Macroprudential regulation is the approach to financial regulation that aims to mitigate risk to the financial system as a whole (or "systemic risk"). After the 2008 financial crisis, there has been a growing consensus among policymakers and economic researchers about the need to re-orient the regulatory framework towards a macroprudential perspective.
History As documented by Clement (2010), the term "macroprudential" was first used in the late 1970s in unpublished documents of the Cooke Committee (the precursor of the Basel Committee on Banking Supervision) and the Bank of England. But only in the early 2000s—after two decades of recurrent financial crises in industrial and, most often, emerging market countries—did the macroprudential approach to the regulatory and supervisory framework become increasingly promoted, especially by authorities of the Bank for International Settlements. A wider agreement on its relevance was reached after the 2008 financial crisis.
Objectives and justification The main goal of macroprudential regulation is to reduce the risk and the macroeconomic costs of financial instability. It is recognized as a necessary ingredient to fill the gap between macroeconomic policy and the traditional microprudential regulation of financial institutions.Bank of England (2009). The role of macroprudential policy. Bank of England Discussion Paper, November.
Macroprudential vs microprudential regulation + The macro- and microprudential perspectives compared Macroprudential Microprudential Proximate objective Limit financial system-wide distress Limit distress of individual institutions Ultimate objective Avoid output (GDP) costs Consumer (investor/depositor) protection Characterisation of risk Seen as dependent on collective behaviour ("endogenous") Seen as independent of individual agents' behaviour ("exogenous") Correlations and common exposures across institutions Important Irrelevant Calibration of prudential controls In terms of system-wide risk; top-down In terms of risks of individual institutions; bottom-up Source: Borio (2003)
Theoretical rationale On theoretical grounds, it has been argued that a reform of prudential regulation should integrate three different paradigms: the agency paradigm, the externalities paradigm, and the mood swings paradigm. The role of macroprudential regulation is particularly stressed by the last two of them.
The agency paradigm highlights the importance of principal–agent problems. Principal-agent risk arises from the separation of ownership and control over an institution which may drive behaviors by the agents in control which would not be in the best interest of the principals (owners). The main argument is that in its role of lender of last resort and provider of deposit insurance, the government alters the incentives of banks to undertake risks. This is a manifestation of the principal-agent problem known as moral hazard. More concretely, the coexistence of deposit insurances and insufficiently regulated bank portfolios induces financial institutions to take excessive risks. This paradigm, however, assumes that risk arises from individual malfeasance, and hence it is at odds with the emphasis on the system as a whole which characterizes the macroprudential approach.
In the externalities paradigm, the key concept is called pecuniary externality. This is defined as an externality that arises when one economic agent's action affects the welfare of another agent through effects on prices. As argued by Greenwald and Stiglitz (1986), when there are distortions in the economy (such as incomplete markets or imperfect information), policy intervention can make everyone better off in a Pareto efficiency sense. Indeed, a number of authors have shown that when agents face borrowing constraints or other sorts of financial frictions, pecuniary externalities arise and different distortions appear, such as overborrowing, excessive risk-taking, and excessive levels of short-term debt. In these environments macroprudential intervention can improve social efficiency. An International Monetary Fund policy study argues that risk externalities between financial institutions and from them to the real economy are market failures that justify macroprudential regulation.De Nicolo, G., G. Favara and L. Ratnovski (2012). Externalities and macroprudential policy, IMF Staff Discussion Note 12/05.
In the mood swings paradigm, animal spirits (Keynes) critically influence the behavior of financial institutions' managers, causing excess of optimism in good times and sudden risk retrenchment on the way down. As a result, pricing signals in financial markets may be inefficient, increasing the likelihood of systemic trouble. A role for a forward-looking macroprudential supervisor, moderating uncertainty and alert to the risks of financial innovation, is therefore justified.
Indicators of systemic risk In order to measure systemic risk, macroprudential regulation relies on several indicators. As mentioned in Borio (2003),Borio, C. (2003). Op.cit. an important distinction is between measuring contributions to risk of individual institutions (the cross-sectional dimension) and measuring the evolution (i.e. procyclicality) of systemic risk through time (the time dimension).
The cross-sectional dimension of risk can be monitored by tracking balance sheet information—total assets and their composition, liability and capital structure—as well as the value of the institutions' trading securities and securities available for sale. Additionally, other sophisticated financial tools and models have been developed to assess the interconnectedness across intermediaries (such as CoVaR),See Adrian, T. and Brunnermeier, M. (2011). CoVaR. NBER Working Papers 17454, National Bureau of Economic Research. and each institution's contribution to systemic risk (identified as "Marginal Expected Shortfall" in Acharya et al., 2011).Acharya, V., Pederssen, L., Phillipon, T. and Richardson, M. (2010). Measuring Systemic Risk. New York University. Mimeo.
