Economics and Banking – Page 410 – Digital Finance Analytics (DFA) Blog

Market manipulation – ASIC better get it right, first time

Greg Medcraft, chairman of the corporate regulator ASIC, is a distinguished banker who worked for 27 years in the obscure world of asset securitisation with the large French bank Societe Generale. He helped to set up the American Securitisation Forum (ASF) and is also chairman of the international securities industry body, IOSCO, which bills itself as “the global standard setter for securities markets regulation”.

Mr Medcraft then is probably as well placed as anyone in Australia to understand the complexities of the financial markets that gave rise to the interest rate benchmark manipulation scandals, which are grouped under the general term LIBOR but include other benchmarks such as EURIBOR, TIBOR and the local variant, BBSW (Bank Bill Swap Rate).

The fallout from these scandals rolls on but according to reporting by Adele Ferguson (a one-woman regulator) it will soon be the turn of BBSW to take the spotlight.

The reasons that manipulation of interest rate benchmarks took place are complicated, caused by an explosion of financial trading in the last 20 years, especially in so-called Interest Rate Swaps (IRS), and the failure of regulators to handle the flood of new types of securities.

[For an academic explanation of the phenomenon, see here and here and for a general overview see here.]

The initial reaction to the revelations that Australian banks just might be involved with manipulating BBSW was outrage, especially from AFMA, the investment bankers’ industry body. This stance was however undermined when, in January 2014, ASIC accepted an “enforceable undertaking” from BNP Paribas (BNP) in relation to potential misconduct involving BBSW.

Since then, however, there has been little information about other possible instances of BBSW manipulation other than ASIC’s investigations were ongoing and ongoing and ongoing.

It is strongly rumoured that ANZ will be in the firing line when ASIC eventually decides to take regulatory action, long after other jurisdictions have done so. This is, in part to do with the salacious revelations emerging from a civil case brought by ANZ traders against the bank for wrongful dismissal related to possible manipulation of BBSW.

ASIC is in the spotlight and it really has to put up or shut up.

Many of the big birds have already flown. With the recent departure of Mike Smith from ANZ, all of the CEOs of the big Australian banks who were in charge when the BBSW investigation was started have gone. ASIC’s inquires have taken so long that the chances of getting any “clawback” of bonuses if serious misconduct is proven have disappeared.

Unfortunately, Mr Medcraft is an accountant rather than a lawyer and ASIC faces a real legal quandary – whether to prosecute the individuals involved, the banks they worked for, or both. All of these paths are fraught with possible dangers.

Going after individuals is difficult. Although the UK Serious Fraud Office had a win against Tom Hayes, the Libor Mastermind, it had a spectacular loss against six brokers who had been accused of supporting Hayes. The failure to convict the brokers resulted in the ridiculous situation where Hayes was convicted but his alleged co-conspirators walked free.

A UK legal expert, Alison McHaffie noted that

“Apart from being acutely embarrassing to the SFO, these verdicts show how difficult it is to demonstrate criminal activity by individuals for this type of market misconduct

It is always easier to bring regulatory action rather than criminal prosecution.”

Which brings us to the second option, going after the banks.

If the reports are correct, ASIC may be considering prosecuting ANZ, although it is difficult to see under which statute. In the past, Mr Medcraft has pointed to Section 12.2 of the Commonwealth Criminal Code, which he argued would allow

“companies to be charged with being an accessory to a crime if the company’s culture encouraged or tolerated breaches of law.”

But that was in the days when “culture” was flavour of the moment.

It would be a brave (and probably foolhardy) regulator who would take on a single bank alone, hoping to prove conclusively in court that the bank’s culture was responsible for fraud and misconduct. That is only a bonanza for lawyers for the next decade.

So what to do?

History has shown that a single regulator can do very little on their own, especially one whose mandate is so diffuse and its staff so overstretched.

Overseas experience has shown that when multiple regulators get together, share information, skills and most importantly purpose they can succeed in jointly fining multiple banks. Singly, regulators can get picked off – as a pack they can be successful.

