Macroprudential Financial Regulation Is a Myth

If you follow the financial press, you have probably seen coverage of the new bank capital requirements that federal regulators proposed last year. These rules would strengthen capital levels for the United States’ largest banks and thereby complete the implementation of international standards for safeguarding the banking system in response to the 2008 financial crisis. In a new article, we show that even if the banking agencies finalize these rules over the banking sector’s fierce opposition, financial regulators’ job is far from finished. We contend that to prevent another crisis, policymakers must reconsider not only the stringency of regulation governing the financial system, but also the type of regulation as well.

Traditionally, policymakers have adopted a “microprudential” approach to financial regulation. That is, they have sought to ensure the safety of individual financial institutions to prevent them from collapsing. After mortgage-backed securities and derivatives triggered a market-wide meltdown in 2008, however, policymakers and academics began to appreciate that this microprudential approach had ignored critical interconnections within the financial system. Thus, a new strategy known as “macroprudential” regulation emerged as a complementary framework better suited to mitigating risks in modern financial markets. In contrast to microprudential regulation’s focus on the solvency of individual financial institutions, macroprudential regulation aimed to safeguard the financial system by addressing market-wide vulnerabilities.

With the crisis fresh in mind, policymakers and academics eagerly embraced a macroprudential perspective. In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) instituted a slew of new financial stability tools, including enhanced capital requirements, stress tests, and liquidity rules for the largest banks. Many international jurisdictions enacted similar measures, encouraged by global standard-setting bodies that enthusiastically heralded macroprudential regulation as a guiding principle.

In the wake of these reforms, it is now widely accepted that the prevailing approach to financial regulation – both in the United States and abroad – is predominantly macroprudential. For example, former Federal Reserve Chairman Ben Bernanke noted that “a central element” of Dodd-Frank “is the requirement that the Federal Reserve and other financial regulatory agencies adopt a so-called macroprudential approach.” Former Bank of England Chief Economist Andrew Haldane observed that “we have new macroprudential agencies and policies popping up all over the world.” Meanwhile, European Central Bank President Christine Lagarde touted that “macroprudential policy for banks has developed from an idea into a reality.” Numerous scholars, including us, have echoed these descriptions of the post-2008 financial regulatory framework as macroprudential, without considering whether the “macroprudential” label is appropriate.

In our article, we scrutinize the post-2008 regulatory framework and conclude that the macroprudential characterization is misleading. Despite the macroprudential label, modern financial regulation is still predominantly microprudential. Some post-2008 policy innovations nudged financial oversight in a macroprudential direction, but the dominant tools financial regulators use today are just super-sized versions of the microprudential approaches that have existed for decades.

Consider several examples of post-crisis regulatory innovations that are regularly – and, we argue, inaccurately – characterized as macroprudential. Experts commonly describe the international Basel III capital accord as macroprudential. In reality, however, the Basel III framework simply strengthened the microprudential risk-based and leverage capital rules that have formed the basis of U.S. bank regulation since the 1980s. Similarly, the post-crisis stress testing regime – in which supervisors use financial models to assess institutions’ viability during a hypothetical crisis – is popularly believed to be macroprudential. In practice, however, the stress test is a partial equilibrium analysis that overlooks interconnections and feedback loops among different financial institutions – a classic microprudential limitation. Post-crisis liquidity rules that require banks to hold minimum amounts of high-quality, easy-to-sell assets are likewise believed by some observers to be macroprudential. Yet these liquidity requirements are principally microprudential in that they prioritize the safety of individual financial institutions, potentially to the detriment of the financial system as a whole. In many cases, post-crisis regulatory tools could in theory serve macroprudential purposes, but policymakers have chosen to implement them in a way that limits their macroprudential reach.

To be clear, we do not intend to be overly critical of the post-2008 financial regulatory reforms, which significantly improved on the pre-crisis regulatory framework and enhanced financial stability. Indeed, the mislabeling of the post-2008 reforms as “macroprudential” has likely stuck in the collective consciousness because the new rules are such a meaningful advancement over the purely microprudential approach used before the crisis. Given the significance of the reforms, it is understandable that policymakers and scholars would frame them as more paradigm-shifting than they actually were.

The inaccurate portrayal of the post-2008 regulatory framework as macroprudential has serious consequences, as the 2023 banking crisis vividly demonstrated. Since financial oversight remains predominantly microprudential, authorities are prone to overlook interconnections and vulnerabilities within the financial system – such as the correlated uninsured deposits that Silicon Valley Bank issued prior to its sudden demise. A more robust macroprudential approach could help detect and deter such risks, but the incorrect assumption that today’s framework is already macroprudential impedes additional macroprudential reforms.

Our article establishes a roadmap for policymakers to reorient the prevailing, super-sized version of microprudential regulation toward genuine macroprudential oversight. To optimize macroprudential regulation, Congress would need to enact structural reforms to address gaps in the United States’ balkanized regulatory system that impede effective systemic risk oversight. Even if Congress does not act, however, the current regulatory agencies can still enhance macroprudential oversight using their existing legal authorities. For example, we recommend that the agencies strengthen countercyclical capital rules, fix unworkable liquidity requirements, create general equilibrium stress tests, address correlation risks, and mandate central clearing for systemically important instruments. While not an exhaustive list of potential macroprudential reforms, these enhancements would represent a significant step toward the macroprudential orientation that modern financial market oversight demands.

This post comes to us from Jeremy C. Kress, assistant professor of business law at the Stephen M. Ross School of Business at the University of Michigan, and Jeffery Y. Zhang, assistant professor of law at the University of Michigan Law School. It is based on their recent article, “The Macroprudential Myth,” forthcoming in the Georgetown Law Journal and available here.

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