VoxEU Column Financial Markets

The rise and apparent fall of macro-prudential regulation

Policymakers embraced the rhetoric of macro-prudential regulation in response to the crisis, but most of their proposals have just suggested more micro-prudential regulations of the sort that already failed. This column criticizes those proposals and outlines what real macro-prudential approaches would look like.

An early consensus to emerge from the wreckage of the global financial system was that in addition to the old regulation, we needed a new type – macro-prudential regulation. This became so readily accepted, at a time when policy makers were ready to accept almost anything that appeared to be affirmative action, that the term “macro-prudential regulation” quickly became a cliché – overused and poorly understood. So poorly understood, it now appears, that despite much talk of the need for macro-prudential regulation and its cousin, systemic risk regulation, it is actually hard to find any detailed macro-prudential regulation in the US administration’s white paper. Bank of England Governor Mervyn King has also pointed out that despite being given broader responsibility for systemic risk by the UK Government, he has not yet been given any macro-prudential tools to achieve it.

The term macro-prudential regulation was probably first used in the late 1980s by Andrew Crockett, former General Manager of the Bank of International Settlements. In more recent years his colleagues at the Basel-based BIS, in particular, Bill White and Claudio Borio, championed the idea along with some policy officials – it may be unhelpful to them to identify these by name – and macroeconomists like Charles Goodhart, John Eatwell, Jose-Antonio Ocampo, me and others. The point of macro-prudential regulation is that financial firms acting in an individually prudent manner may collectively create systemic problems. Macro-prudential regulation is a response to a failure of composition problem – we cannot make the financial system safe merely by making every financial institution and product safe.

Proposals to improve the regulation of firms, products and markets – contained in the Obama administration’s white paper – are generally a good thing, but they are not macro-prudential. Moreover, these proposals neglect the critical observation that we have spent the last 20 years tightening up micro-prudential regulation and yet financial crashes are just as deep if not more so, and they do not occur randomly, which a failure of a rogue firm might imply, but always follow booms. The cycle of financial boom and crash implies there is something “macro” going on we need to address separately.

A common source of macro-prudential risk is common behaviour by financial firms – often as a result of close adherence to micro-prudential rules. During booms, asset prices rise and measured risks fall. Acting prudently, financial firms will feel it is safe to expand lending. All financial firms expanding together will lead to a scramble for assets that will lead to unsustainable valuations and lending. During the resulting crashes, asset prices collapse temporarily and measured risks soar. In “Sending the herd off the cliff edge” (Persaud 2000), I showed how all financial firms responding to common, prudential, market-based risk controls would lead them all to want to sell the same assets at the same time, creating a liquidity black hole.

Macro-prudential regulation is about encouraging different behaviour than a prudent firm would follow, wherever this prudential behaviour could undermine the financial system if followed by everyone. It is rather like the paradox of saving. Individually saving is good; collectively we can have too much of it. A classic macro-prudential tool that Charles Goodhart and I have advocated is to raise capital adequacy requirements, not for all times, but specifically when aggregate borrowing in an economy or a sector is above average in an attempt to put sand in the systemically dangerous spiral of rising asset prices leading to rising borrowing to buy assets, leading to rising asset prices. This will not end boom-bust cycles, but it will help to reduce their amplitude. Another macro-prudential tool would be to take a holistic approach to financial regulation and encourage certain risks to flow to places with a capacity for that risk. When the crash comes, firms that can absorb short-term liquidity risks, perhaps because they have long-term funding, are not forced to join the selling frenzy in the name of common prudential rules for all, but are more able to buy and diversify liquidity risks across time. This would forestall the implosion of the financial system that would occur if there are no buyers, only sellers.

Buried beneath the Obama Administration’s proposals are hints at counter-cyclical provisioning, extra capital for liquidity risks at banks, and differentiated accounting, but the paper essentially gives too much to those carrying the pitch forks in Congress who argue that what was wrong was that we didn’t have enough regulation. The brave observation is that we had too much of the wrong regulation. Doubling up existing regulation will satisfy the justifiable moral outrage against bankers that many voters feel; but it will lead to more of the same in financial boom and bust because it is insufficiently macro-prudential.


Persaud, Avinash (2000). “Sending the herd off the cliff edge: The disturbing interaction between herding and market-sensitive risk management practices.” World Economics 1(4): 15-26.

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