In the Australian context, what this means is that, while ASIC might be the spearhead, the real firepower should be provided by the Council of Financial Regulators, comprising ASIC, APRA and the RBA. When ASIC finally decides to prosecute someone for manipulating the market, the other members of the CFR should not only come out in unequivocal support of ASIC but also announce how they will use their powers to support ASIC, such as, for example in the case of APRA, additional operational risk capital charges for misconduct.

The curtain is about to go up on the second act of the BBSW tragedy (or is it farce), and we await the entry of the villain(s) with keen expectancy. But will the show close on its first night, with no prospect of a revival?

Author: Pat McConnell, Honorary Fellow, Macquarie University Applied Finance Centre, Macquarie University

What Is Behind the Weakness in Global Investment?

A newly released Bank of Canada Staff Discussion Paper explores why the recovery in private business investment globally remains extremely weak more than seven years after the financial crisis.

The global financial crisis resulted in a broad-based collapse of business investment, with the level of investment falling well over 10 per cent in most member countries of the Organisation for Economic Co-operation and Development (OECD).

An uneven recovery followed, led by oil-exporting regions, which benefited from a rebound in energy prices. The post-crisis recovery in business investment has been underwhelming. Annual investment growth in OECD countries averaged a mere 2.2 per cent between 2010 and 2014, compared to around 3.5 per cent in the decade leading up to the financial crisis.

The bulk of this weakness was unexpected, and has resulted in investment consistently underperforming relative to forecasts of both public and private forecasters. Over the past few years, several institutions, including the OECD, the International Monetary Fund (IMF), the Bank for International Settlements and the Banque de France, have investigated this “investment puzzle” to identify some of the factors that standard models might fail to capture.

This paper contributes to the ongoing policy debate on the factors behind this weakness by analyzing the role of growth prospects and uncertainty in explaining developments in non-residential private business investment in large advanced economies since the crisis. Augmenting the traditional models of investment with measures of growth expectations for output and uncertainty about global demand improves considerably the ability to explain investment growth.

Our results suggest that the main driver behind the weakness in global investment in recent years is primarily a pessimistic outlook on the part of firms regarding the strength of future demand. Lower levels of uncertainty have supported investment growth modestly over 2013–14. Similarly, diminishing credit constraints, lower borrowing costs and relatively stronger corporate profits have also supported the recovery in business investment from 2010 onward.

Our findings have two important implications for the global outlook for investment. First, the expected improvements in global growth should support a recovery in investment; however, a slowdown in growth in emerging-market economies or further growth disappointment in advanced economies could restrain this recovery. Second, the ongoing recovery in investment remains vulnerable to uncertainty shocks.

Note: Bank of Canada staff discussion papers are completed staff research studies on a wide variety of subjects relevant to central bank policy, produced independently from the Bank’s Governing Council. This research may support or challenge prevailing policy orthodoxy. Therefore, the views expressed in this paper are solely those of the authors and may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank.

Federal Reserve Board announced a $131m penalty against HSBC North America

The Federal Reserve Board on Friday announced a $131 million penalty against HSBC North America Holdings, Inc. and HSBC Finance Corporation for deficiencies in residential mortgage loan servicing and foreclosure processing. The penalty is being assessed in conjunction with an agreement involving similar deficiencies that HSBC announced Friday with the U.S. Department of Justice, other federal agencies, and the state attorneys general.

The penalty assessed by the Board is the maximum amount allowed under the law, taking into account the circumstances of HSBC’s unsafe and unsound practices and foreclosure activities. The penalty may be satisfied by providing borrower assistance or remediation in conjunction with the Department of Justice settlement, or by providing funding for nonprofit housing counseling organizations. If HSBC does not satisfy the full penalty amount within two years, the remaining amount must be paid to the U.S. Department of Treasury. The Board will closely monitor compliance by HSBC with the requirements of the order.

The terms of the monetary assessment against HSBC are similar to those that were part of the penalties issued by the Board in February 2012 and July 2014 against six other mortgage servicing organizations that reached similar agreements with the U.S. Department of Justice and the state attorneys general.

