FOCUSED AND QUICK (FAQ) Issue 39
MACROPRUDENTIAL POLICY: what it is and what it is not
Summary Despite increasing attention on macroprudential policy in economic and financial policy agendas, disagreements and debates remain over its definition, scope, framework, and instruments, not to mention the more complicated technical issues such as risk measurement and assessment and calibration of policy instruments. Given this fuzziness, the danger lies in over-stretching macroprudential policy to be something more than what it is intended. Doing so can lead to a misunderstanding that macroprudential policy is the answer to all systemic risk issues, overstepping the importance and role of other policies. Hence, before going headlong down this road, there is urgency in aligning our understanding of macroprudential policy, beginning with the most basic issue: what it is and what it is not.
The first use of the term "macroprudential" dates back to 1979, at a meeting of the Cooke Committee - the forerunner of the present Basel Committee on Banking Supervision (BCBS) of the Bank for International Settlements (BIS), to address the link between prudential regulations and macroeconomic concerns, which at the time focused on the implications on financial stability of rapidly growing bank lending to emerging economies. (Clement, 2010) Such a microprudential problem was deemed to carry with it a macroeconomic consequence such that the problem became a "macroprudential" one. Over the years, more attention was paid to the concept of macroprudential, particularly in Europe. In 1986, the Euro-currency Standing Committee (ECSC) reported on the use of macroprudential policy to promote the safety and soundness of the broad financial system and payments mechanism with respect to the risk inherent in financial innovations.
By the late 1990s, the term began to receive attention from outside the central banking circles, including the International Monetary Fund (IMF) in the wake of the 1997 Asian crisis. In the IMF report "Toward a framework for a sound financial system" released in 1998, a macroprudential perspective is cited alongside microprudential as crucial for effective bank supervision. The main follow-up to the report included works on development of financial system vulnerability indicators as well as the Financial Sector Assessment Programs (FSAP). Still, the meaning of macroprudential remained vague and it seemed those who used it, used it to mean similar but different things.
Now, some thirty years after macroprudential was termed, debates on its interpretation continue. Currently, the most agreed upon definition of macroprudential policy is one that came out of a joint work between the Financial Stability Board (FSB), the BIS and the IMF mandated by G20 Leaders in 2010.According to the working group, macroprudential policy is defined as "a policy that uses primarily prudential tools to limit systemic or system-wide financial risk , thereby limiting the incidence of disruptions in the provision of key financial services that can have serious consequences for the real economy." (FSB, IMF and BIS, 2011)
Other interpretations overlap with this at one point or another. For example, the strict BIS view actually prefers to focus on the use of prudential instruments (bank regulation and supervision policies e.g. capital buffers provisioning requirements etc.) in pursuit of financial stability, thus macroprudential is a macro perspective of prudential regulation . (Borio, 2003 and 2009) The problem with this narrow definition is that it tends to limit the range of policy instruments. Thus, the IMF's view allows for the inclusion of non-prudential instruments as part of the macroprudential policy toolkit, provided that they (i) target explicitly and specifically systemic risk; and (ii) are underpinned by the necessary governance arrangements of the macroprudential authority to ensure there is no slippage in their use. These instruments include capital account policies as well as other monetary instruments. (IMF, 2011) Perhaps in the most extreme case is when macroprudential is seen as effectively synonymous with any policy that promotes financial stability or limit systemic risk. (Borio, 2010) The danger with such a broad definition is that it tends to blur areas of responsibilities among different authorities sharing the same objective.
