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The macroprudential approach to regulation and supervision

There is now a growing consensus among policymakers and academics that a key element to improve safeguards against financial instability is to strengthen the “macroprudential” orientation of regulatory and supervisory frameworks. This column explains the approach and various issues that regulators must address to implement it.

There is now a growing consensus among policymakers and academics that a key element to improve safeguards against financial instability is to strengthen the “macroprudential” orientation of regulatory and supervisory frameworks. Paraphrasing Milton Friedman, one could even say that “we are all macroprudentialists now”. And yet, a decade ago, the term was hardly used.

An old idea whose time has come

In fact, the term is not new. At the Bank for International Settlements (BIS), its usage goes back to at least the late 1970s, denoting a systemic or system-wide orientation of regulatory and supervisory frameworks and their link to the macroeconomy. It was already recognised then that focusing exclusively on the financial strength of individual institutions could miss an important dimension of the task of securing financial stability.

The term’s appearance in public documents is of more recent vintage (e.g., BIS 1986). And it was not until the beginning of the new century that efforts were made to define it more precisely, so as to derive specific implications for the architecture of prudential arrangements. This was first done in a speech by the then-BIS General Manager (Crockett 2000) and elaborated in subsequent research (e.g., Borio 2003). In those days, the usage of the term was already becoming more common (e.g., IMF 2000). Subsequently, the macroprudential perspective slowly gained further ground, as described in Knight (2006), White (2006), and BIS (2008), until the current financial crisis gave it an extraordinary boost.

What does it mean?

At the same time, the usage of the term remains ambiguous. What does “macroprudential” really mean? What are its implications for policy? Drawing on the long BIS tradition, this column provides a specific characterisation of the macroprudential approach and highlights some policy implications. In the process, it brings together strands of analysis that may appear as unrelated.

The macroprudential approach has two distinguishing features. It focuses on the financial system as a whole, with the objective of limiting the macroeconomic costs of episodes of financial distress. And it treats aggregate risk as dependent on the collective behaviour of financial institutions (in economic jargon, as partly “endogenous”). This contrasts sharply with how individual agents treat it. They regard asset prices, market/credit conditions and economic activity as independent of their decisions, since, taken individually, they are typically too small to affect them.

In turn, the macroprudential approach is best thought of as consisting of two dimensions.

  • How risk is distributed in the financial system at a given point in time – the “cross-sectional dimension”.
  • How aggregate risk evolves over time – the “time dimension”.

The key issue in the cross-sectional dimension is how to deal with common (correlated) exposures across financial institutions. These arise either because institutions are directly exposed to the same or similar asset classes or because of indirect exposures associated with linkages among them (e.g. counterparty relationships). Common exposures are critical because they explain why institutions can fail together. Just as an asset manager, who cares about the loss on her portfolio as a whole, focuses on the co-movement of the portfolio’s securities, so a macroprudential regulator would focus on the joint failure of institutions, which determines the loss for the financial system as a whole. The main policy question is how to design the prudential framework to limit the risk of losses on a significant portion of the overall financial system and hence its “tail risk”.

The key issue in the time dimension is how system-wide risk can be amplified by interactions within the financial system as well as between the financial system and the real economy. This is what pro-cyclicality is all about (e.g., Crockett 2000, Borio et al 2001, BIS 2001, Brunnermeier et al 2009). Feedback effects – the endogenous nature of aggregate risk – are of the essence. During expansions, declining risk perceptions, rising risk tolerance, weakening financing constraints, rising leverage, higher market liquidity, booming asset prices, and growing expenditures mutually reinforce each other, potentially leading to the overextension of balance sheets. The reverse process operates more rapidly, as financial strains emerge, amplifying financial distress. As a result, actions that are rational and compelling for individual economic agents may result in undesirable aggregate outcomes, destabilising the whole system. The main policy question is how to dampen the inherent pro-cyclicality of the financial system.

Monitoring

A macroprudential approach has implications for the monitoring of threats to financial stability and for the calibration of prudential tools.

Monitoring should not consider institutions on a stand-alone basis or be limited to peer-group analysis. Rather, it should pay special attention to the sources of non-diversifiable, or “systematic”, risk in the financial system. Hence the importance of common exposures across institutions and of possible symptoms of generalised overextension in balance sheets during economic expansions and macro risks. Notable examples are unusually rapid increases in credit and asset prices and unusually low risk premia. The build-up to the current crisis has hammered home the importance of all of these factors.

In the cross-sectional dimension, the guiding principle for the calibration of prudential tools is to tailor them to the individual institutions’ contribution to system-wide risk. Ideally, this would be done in a top-down way. One would start from a measure of system-wide tail risk, calculate the contribution of each institution to it and then adjust the tools (capital requirements, insurance premia, etc.) accordingly. This would imply having tighter standards for institutions whose contribution is larger, contrasting sharply with the microprudential approach, which would have common standards for all regulated institutions. In turn, that contribution will depend on features that are either specific to the institution itself (e.g., its size and probability of failure) or relevant for the system as a whole (its direct and indirect common exposures with other institutions).