The Board previously issued an enforcement action in April 2011 requiring HSBC to correct its servicing and foreclosure-related deficiencies. That action was among 14 corrective actions issued against Board-supervised mortgage servicers or their parent holding companies for unsafe and unsound practices in residential mortgage loan servicing and foreclosure processing.

General guide to account opening updated

The Basel Committee on Banking Supervision has revised the General guide to account opening, first published in 2003.

The Basel Committee issues this guide as an annex to the guidelines on the Sound management of risks related to money laundering and financing of terrorism, which was first published in January 2014. These guidelines revised, updated and merged two previous publications of the Basel Committee, issued in 2001 and 2004.

Most bank-customer relationships start with an account-opening procedure. The customer information collected and verified at this stage is crucial to the bank in order for it to fulfil its AML/CFT obligations, both at the inception of the customer relationship and thereafter, but it is also useful in protecting it against potential abuses, such as fraud or identity theft. The policies and procedures for account opening that all banks need to establish must reflect AML/CFT obligations.

The revised version of the General guide to account opening and customer identification takes into account the significant enhancements to the Financial Action Task Force (FATF) Recommendations and related guidance. In particular, it builds on the FATF Recommendations, as well as on two supplementary FATF publications specifically relevant for this guide: Guidance for a risk-based approach: The banking sector and Transparency and beneficial ownership, both issued in October 2014.

As for the remainder of the guidelines, the content of the proposed guide is in no way intended to strengthen, weaken or otherwise modify the FATF standards. Rather, it aims to support banks in implementing the FATF standards and guidance, which requires the adoption of specific policies and procedures, in particular on account opening.

A consultative version was issued in July 2015. The Basel Committee wishes to thank all those who took the trouble to express their views during the consultation process.

Revised Model-Based Market Risk Rules Costly for Banks – Fitch

The overhaul of the internal models approach – used by most banks with large trading books to calculate market risk capital requirements – will be costly, says Fitch Ratings. The Basel Committee on Banking Supervision’s revised market risk framework, published in January and effective from 2019, fundamentally changes the approach.

The model revisions should improve risk assessment capabilities, lead to higher capital charges for hard-to-model trading positions and make it easier to compare banks’ results. But the model approval process and governance are being thoroughly revised and implementing the changes will require considerable investment in technology and risk management.

Banks will need to obtain approval for internal models desk by desk, rather than bank-wide. This will make it easier for supervisors to decline approval for a particular trading desk, if, for example, the desk is unable to satisfy model validation criteria due to back-testing failures or an inability to properly attribute profits and losses across products. But Fitch thinks costs associated with building and running the more sophisticated models will be high.

Instead of running a single bank-wide model for a range of stressed and unstressed risk factors, multiple new models will need to be built, validated and run daily. This will multiply the number of model reviews and operational runs and add to subsequent data analysis and reporting procedures. Additional risk personnel will be required for review, oversight, and reporting purposes.

The amount of regulatory capital models-based banks will need to cover potential market risks following the revisions is uncertain. The Basel Committee’s latest studies show that, for a sample of 12 internationally active banks with large trading books, all of which provided high-quality data, market risk capital charges under the revised approach were 28% higher. But for a broader sample of 44 banks using internal models, the median market risk capital requirements fell by 3% under the revised models.

Fitch thinks the result for the 12 banks could reflect greater concentrations of less liquid credit positions that require more capital, or larger trading positions lacking observable transaction prices, which are subject to a stressed capital add-on. Banks facing higher charges under the regime may re-assess whether certain activities remain profitable.

The new internal models approach replaces value at risk (VaR) with an expected shortfall (ES) measure. VaR does not capture the tail risk of loss distribution, which can arise during significant market stress. The use of ES models for regulatory capital is positive for bank creditors because they could lead to better capitalisation of tail-risk loss events and might motivate risk managers to limit trading portfolios that could lead to outsized losses.

