Institute for Research in Economic and Fiscal issues

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Objectives, Instruments and Problems of Macroprudential Supervision

Since events related to financial, banking, and debt crises regularly make it into the news, a term that seemingly originated from the Bank for International Settlements (BIS) in the late 1970s has become more popular: macroprudential supervision. Whereas microprudential supervision relates to the oversight of individual market participants (e.g. banks), macroprudential policy relates to the supervision of an entire system (e.g. the financial system).

Over the last few years a growing number of voices have been calling for macroprudential supervision in addition to the existing microprudential supervision to create a more robust financial system. When it comes to the effectiveness of macroprudential supervision its proponents appear to be as optimistic as economists of the 1960s who were confident to be able to tame business cycles by using policy instruments to fine-tune the economy. It is possible that the proponents of macroprudential supervision will experience the same disappointment as the economists of the 1960s when they had to find out their policy measures did not lead to the desired outcomes.

Since 2007 the case for macroprudential supervision has often been made. The request for macroprudential policy is based on the insight that behavior by single financial institutions which may be desirable from their individual perspective may in sum lead to outcomes that are anything but desirable. If during a boom banks hand out more credits, the increase in credit volume is attractive for each individual bank. However, for the economy as a whole easy credit may fuel a bubble. Similarly, an individual bank may benefit from reducing its credit volume during the times of a bust to reduce the default risk and to increase its equity ratio. For the economy overall the restriction of credit given by individual banks may make the bust more severe.

The whole economy may also suffer if banks are exposed to similar risks and are highly entangled with one another. The collapse of one financial institution could lead to the collapse of others and thus threaten the stability of the overall financial system.

Such risks that result from individually sound behavior of highly entangled and pro-cyclically acting financial institutions should be reduced by macroprudential policy measures. The objective of macroprudential supervision is therefore to preclude systemic crises whereas the goal of microprudential supervision is to ensure that individual market participants adhere to the rules of the game.

However, to reduce the systemic risk macroprudential supervisors inevitably have to make use of instruments that affect behavior on the micro-level; that is the level of individual financial institutions. Though there are macro phenomena, there can only be micro solutions. Only the behavior of individual enterprises and other market participants gives rise to the observable macro phenomena. Therefore, the instruments of micro- and macroprudential supervision cannot differ with respect to the actors they are aimed at, they can only differ with regard to the goals they pursue.

A macroprudential supervisor is supposed to reduce two sorts of systemic risk. First, highly entangled financial institutions should be less exposed to similar risks. Second, pro-cyclical behavior of financial institutions should be reduced.

Instruments of macroprudential supervision of financial institutions may, among others, concern the rules for granting credit and the accounting rules. A restrictive upper limit on the loan-to-value ratio of loans could be implemented to reduce the financial institutions’ risk exposure. The lower the upper limit of the loan-to-value ratio is in the case of, for instance, private real estate credits the lower is the maximal loan given a certain market value of the real estate borrowed against. Thus, the default risk for credit-granting financial institutions decreases. They are exposed to less risk.

Upper limits for loan-to-value ratios could also have an anti-cyclical element. During a downturn the upper limits could fall while they could rise during a boom. Thereby the credit volume would be dampened during a boom and accelerated during a downturn. The requirements concerning the equity capitalization of financial institutions could also have anti-cyclical elements. Financial institutions could be required to have a higher equity ratio during boom times. Such a constraint would reduce the credit volume. During a contraction the equity capitalization requirements could be weaker to give more leeway to financial institutions when making loans.

On paper risk-reducing and anti-cyclical measures look good. However, especially the implementation of anti-cyclical measures proves to be problematic. That holds true for traditional measures of fiscal and monetary policy as well as for macroprudential measures. The mountains of debt accumulated by states demonstrate that governments do not tend to cut spending during booms to build up a cushion for more difficult times. Rather, governments tend to always spend more than they receive in the form of tax revenue. The central bankers too are no anti-cyclical role models. Being afraid to choke off the boom, interest rates are often not being raised during upswings. As John Taylor, economist at Stanford University, argues convincingly, interest rates were held too low for too long in the US and in the eurozone during the boom of the early 2000s. The monetary policy pursued by the central bankers contributed to the bubbles that started to burst in 2007 – especially on the real estate market.

It is not apparent why a macroprudential supervisor should be more successful at acting anti-cyclical. First, as in the case of governments and central bankers, macroprudential supervisors do not want to be responsible for the slowing down of an upswing. Second, a macroprudential supervisor is confronted with an additional problem. If financial institutions want to increase the credit volume during boom years, they will find ways to do so. If it becomes more difficult for them to use normal credit channels because of regulations, they will find creative solutions to satisfy their customers’ demand for credit. Such a reaction could give rise to structures that are less transparent and to which the supervising agencies possibly have no access. Then financial institutions would still act pro-cyclically, but the supervisors’ perception of the credit market would be more distorted. It would be naïve to think that financial institutions would not react in creative and unforeseeable ways to regulatory barriers. If the pro-cyclical granting of credits is attractive for individual financial institutions, it will probably not be possible to prevent it by regulatory efforts. A debate concerning the failure of governments and central banks to act anti-cyclically could prove more fruitful than a discussion on the implementation of macroprudential measures.

Alexander Fink, PhD

Senior Fellow

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