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CHAPTER 13
Financial Stability
OVERVIEW
Against the backdrop of the 2007–2009 financial crisis, this chapter discusses the growing importance of macroprudential supervision, which focuses on the stability of the financial system as a whole and therefore on the monitoring and assessment of so-called systemic risks.

The chapter sets out the key features of the conceptual framework for macroprudential supervision. The framework starts with identifying intermediate targets, also known as pillars. The first pillar examines financial imbalances, for which a cyclical approach is appropriate. The second pillar looks at externalities, for which a structural approach is appropriate. The failure of a large financial institution, for example, poses an externality to the financial system. Another externality is the interconnectedness of financial intermediaries.

The next stage is to design macroprudential instruments or tools to achieve the targets. On the cyclical side, countercyclical capital buffers and real estate related instruments are applied to contain credit growth and rising house prices. On the structural side, capital surcharges and resolution plans are applied to global systemically important financial institutions. This chapter also discusses the emerging institutional architecture for macroprudential supervision in the EU and the US.

Finally, this chapter touches upon the issue of crisis management and resolution, discussing the main reactive instruments that can be considered in crisis situations. The new Banking Union crisis management framework is analysed in detail. An important element is transferring responsibility for resolution from the national level to the European level under the Single Resolution Mechanism, mirroring the Single Supervisory Mechanism discussed in Chapter 12.

LEARNING OBJECTIVES
After you have studied this chapter, you should be able to:
• explain the concept of macroprudential supervision and the difference between microand macroprudential supervision • explain the concept of systemic risk and describe what makes financial systems prone to this risk

• understand the two pillars of macroprudential supervision

• describe the key instruments used by macroprudential authorities to prevent the buildup of systemic risks • describe the principal features of the crisis management and resolution tools, including bail-in

• explain why improvised cooperation leads to an insufficient level of recapitalisation in the case of a cross-border failure and why this calls for a Banking Union approach.

13.1 Financial stability and macroprudential supervision
Macro- vs. microprudential supervision
Although microprudential and macroprudential supervision are closely related, the financial crisis of 2007–2009 highlighted the important distinction between both concepts (see Hanson et al., 2011).

Microprudential supervision has traditionally been the key focus of supervisory authorities. The intermediate objective of microprudential supervision is to supervise and limit the distress of individual financial institutions, with the ultimate objective of protecting the customers of the institution in question. The fact that the financial system as a whole may be exposed to common risks is not (fully) taken into account. However, by preventing the failure of individual financial institutions, microprudential supervision aims to mitigate or prevent the risk of contagion and the subsequent negative externalities related to a possible fall in the confidence in the stability of the financial system. Macroprudential supervision focuses on the soundness of the financial system as a whole. The intermediate objective of macroprudential supervision is to limit financial systemwide distress, with the ultimate objective of protecting the overall economy from significant losses in real output (see Table 13.1). While risks to the financial system can in theory arise from the failure of one financial institution, the...
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