When calculating ES measures, banks will have to use variable market liquidity horizons – to a maximum of 120 days for complex credit products, against the current fixed 10-day period. We think model inputs will be more realistic, by acknowledging that some instruments take longer to sell or hedge without affecting prices. ES will also constrain recognition of diversification and hedging benefits, extensively used in VaR models to reduce capital charges. We think this will make model outputs more prudent and force banks to better capitalise potential trading losses.

Structural flaws in the way banks calculated capital charges for market risk were exposed during severe market stresses in 2008-2009. The Basel Committee subsequently undertook a fundamental review of the trading book. The original proposals were watered down, but we think the final revised minimum capital standards for model-driven market risk are positive for creditors because improved model standards and more prudent methods employed to capture risk should mean trading risks are more accurately capitalised.

RBA’s Latest Statement Raises Two Interesting Questions

The latest Statement of Monetary Policy, released today, continues to tell the now well rehearsed story. Resources down, China under pressure, local growth slowish, and transitioning from mining, sort of working, whilst home lending continues to grow at above 7% annually. But they kick around two interesting issues. First, why is the unemployment rate so good when growth is sluggish, and second why is the household savings ratio lower now?

Looking at employment first:

…strong employment growth has also been supported by a protracted period of low wage growth which, along with the exchange rate depreciation, may have encouraged firms to employ more people than otherwise. At the same time, growth in the supply of labour has increased through a rise in the participation rate, notwithstanding lower population growth. The unemployment rate declined to around 5¾ per cent in late 2015, having been within a range between 6 and 6¼ per cent since mid 2014. Nevertheless, there is evidence of spare capacity in the labour market, as the unemployment rate is still above recent lows, the participation rate remains below its previous peak and wage growth continues to be low.

Also, the low growth of wages is likely to have encouraged businesses to employ more people than otherwise. Measures of job vacancies and advertisements point to further growth in employment over the coming months. In response to this flow of data, the forecast for the unemployment rate has been revised lower. The fact that the improvement in labour market conditions has occurred against the backdrop of below-average GDP growth raises some uncertainty about the economic outlook. It is possible that the strength in the labour market data contains information about the economy not apparent in the national accounts data, or that the strong growth in employment of late will be followed by a period of weaker employment growth. Alternatively, the strength in labour market conditions relative to output growth may reflect a rebalancing of the pattern of growth towards labour intensive sectors and away from capital intensive sectors.

DFA is of the view that the growth in lower-paid non-wealth producing jobs at the expense of productive jobs is the key – more are now working in the healthcare and services sector (in response to growing demand thanks to demographic shifts), but it just moves the dollar around the system, and does not create new dollars. There is difference between being busy, and being productively (economically speaking) busy.

Turning to the savings ratio:

… after falling for more than two decades, the aggregate household saving ratio in Australia increased sharply in the latter half of the 2000s. While it has since remained close to 10 per cent – which implies that, collectively, households have been saving about 10 per cent of their incomes – the saving ratio has declined modestly over the past three years or so.

Understanding developments in the saving ratio is important because changes in household saving behaviour can have implications for the outlook for aggregate consumption. Trends in the household saving ratio in Australia over recent years are likely to reflect a range of factors, including the effect of the boom in commodity prices and mining investment on household incomes, behavioural changes stemming from the global financial crisis, and the current low level of interest rates. Longer-term factors such as financial deregulation and population ageing have also played a role. Households’ expectations about future income growth and asset valuations, and the uncertainty around those expectations, are also relevant to their saving decisions. Many households accumulate precautionary savings to insure against an unanticipated loss of future income or unexpected expenditure (such as on a medical procedure). At the macroeconomic level, precautionary saving is likely to be particularly important if households are very risk averse or constrained in their ability to borrow to fund consumption when their incomes are temporarily low. For example, the financial crisis is likely to have made households more uncertain about their future employment or income growth and/or led them to reassess their tolerance for risk, which would have encouraged them to increase their rate of saving. Surveys at that time showed an increase in the share of households nominating bank deposits or paying down debt as the ‘wisest place for saving’, although this may have also reflected lower expected rates of return on other financial assets following the financial crisis.