First is the objective . Every school of thoughts agrees that the objective of macroprudential policy is to limit system-wide financial distress with significant losses in terms of real output for the economy . (FSB, IMF, BIS, 2011) This is the most important distinguishing characteristic of macroprudential from microprudential perspective, which focuses on financial distress at individual institutions, regardless of their impact on the overall system. Differing in focus, macroprudential policy then pays attention to correlations and common exposures across institutions and view risks as in part endogenous with respect to the behaviour of the financial system rather than something exogenous. (Borio, 2003 and 2009)
Second is the number of dimensions of systemic risk . Macroprudential policy aims to address two dimensions of systemic risk: the time dimension or how systemic risk evolves over time and the cross-sectional dimension or how risk is distributed at a given point in time. On the time dimension, the key issue is to mitigate or dampen financial system "procyclicality", which refers to how systemic risk can be amplified by interactions within the financial system and between it and the real economy. For instance, in an economic upturn, ample credit availability can result in rising leverage and rapid increases in asset prices. Higher asset prices strengthen financial institutions' balance sheets, allowing them to extend more credit, thus further amplifying growth. On the other hand, in an economic downturn, substantial deleveraging and reduction of credits can induce widespread financial distress, thus further exacerbating the contraction. The key issue is how to build up buffers in good times to be run down in bad times. On the cross-sectional dimension, the key issue is to reduce systemic risk concentrations that arise from similar exposures across financial institutions or balance sheet linkages among them. Here, the key issue is to ensure that capital buffers called upon at individual institutions match their contribution to systemic risk, thereby containing spillovers from their failure. (Borio, 2003 and 2009, IMF, 2011) Chart 1 illustrates the two risk dimensions.
While many policies can be used with an aim to preserve financial stability and address systemic risk, not all of them should be considered macroprudential. And among those policies that are considered macroprudential, it must be understood that they complement but cannot substitute for sound microprudential and macroeconomic policies. (Caruana, 2011)
Chart 2 depicts a financial stability framework consisting of an array of policies, which expands outward from the heart of any economy, that is, a strong macroeconomic foundation . Both the monetary and fiscal authorities should first and foremost ensure that imbalances will not be created by their own actions. Here, price stability (inflation targeting and flexible exchange rate regime) and fiscal prudence are key. Monetary policy, in particular, plays a crucial role in setting the price of leverage in the financial system and the economy such that the more monetary policy leans against emerging imbalances, the less is the need for macroprudential actions. Strong and resilient financial institutions come next . With higher resiliency to both idiosyncratic (microprudential concern) and system-wide (macroprudential concern) shocks, the cost associated with any downfall becomes smaller. A prompt and effective crisis management mechanism also plays a role of a curer in times of distress as highlighted time and again during past episodes of financial crises. Other policies also play their parts . For example, competition policy helps enhance efficiency while in times of need, extraordinary measures intended for crisis prevention should also play their respective role. (IMF, 2011)
A strong macroeconomic foundation is like a person's overall health condition. Just like how a strong person is less prone to illnesses, a strong economic backdrop supported by the notion of price stability is less prone to financial imbalances. There are at least monetary policy can affect risk taking of banks. First , a reduction in the policy rate boosts asset and collateral values , which in turn strengthens banks' balance sheets and lower estimates of losses. So, they borrow to lend more and take higher positions in stocks. Second , a low interest rate reduces the return from safe investment such as government bonds, and induces incentives for asset managers to search for higher yields from higher-risk instruments. Third , monetary policy can affect habit formation . During an economic expansion supported by eased monetary conditions, investors may become less risk-averse because their income increases relative to the norm. Finally , risk-taking can also be influenced by the Monetary Policy Committee (MPC)'s communication and reaction function . For example, when one perceives that the MPC will lower the policy rate in anticipation of a bad economic outturn, the probability of large downside risks actually declines, thereby producing an insurance effect and encourages higher risk-taking. For these reasons, some argue that in good times monetary policy should perhaps be kept tighter than strictly required in order to discourage banks' incentive to take on risks. (Altunbas et. al, 2010) Chart 3 summarizes these relationships.
The above highlights how good monetary policy conduct helps lessen financial imbalances and thereby support the role of macroprudential policy. On the flip side, prudential support can also be important for monetary policy implementation. One lesson from the recent global financial crisis is that low inflation and a stable macroeconomy is not sufficient to secure financial stability Credits and asset prices become more instrumental. Though the argument for monetary policy to lean more against the build-up of financial imbalances even when near-term inflation pressure remains subdued so as to limit the risk of a subsequent unwinding has become stronger in recent years, raising the interest rate to tackle asset price inflation encounters several problems . First, the extent of monetary policy tightening required may be very large, thus producing undesirable impact on vulnerable sectors i.e. the interest rate is a blunt instrument. Second, given the lag in policy transmission, a rate hike can end up being not only too little but also too late. Third, even a smallest rate increase may be controversial especially when growth prospects are highly uncertain or there is a risk of inducing substantial capital inflows.
