13.3 Macroprudential Policies and Financial Stability

Macroprudential policies aim to prevent financial crises by managing systemic risks. They complement monetary policy by focusing on the stability of the entire financial system, using tools like capital buffers and lending limits to curb excessive risk-taking and build resilience.

Coordination between monetary and macroprudential policies is crucial but challenging. While they can reinforce each other, conflicts may arise when objectives diverge. Policymakers must balance trade-offs and consider potential spillovers to maintain financial stability effectively.

Macroprudential Policies for Stability

Objectives and Focus

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• Macroprudential policies are regulatory and supervisory measures aimed at mitigating systemic risk and maintaining the stability of the financial system as a whole
• The primary objectives of macroprudential policies
  • Prevent the buildup of financial imbalances
  • Reduce the vulnerability of the financial system to shocks
  • Limit the spillover effects of financial distress on the real economy (housing market, corporate sector)
• Macroprudential policies focus on
  • Interconnectedness and common exposures of financial institutions (banking system, shadow banking)
  • Procyclical nature of financial activities (credit growth, asset price inflation)
• These policies complement microprudential regulations, which focus on the soundness of individual financial institutions (banks, insurance companies)

Relationship with Microprudential Policies

• Macroprudential policies take a system-wide perspective, addressing risks that arise from the collective behavior and interactions of financial institutions
• In contrast, microprudential policies focus on the safety and soundness of individual financial institutions
• Both macroprudential and microprudential policies are essential for maintaining financial stability
  • Macroprudential policies target systemic risks and externalities not fully captured by microprudential regulations
  • Microprudential policies ensure the resilience of individual institutions, which is a necessary condition for overall financial stability

Macroprudential Policy Tools

Credit-related Tools

• Countercyclical capital buffers (CCyB) require banks to hold additional capital during periods of excessive credit growth to absorb potential losses and maintain lending during downturns
• Loan-to-value (LTV) ratio limits restrict the amount of credit that can be extended to borrowers based on the value of the collateral (real estate, vehicles)
  • LTV limits can be adjusted over the financial cycle to curb excessive credit growth and mitigate asset price bubbles
• Debt-to-income (DTI) ratio limits cap the amount of debt a borrower can take on relative to their income
  • DTI limits help ensure borrowers' ability to repay and reduce the risk of default

Sectoral Tools

• Sectoral capital requirements and risk weights impose higher capital charges on exposures to specific sectors or asset classes deemed to be risky
  • Examples include higher risk weights for real estate loans or foreign currency lending
• These tools help mitigate concentration risks and discourage excessive lending to vulnerable sectors
• Sectoral tools can be targeted at specific segments of the credit market (mortgages, commercial real estate) or borrower types (households, corporates)

Liquidity and Funding Tools

• Liquidity requirements ensure that banks have sufficient liquid assets to withstand short-term stress
  • Liquidity coverage ratio (LCR) requires banks to hold high-quality liquid assets to cover net cash outflows over a 30-day stress period
  • Net stable funding ratio (NSFR) incentivizes banks to fund their activities with more stable sources of funding over a one-year horizon
• These tools help mitigate liquidity risks and reduce the vulnerability of banks to sudden funding shocks (bank runs, market freezes)
• Liquidity tools can be adjusted over the financial cycle to build up buffers during boom times and allow drawdowns during stress periods

Surveillance and Stress Testing

• Macroprudential surveillance tools help authorities assess the resilience of the financial system to adverse scenarios and identify potential vulnerabilities
  • Examples include systemic risk indicators, network analysis, and early warning models
• Stress testing exercises evaluate the impact of severe but plausible shocks on the financial system
  • Stress tests can be used to assess the capital and liquidity adequacy of banks under adverse scenarios (severe recession, market turmoil)
• These tools inform the calibration and implementation of macroprudential policies and help identify areas requiring supervisory attention or policy action

Macroprudential Policy Effectiveness

Empirical Evidence

• Empirical studies suggest that macroprudential policies can be effective in
  • Curbing excessive credit growth and leverage (LTV and DTI limits, sectoral tools)
  • Reducing the likelihood and severity of financial crises (countercyclical buffers, liquidity requirements)
  • Mitigating the impact of financial stress on the real economy (maintaining bank lending, supporting economic recovery)
• LTV and DTI limits have been found to be particularly effective in moderating housing price growth and reducing the risk of real estate bubbles
• Countercyclical capital buffers can help banks build up capital reserves during boom times, which can be drawn down during periods of stress to maintain lending and support the real economy

Challenges and Limitations

• The effectiveness of macroprudential policies may be limited by
  • Regulatory arbitrage, as financial activities migrate to less regulated sectors (shadow banking)
  • Cross-border spillovers, as domestic policies may be circumvented through foreign lending or borrowing
  • Difficulty in calibrating the appropriate level and timing of interventions, given the inherent uncertainty in identifying and measuring systemic risks
• The impact of macroprudential policies on asset price bubbles is more ambiguous
  • These policies primarily target credit growth and may not directly address irrational exuberance or speculative dynamics in asset markets
  • Other factors, such as monetary policy, investor sentiment, and global liquidity conditions, also play a role in driving asset price fluctuations

Monetary vs Macroprudential Coordination

Complementary Roles

• Monetary policy and macroprudential policies have complementary roles in promoting financial stability, but they operate through different channels and have distinct objectives
• Monetary policy primarily focuses on price stability and economic growth, using tools such as interest rates and open market operations
• Macroprudential policies aim to mitigate systemic risk and maintain the resilience of the financial system, using tools such as capital buffers and lending limits
• In some cases, monetary policy and macroprudential policies may reinforce each other
  • Tighter monetary policy can help curb excessive credit growth and asset price inflation, complementing macroprudential measures
  • Macroprudential policies can help mitigate the financial stability risks associated with prolonged periods of low interest rates

Potential Conflicts and Trade-offs

• There may also be potential conflicts between monetary and macroprudential policies, particularly when their objectives diverge
• Low interest rates and accommodative monetary policy can encourage risk-taking and fuel financial imbalances, even as macroprudential policies aim to contain them
• Macroprudential policies that constrain credit growth or increase the cost of borrowing may have contractionary effects on the economy, potentially conflicting with monetary policy objectives
• Policymakers need to carefully consider the trade-offs and potential spillovers between monetary and macroprudential policies, and adjust their strategies accordingly

Coordination and Institutional Arrangements

• Effective coordination between monetary and macroprudential authorities is crucial to ensure that the policies are aligned and do not work at cross-purposes
• Institutional arrangements can facilitate information sharing and policy coordination between central banks and macroprudential authorities
  • Joint decision-making bodies or committees can help align policy objectives and actions
  • Memoranda of understanding can establish clear roles, responsibilities, and communication channels between the relevant authorities
• The specific institutional setup may vary across countries, depending on the legal and governance frameworks, as well as the level of financial sector development and complexity
• Regardless of the specific arrangement, close cooperation and regular dialogue between monetary and macroprudential policymakers are essential for promoting financial stability in a coherent and effective manner