The level of interest rates can also influence the saving ratio. On the one hand, the current low level of interest rates reduces both the return to saving and the cost of borrowing, which encourages households to bring forward consumption; this might explain some of the recent decline in the aggregate household saving ratio. Low interest rates also support the value of household assets, which increases the amount of collateral households can borrow against, and potentially reduces the incentives for households to save. On the other hand, the household sector in aggregate holds more debt than interest-earning assets, so cyclically low interest rates provide a temporary boost to disposable income through a reduction in net interest payments, some of which may be saved. Households also need to save more to achieve a given target level of savings when interest rates are low.

Structural changes to the Australian financial system have been important longer-term drivers of changes in household saving behaviour. Financial deregulation in the 1980s and a structural shift to low inflation and low interest rates in the 1990s allowed households that were previously credit constrained to accumulate higher levels of debt for a given level of income. This rise in indebtedness was accompanied by strong growth in housing prices and a reduction in the household saving ratio to unusually low levels. In this way households were able to support consumption via the withdrawal of housing equity. Innovation in financial products – such as credit cards and home-equity loans – also gave households much better access to finance. The adjustment to these structural changes in the financial system appears to have largely run its course by the mid 2000s.

The ageing of the population is another longer-term influence on the saving ratio. If shares of younger and older households in the population were constant over time, the different saving behaviours of these households would not affect the aggregate saving ratio. However, Australia’s baby-boomer generation is a larger share of the population now and has been entering the retirement phase since around 2010. Because households save less in their later years, this is expected to have a gradual but long-lasting downward influence on the aggregate household saving ratio. However, a potentially offsetting influence is rising longevity, which may lead households to save more during their working years to finance a longer period of retirement.

The amount that each of these drivers have contributed to recent trends in the aggregate household saving ratio is unclear. It is also uncertain how they will evolve over the next few years, although the Bank’s central forecast embodies a further modest decline in the saving ratio, that reflects, in part, the unwinding of the impact on saving from the earlier boom in commodity prices and mining investment.

Using data from the DFA household surveys, we note three factors in play. First, household confidence levels still below long term trends, so we would expect households to continue to save, if they can, against perceived future risks. Second, older households hold the bulk of the savings, and they are indeed growing as a proportion of the total, so again we would expect to see a rise, not a fall in the ratio. But, the third factor, is in our view, the most significant. That is that many are relying on income from savings, and as deposit interest rates have fallen (and alternative investment options become more risky), some have switched savings into investment property and others are having to eat into capital to survive. The RBA’s policy settings of low interest rates, and high house prices are being reflected back in lower savings ratios.

DFA Comments On Keen Mortgage Pricing, For Some

DFA contributed to a piece on ABC RN Breakfast which discussed the deep discounting currently available for selected mortgage borrowers, reflecting heightened competition, more difficult funding and changes in demand. You can listen to the segment, which also included Sally Tindall, Money Editor, RateCity and Alan Oster, Chief Economist, National Australia Bank. The reporter was Sheryle Bagwell, Business Editor.

Mortgage delinquencies on the rise, says Moody’s

From Australian Broker.

Changing economic conditions at home and abroad will result in an increase in the number of Australian mortgage delinquencies in the coming year, according to credit rating firm Moody’s.

The latest monthly review of the performance of Australian prime residential mortgages by ratings firm Moody’s shows delinquencies in excess of 30 days rose to 1.20% in November 2015 from 1.14% in October 2015.

Moody’s puts that monthly increase down to seasonal factors such as household overspending in the run up to Christmas, but still believes 2016 will see a higher number of delinquencies than 2015.

“The housing market has shown signs of cooling over recent months,” Moody’s assistant vice president – analyst Alana Chen said.

“Strong housing market activity in both Sydney and Melbourne helped foster relatively strong economic performance in the respective states of New South Wales and Victoria in 2015.

