The global financial crisis forced regulators to realize that traditional monetary measures cannot adequately ensure financial stability. As an alternative, macroprudential policy can complement and supplement monetary policy in dealing with macroeconomic as well as stability issues. Yet the debate on macroprudential policy remains quite obscure for many.
In a recent article just published in Banking & Financial Services Policy Report (a longer version is available here), my co-authors and I provide an overview of macroprudential policy discussion from the fundamental rationales behind such policies to the set of measures currently used. The main messages can be summarized as follows.
Systemic Risk and Macroprudential supervision
Macroprudential supervision focuses on the stability of entire industries and the health of the relationships within the financial sector that can significantly impact the economy. The main goal of a regulatory framework is to monitor systemic risk in order to prevent unnecessary constraints on the supply of credit, especially in time of stress. We learned from the crisis that financial institutions that do not fully bear the cost of their actions but affect other participants in the financial system can generate such a risk. Most policymakers (governments, central banks, and international institutions) agree on the need for macroprudential policy to reduce systemic risk, whether it is to correct for market failure, that is the risk of contagion due to the failure of systemically important institutions or smooth financial cycles, that is avoiding bubbles.
The framework under Basel III attempts to address these dimensions of systemic risk by significantly increasing capital buffers for risks related to the interconnectedness of the major dealers (and mitigate the contagion risk), and incentivizing institutions to reduce counterparty risk through clearing and active management (and mitigate the procyclical risk). Yet, several issues have arisen when countries tried to implement these regulations. The most fundamental ones can be summarized as follows.
Contagion risk: by focusing mostly on banks, the identification of the global and domestic/national systemically important financial institutions (G-SIFIs and D/N-SIBs) has helped reducing the direct contagion risk of these institutions. But it also triggered the relocation of financial activities to less regulated markets: the increase in the share of home-purchase originations by independent mortgage companies in the US provides an interesting illustration, growing from 35 percent in 2010 to 47 percent in 2014. Another issue is the identification of the systemic institutions as it currently relies on stress tests that are country-specific and rather opaque. Using a more transparent approach with publicly available market data and published models, NYU-Stern Volatility Lab generates similar measures, yet its assessment tends to differ from official stress test.
Procyclical risk: Basel III introduces a framework for a time-varying capital buffer on top of the minimum capital requirement. The countercyclical capital buffers are intended to make banks more resilient against imbalances in credit markets and thereby enhance medium-term prospects for the economy. While the idea of deflating a bubble instead of letting it burst is quite appealing, several difficulties arise when trying to implement it. One obvious concern is to accurately monitor the credit cycle. The credit-to-GDP ratio suggested in Basel III is an aggregate indicator widely available. Yet, it does not provide any information regarding the source and quality of the credit. We suggest using the composition of bank funding as a complement of information. In “normal” time, core liabilities, namely retail deposits of domestic households and businesses, are stable and grow in line with the economy. In times of “excessive” credit growth, non-core liabilities, that is all the other sources of funding, increase in order to fund the fast-growing lending that cannot be accommodated by core liabilities. These indicators are complementary in the effort to understand the vulnerability of a country’s financial market based on its reliance on short-term funding or short-term foreign currency debt as well as type of lender. Both sets of information are essential when designing well-targeted policy. Finally, the composition of the economy’s non-core liabilities may also indicate a buildup of systemic risk as non-core liabilities are often in foreign currencies, cross-held by other intermediaries, or of shorter duration than retail deposits.
Regulators’ dilemma and challenges.
Assuming policymakers are able to reliably identify the buildup of financial risks in order to effectively lean against the cycle several concerns remain: even when excesses are evident, assessing their impact on the real economy and weighing them against the effects of tighter macroprudential policy are quite challenging. The difficulties range from the risk of diagnostic error (both Type I and II) to how to account for country circumstances and characteristics (financial structure, industrial organization, ownership structure, openness, exchange rate regime, international financial integration, and political economy).
Beyond dealing with the timing and type of macroprudential measures, there is also the issue of who is going to oversee and be responsible for carrying out macroprudential policy. In the United States, the system for implementing macroprudential tools and measures is composed of many independent regulators, each of whom has mandates focused on particular institutions or markets. The legislation governing each agency limits its objectives and the reach of its regulations. No agency has the explicit objective of maintaining financial stability—for taking into account the macroprudential add-ons to microprudential oversight.
The Financial Stability Oversight Council (FSOC), created as part of the Dodd-Frank legislation, has made progress in promoting cooperation among many agencies in the context of shared goals. Yet, the IMF in its latest comprehensive assessment of the U.S. financial system notes that the institutional structure for implementing macroprudential policy needs significant improvement. A strong institutional framework is essential to ensure that the policy can work effectively. It must foster the ability to act in the face of evolving systemic threats, assuring access to information and defining an appropriate range and reach of macroprudential instruments. In other words, the FSOC structure needs to be changed to enhance its independence and its ability to take unpopular stands, especially on countercyclical macroprudential policy.
At its core, the emerging political economy of macroprudential regulation suffers from a political constituency problem. As Claudio Borio of the Bank for International Settlements recounts, there is no ready-made constituency against the inebriating feeling of growing rich that is characteristic of a financial boom. Unlike monetary policy, whose prowess in fighting inflation can be linked to an individual’s own welfare, a macroprudential perspective alludes to systemically beneficial outcomes only tenuously associated with individual gains. In this type of circumstance, it is understandable that politicians might not want to be associated with a policy that could be viewed as “taking away the punch bowl.”
Because the relationship between central banks and government institutions is at an early stage when it comes to managing macroprudential policy, challenges are still being identified. For now, it is safe to say that if institutional silos and rivalries develop, it could hinder risk identification and mitigation, undermining the effectiveness of the policy. The overlap among policy areas is another major challenge. There is also a political challenge in the relationship between finance ministries and central banks on macroprudential questions, given that many decisions will have fiscal as well as financial and monetary implications with institutional politics at play.
Ultimately, the success of macroprudential supervision in supporting financial market stability and, thus, long-term investors’ ability to provide capital to the real economy, will rely on these key components: strong governance; an overall macroeconomic policy framework; a holistic approach to regulation that includes ongoing consultation with asset managers, banks, insurance companies and other financial institutions before taking action; and international coordination.
 Every year, the Financial Stability Board and similar institutions in other countries publish a list of G-SIBs and D/N-SIBs based on a methodology that refers to size, interconnectedness, cross-border activity, the lack of available substitutes, and complexity. Then, each country applies its regulatory measures (Dodd-Frank for the United States) such as higher loss absorbency, more intensive scrutiny, and resolution planning requirements.
 Borio, Claudio. “Macroprudential Policy and the Financial Cycle: Some Stylized Facts and Some Suggestions,” Re-Thinking Macro II conference, IMF, Washington, April 16-17, 2013.
The preceding post comes to us from Claude Lopez, Director of Research, Milken Institute. The post is based on her recent co-authored article, “Macroprudential Policy: Silver Bullet or Refighting the Last War?”, which is available here. A shorter version has been published in the Banking & Financial Services Policy Report.