To address the time dimension of risk, a wide set of variables are typically used, for instance: ratio of credit to GDP, real asset prices, ratio of non-core to core liabilities of the banking sector, and monetary aggregates. Some early warning indicators have been developed encompassing these and other pieces of financial data (see, e.g., Borio and Drehmann, 2009).Borio, C. and Drehmann, M. (2009). Assessing the Risk of Banking Crises – Revisited. BIS Quarterly Review, March. Furthermore, macro stress tests are employed to identify vulnerabilities in the wake of a simulated adverse outcome.
Macroprudential tools
A large number of instruments have been proposed;See, inter alia, Shin, H. (2011). Macroprudential policies beyond Basel III. In: BIS Papers No 60, December; Hanson, S., Kashyap, A. and Stein, J. (2011). A macroprudential approach to financial regulation. Journal of Economic Perspectives, 25: 3-28; Goodhart C. and Perotti, E. (2012). Preventive macroprudential policy. VoxEU.org, 29 February; and the references in Galati, G. and Moessner, R. (2011). Macroprudential policy – a literature review. BIS Working Papers No 337, February. however, there is no agreement about which one should play the primary role in the implementation of macroprudential policy.
Most of these instruments are aimed to prevent the procyclicality of the financial system on the asset and liability sides, such as:
Cap on loan-to-value ratio and loan loss provisions Cap on debt-to-income ratio
The following tools serve the same purpose, but additional specific functions have been attributed to them, as noted below:
Countercyclical capital requirement – to avoid excessive balance-sheet shrinkage from banks in trouble. Cap on leverage – to limit asset growth by tying banks' assets to their equity. Levy on non-core liabilities – to mitigate pricing distortions that cause excessive asset growth. Time-varying reserve requirement – as a means to control capital flows with prudential purposes, especially for emerging economies.
To prevent the accumulation of excessive short-term debt:
Liquidity coverage ratio Liquidity risk charges that penalize short-term funding Capital requirement surcharges proportional to the size of maturity mismatch Minimum haircut requirements on asset-backed securities
In addition, different types of contingent capital instruments (e.g., "contingent convertibles" and "capital insurance") have been proposed to facilitate bank's recapitalization in a crisis event.). Raviv, A., (2004). Bank Stability and Market Discipline: Debt-for-Equity Swap versus Subordinated Notes. Brandeis University. Mimeo. Flannery, M., (2002). No pain, no gain? Effecting market discipline via ‘reverse convertible debentures. Chapter 5 of Hall S. Scott, ed. Capital Adequacy Beyond Basel: Banking Securities and Insurance, Oxford: Oxford University Press. Mimeo.
Implementation in Basel III Basel III reflects a macroprudential approach to financial regulation.See Borio, C. (2011). Rediscovering the macroeconomic roots of financial stability policy: journey, challenges and a way forward. BIS Working Papers No 354, September. The Basel Committee on Banking Supervision acknowledged the systemic significance of financial institutions and under Basel III banks' capital requirements were strengthened and liquidity requirements, a leverage cap and a countercyclical capital buffer were introduced. Also, the largest and most globally active banks were required to hold more and higher-quality capital, which is consistent with the cross-section approach to systemic risk.
Effectiveness of macroprudential tools For the case of Spain, Saurina (2009) argues that dynamic loan loss provisions (introduced in July 2000) are helpful to deal with procyclicality in banking, as banks are able to build up buffers for bad times.Saurina, J. (2009). Dynamic provisioning: The case of Spain. The World Bank. Note Number 7, July.
In the US, a foreign country’s tightening of loan-to-value ratios and local-currency reserve requirements is found to be associated with increased lending by US branches and subsidiaries of foreign banks. Moreover, tighter capital requirements outside the US shift domestic lending by US banks to the US and to other countries, while tighter US capital requirements reduce lending by US banks to foreign residents.
Using data from the UK, Aiyar et al. (2012) find that unregulated banks in the UK have been able to partially offset changes in credit supply induced by time-varying minimum capital requirements over the regulated banks. Hence, they infer a potentially substantial "leakage" of macroprudential regulation of bank capital.Aiyar, S., Calomiris, C. and Wieladek, T. (2011). Does Macro-Pru leak? Evidence from a UK policy experiment. NBER Working Papers 17822, National Bureau of Economic Research.
For emerging markets, several central banks have applied macroprudential policies (e.g., use of reserve requirements) at least since the aftermath of the 1997 Asian financial crisis and the 1998 Russian financial crisis. Most of these central banks' authorities consider that such tools effectively contributed to the resilience of their domestic financial systems during the 2008 financial crisis.For the case of some Latin American countries, see e.g. Castillo, P., Contreras, A., Quispe, Z. and Rojas, Y. (2011). Política macroprudencial en los países de la región. In: Revista Moneda, Central Bank of Peru.
Costs of macroprudential regulation