“But a slower pace of house price growth will mean a slowdown in economic activity and will contribute to a deterioration in mortgage performance in 2016 from current exceptionally healthy levels.”

Moody’s predicts the slower growth of house prices will continue as the Australian economy faces some challenges through 2016.

“Slowing growth in China, Australia’s biggest export market, and declining commodity prices, which are at or near multi-year lows, will also put pressure on the Australian economy and contribute to below-trend growth and a soft labour market in 2016,” Chen said.

But while Moody’s predicts a growing number of borrowers are at risk of becoming delinquent, not all are convinced that will be the case.

“With all respect to Moody’s, who have a number of economists working on this sort of thing, I find it difficult to believe we’re going to see a real rise in the number of delinquencies,” Jane Slack-Smith, director of Investors Choice Mortgages, told Australian Broker‘s sister publication, Your Investment Property.

“I’ve been a broker for 10 years and a property investor for a long time too and that’s given me a lot of experience in reading the market and I can’t really see anything at the moment that’s going to cause a rise (in delinquencies).”

Slack-Smith believes the period of low interest rates have allowed a large proportion of Australian borrowers to get in position where they a comfortable with their financial commitments, while others have been prevented from getting in over their heads.

“With the lower interest rates we’ve had I think a lot of people have taken advantage of that. A lot of people have built up their redraw or offset account so they’re in a position where they’re pretty comfortable with everything,” she told Your Investment Property.

“The other thing is that the APRA and ASIC changes have quelled a lot of irresponsible lending that might have happened.

“It was a pretty heavy handed approach, but the fact that people were assessed on a 7.5% interest rate and the servicing criteria was made tougher means there’s already been a buffer built in so that people can manage if we do see interest rates start to move up.”

No Change To The Cash Rate Today – RBA

At its meeting today, the Board decided to leave the cash rate unchanged at 2.0 per cent.

Recent information suggests the global economy is continuing to grow, though at a slightly lower pace than earlier expected. While several advanced economies have recorded improved growth over the past year, conditions have become more difficult for a number of emerging market economies. China’s growth rate has continued to moderate.

Commodity prices have declined further, especially oil prices. This partly reflects slower growth in demand but also very substantial increases in supply over recent years. The decline in Australia’s terms of trade, which began more than four years ago, has therefore continued.

Financial markets have once again exhibited heightened volatility recently, as participants grapple with uncertainty about the global economic outlook and diverging policy settings among the major jurisdictions. Appetite for risk has diminished somewhat and funding conditions for emerging market sovereigns and lesser-rated corporates have tightened. But funding costs for high-quality borrowers remain very low and, globally, monetary policy remains remarkably accommodative.

In Australia, the available information suggests that the expansion in the non-mining parts of the economy strengthened during 2015 even as the contraction in spending in mining investment continued. Surveys of business conditions moved to above average levels, employment growth picked up and the unemployment rate declined in the second half of the year, even though measured GDP growth was below average. The pace of lending to businesses also picked up.

Inflation continues to be quite low, with the CPI rising by 1.7 per cent over 2015. This was partly caused by declining prices for oil and some utilities, but underlying measures of inflation are also low at about 2 per cent. With growth in labour costs continuing to be quite subdued as well, and inflation restrained elsewhere in the world, consumer price inflation is likely to remain low over the next year or two.

Given these conditions, it is appropriate for monetary policy to be accommodative. Low interest rates are supporting demand, while regulatory measures are working to emphasise prudent lending standards and so to contain risks in the housing market. Credit growth to households continues at a moderate pace, albeit with a changed composition between investors and owner-occupiers. The pace of growth in dwelling prices has moderated in Melbourne and Sydney over recent months and has remained mostly subdued in other cities. The exchange rate has continued its adjustment to the evolving economic outlook.

At today’s meeting, the Board judged that there were reasonable prospects for continued growth in the economy, with inflation close to target. The Board therefore decided that the current setting of monetary policy remained appropriate.