Specifically targeted macroprudential policies can fill these gaps. (Borio and Shim, 2007) For example, against a build-up of imbalances in the real-estate sector, a lower loan-to-value ratio can be imposed on mortgage lending. In the case of credit booms in the household sector, a tighter credit standard such as minimum income requirement or maximum credit-to-income can be applied. The BOT has done both in the past. Below is a list of common prudential instruments used for macroprudential aim.
The current episode of strong capital flows into emerging market economies is an important policy challenge confronting central bankers as it puts a premium on the sound conduct of macroeconomic policies. To deal with this issue, an appropriate policy mix must be designed. Amongst the options available is macroprudential policy. However, attempts to include capital controls as part of the macroprudential policy toolkit have recently spurred a lot of discussions . It is true that most of the time when capital controls are considered, they are intended to preserve financial stability. For this reason, the IMF has been somewhat generous in its stance in allowing a possible classification of non-prudential instruments including capital controls as macroprudential. This approach is fair but one must bear the risk of opening Pandora's Box where (1) macroprudential is claimed for other agenda, including the exercises of non-competitive policy and (2) the macroprudential authority is assigned with too much power and responsibility, stepping over policy boundaries and reducing the effectiveness of other policies.
The BIS views capital controls as a separate type of policy responses to capital flows from macroprudential policies. The rationale is to think in terms of a hierarchy of policy responses , beginning from inside the country's macroeconomy and financial system i.e. the pre-condition and then looking beyond. First is the need to preserve domestic monetary stability . This calls for tighter monetary policy to contain domestic price pressures in view of sustainable growth in the long run. Fiscal consolidation and appropriate exchange rate adjustments are also important. Given the strong macroeconomic defense, the second line of policy response is macroprudential measures , which target flows that are already "in" the financial system and various sectors of the economy . From this perspective, capital controls are not macroprudential. They are considered as measures of last resort or a safety valve to address transitory capital flows in highly unusual circumstances. If in place for too long, the chance of adverse economic side effects and resource misallocations can be more damaging than the short-term gain. (Caruana, 2011)
We generally agree with this view - that capital controls may be used to curb systemic risk but one should not confuse such capital account regulations with the traditional spirit of macroprudential regulations. At the core of the BOT's framework in dealing with capital flows is the flexible exchange rate regime, which acts as an automatic stabilizer. Exchange rate intervention can come into play to dampen excessive pressures and volatility from time to time. Macroprudential measures are then used to deal with specific pockets of vulnerabilities resulting from capital that are already inside the country. Measures that deal directly with the size and type of incoming and outgoing flows are categorized as capital account regulations. (Trairatvorakul, 2011)
Macroprudential policy is not a new concept but understanding it has become more challenging as the complexity of our economy and financial system grows. In essence, macroprudential policy is part of the overarching policy toolkit to address systemic risk and preserve financial stability. It is not the answer, but only part of the answers. Sound macroeconomic policies are the heart and soul while prudent microprudential regulation and supervision, effective crisis management framework as well as other policies to strengthen the financial system must not be forgotten.
Vararat Khemangkorn
Senior Economist
Monetary Policy Department
Altunbas Yener, Gambacorta Leonardo and Marques-Ibanez David, 2010. "Does monetary policy affect bank risk-taking?"
Borio Claudio, 2003. "Towards a macroprudential framework for financial supervision and regulation?"
________________, 2009. "Implementing the macroprudential approach to financial regulation and supervision."
________________, 2010. "Implementing a macroprudential framework: blending boldness and realism."
Borio Claudio and Ilhyock Shim, 2007. "What can (macro)-prudential policy do to support monetary policy?"
Caruana Jaime, 2011. "Capital flows to the emerging market economies: a perspective on policy challenges." Speech at the 46 SEACEN Governors' Conference
Clement Piet, 2010. "The term macroprudential: origins and evolution."
Committee on the Global Financial System (CGFS), 2010. "Macroprudential instruments and frameworks: a stocktaking of issues and experiences."
Financial Stability Board, International Monetary Fund, and Bank for International Settlements, 2011. "Macroprudential Tools and Frameworks." Update to G20 Finance Ministers and Central Bank Governors
International Monetary Fund (IMF), 2011. "Macroprudential policy: an organizing framework."
Trairatvorakul Prasarn, 2011. "Living with capital flows: a delicate balancing act." Speech at the 5 th Annual Euromoney Thailand Investment Forum
Source: Bank of Thailand