. By injecting liquidity at low interest rates banks solvency is generally improved. Consequently the question of the optimal interest rate policy is to be considered. Two recent theoretical contributions, Allen, Carletti and Gale{2l}], and Freixas, Martin and Skeie [MW] argue that this is indeed the case. The eicient functioning of the interbank market is improved by setting Iota.r interest rates during a crisis and higher interest rates in normal times. The implication is here that monetary policy should also take into accotmt the possible risks associated with a systemic crisis. At these interest rates the Central Bank should provide the aggregate amount of liquidity banks require. Perotti and Suarez (BUD?) liquidity insurance proposal would have a similar effect as the cost of liquidity is higher in normal times because of the liquidity insurance premium