In the time dimension, the guiding principle is to calibrate policy tools so as to encourage the build-up of buffers in good times so that they can be drawn down as strains materialise. By allowing the system to absorb the shock better, this would help to limit the costs of incipient financial distress. Moreover, the build-up of the buffers, to the extent that it acted as a kind of dragging anchor or “soft” speed limit, could also help to restrain the build-up of risk-taking during the expansion phase. As a result, it would also limit the risk of financial distress in the first place.

The gathering consensus

The growing consensus on the need to strengthen the macroprudential approach is easily apparent in both policy and academic communities (e.g., Mayes et al 2009, Brunnermeier et al. 2009). The importance of monitoring threats to financial stability on a system-wide basis has been recognised for some time. Hence the proliferation of central bank financial stability reports and the efforts made to develop tools such as early warning indicators and macro stress-tests (e.g., Borio and Drehmann 2008, 2009). More recently, the cross-sectional dimension of the macroprudential approach has attracted considerable attention. Academic work has been seeking to estimate the contribution to system-wide risk of individual institutions (e.g., Acharya and Richardson 2009) and there have been calls for policymakers to extend official oversight to all financial institutions that are “systemic”, regardless of their legal form (e.g., De Larosière et al 2009, G20 2009). Above all, however, it is the time dimension that has been in the limelight. Dampening the pro-cyclicality of the financial system is now widely regarded as a priority (e.g., Brunnermeier et al 2009, Calomiris 2009, Mayes et al 2009, De Larosière et al 2009, G20 2009, FSF 2009). Several work streams under the aegis of the Financial Stability Forum are examining how this might be done. The BIS is actively working in all of these areas.

Future challenges

Looking ahead, the challenges involved in implementing a macroprudential approach to regulation and supervision should not be underestimated (Borio and Drehmann 2008). Some of these are analytical. Both measuring system-wide risks and calibrating policy tools are far from straightforward. For example, what size of capital buffers are needed so that they can be credibly run down without markets insisting on much higher ones at times of potential stress? And how far can their build-up and release be based on rules rather than discretion? Other challenges are of a more institutional and political economy nature. For instance, it is essential to align authorities’ objectives with control over instruments and the know-how to use them. This means that careful thought should be given to mandates, to the composition of the bodies in charge of implementing the approach, and to the necessary insulation from political pressures, which might inhibit attempts to “take away the punch bowl as the party gets going”. Whatever the specifics, this is bound to call for closer cooperation between supervisory authorities and central banks.

Note: The views expressed are those of the author and do not necessarily reflect those of the BIS.

References

Acharya, V and M. Richardson (eds) (2009). Restoring financial stability: How to repair a failed system, Wiley, March 2009.
Bank for International Settlements (1986) Recent innovations in international banking, Report prepared by a Study Group established by the central banks of the Group of Ten countries, Basel, April.
Bank for International Settlements (2001) 71st BIS Annual Report, Basel, June.
Bank for International Settlements (2008) 78th BIS Annual Report, Basel, June.
Borio C (2003) “Towards a macroprudential framework for financial supervision and regulation?”, CESifo Economic Studies, vol 49, no 2/2003, pp 181–216. Also available as BIS Working Papers, no 128, February.
Borio, C and M Drehmann (2008) “Towards an operational framework for financial stability 'fuzzy' measurement and its consequences”, 12th Annual Conference of the Banco Central de Chile, Financial stability, monetary policy and central banking, Santiago, 6–7 November.
Borio, C and M Drehmann (2009) “Assessing the risk of banking crises – revisited”, BIS Quarterly Review, March, pp. 29-46.
Borio, C, C Furfine and P Lowe (2001) “Procyclicality of the financial system and financial stability issues and policy options” in “Marrying the macro- and micro-prudential dimensions of financial stability”, BIS Papers, no 1, March, pp 1–57.
Brunnermeier, M, A Crockett, C Goodhart, M Hellwig, A Persuad and H Shin.(2009): “The fundamental principles of financial regulation,” Geneva Reports on the World Economy 11 (Preliminary Conference Draft).
Calomiris, C (2009) “Financial innovation, regulation, and reform”, Cato Journal, forthcoming.
Crockett, A (2000) “Marrying the micro- and macroprudential dimensions of financial stability”, BIS Speeches, 21 September.
De Larosière et al (2009) De Larosière Report, various authors.
Financial Stability Forum (2009) Report of the Financial Stability Forum on addressing procyclicality in the financial system, Basel, April.
Group of Twenty (2009) G20 Working Group 1: Enhancing sound regulation and strengthening transparency, 25 March.
International Monetary Fund (2000) “Macroprudential indicators of financial system soundness”, various authors, Occasional Paper No 192, April.
Knight, M (2006) “Marrying the micro and macroprudential dimensions of financial stability: six years on”, speech delivered at the 14th International Conference of Banking Supervisors, BIS Speeches, October.
Mayes, D, R Pringle and M Taylor (2009) (editors) Towards a new framework for financial stability, Central Banking Publications.
White, W (2006) “Procyclicality in the financial system: do we need a new macrofinancial stabilisation framework?”, BIS Working Papers, no 193, January.

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