Over the period ahead, new information should allow the Board to judge whether the recent improvement in labour market conditions is continuing and whether the recent financial turbulence portends weaker global and domestic demand. Continued low inflation may provide scope for easier policy, should that be appropriate to lend support to demand.

Commodity Price Shocks and Financial Sector Fragility

A newly released IMF working paper investigates the impact of commodity price shocks on financial sector fragility.

Using a large sample of 71 commodity exporters among emerging and developing economies, it shows that negative shocks to commodity prices tend to weaken the financial sector, with larger shocks having more pronounced impacts. More specifically, negative commodity price shocks are associated with higher non-performing loans, bank costs and banking crises, while they reduce bank profits, liquidity, and provisions to nonperforming loans. These adverse effects tend to occur in countries with poor quality of governance, weak fiscal space, as well as those that do not have a sovereign wealth fund, do not implement macro-prudential policies and do not have a diversified export base.

The recent decline in commodity prices, especially for oil, has revived once again interest in their economic impact. Most commodities prices have declined by about 50 percent between mid-2014 and mid-2015, leading to significant losses in export earnings for commodity exporters. While commodity markets may be undergoing a transition to an era of low prices, such a sharp decline is not unprecedented.

Adverse commodity price shocks can also contribute to financial fragility through various channels. First, a decline in commodity prices in commodity-dependent countries results in reduced export income, which could adversely impact economic activity and agents’ (including governments) ability to meet their debt obligations, thereby potentially weakening banks’ balance sheets. Second, a surge in bank withdrawals following a drop in commodity prices may significantly reduce banks’ liquidity and potentially lead to a liquidity mismatch.

If large enough, commodity price shocks can also adversely affect bank balance sheets by weighing on international reserves and increasing the risk of currency mismatches. Third, a decline in commodity prices can reduce commodity exporters’ fiscal performance (by lowering revenue), which in turn may push government to adjust their budgets to accommodate revenue shortfalls. Often this can happen in a disorderly manner through the accumulation of payment arrears to suppliers and contractors, who in turn are unable to adequately service their bank loans.

Macro-prudential policies are gaining attention internationally as a useful tool to address system-wide risks in the financial sector. Macro-prudential policies act as an important factor for the stability of the financial sector. Macro-prudential instruments cover policies related to borrowers, loans, banks’ assets or liabilities, foreign currency credit, reserve requirements and policies that encourage counter-cyclical buffers (capital, dynamic provisioning and profits distribution restrictions). They may act as a tool to monitor the financial sector, therefore reducing the risk-taking and allowing the government to intervene on time.

The results show that negative commodity price shocks increase NPLs and bank costs, and decrease bank profits only in countries without macro-prudential policies. In contrast, countries with macro-prudential instruments are better able to cope with the detrimental impacts of adverse commodity price shocks. The implementation of macroprudential policy does not matter when it comes to provisions to NPLs as commodity price slumps lower provisions to NPLs in countries with or without macro-prudential policy.

Adverse commodity price shocks tend to lead to financial problems in non-diversified economies. The results also highlight that the detrimental effects of commodity price shocks are more common in countries with a low diversification of their export base. A lack of diversification may increase exposure to adverse external shocks and vulnerability to macroeconomic instability. While a diversified export base may allow countries to better handle declines in commodity related revenues with alternative sources.

In terms of policy implications, the findings underscore the necessity of adopting policies to increase the resilience of resource rich-countries. First, developing countries should promote sound economic policies and good governance that will ensure the effective use of natural resource windfalls and build fiscal buffers, including through sovereign wealth funds or similar arrangement. The presence of a sovereign wealth fund can effectively mitigate the impact of commodity price shocks and stabilize the economy. More generally, sound fiscal policy, characterized by low debt levels is an important buffer against exogenous shocks. Second, countries should implement macro-prudential policies in order to limit or mitigate systemic risk. Finally, countries should diversify their production and exports base in order to have more alternative sources of revenues allowing them to deal with the volatility of commodity exports related revenues.

Note: IMF Working Papers describe research in progress by the authors and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.