Microprudential regulation aims to prevent the government from being faced with a choice between spending taxpayer money to bailout an insolvent financial institution or suffering a financial and economic collapse. Banking collapses are so costly that it is difficult to resist bailouts when they happen. But the expectation of bailouts generates moral hazard, stoking leverage and risk taking. Microprudential regulation, in the form of leverage and liquidity restrictions of varying complexity, aims to limit the opportunities for bank executives, shareholders, and depositors to take advantage of expected bailouts.
Macroprudential policy, on the other hand, goes further. For macroprudential policymakers, it is not sufficient for banks not to fail during a recession: banks should remain healthy and able to lend freely to solvent businesses and households. The banking sector should not only be stable, it should not amplify macroeconomic shocks. Ultimately, macroprudential policy should ensure that conventional monetary policy, which relies on a healthy banking sector, remains effective even in crisis periods.
This motivation is made clear by considering the primary tool of macroprudential policy—the countercyclical buffer. The countercyclical buffer imposes an additional restriction on bank leverage over and above the limits imposed by microprudential policymakers to ensure solvency in the face of macroeconomic distress. The idea is that the countercyclical buffer should increase in macroeconomic upturns, shoring up the solvency of the financial sector, then it should decrease in macroeconomic downturns, allowing banks to operate at higher leverage and to continue lending during the downturns.
Macroprudential policy has been motivated by developments in economic theory (developments from both before and after the Global Financial Crisis). When banks lend, and when firms and households borrow, they don’t take into account the effects of this lending on financial stability in future periods of financial stress. When leverage is high, macroeconomic shocks are more costly; recessions are more severe and more persistent. Conversely, during recessions, banks who reduce lending, and firms and households who reduce their borrowing, don’t take into account the wider macroeconomic consequences of their prudence, which can similarly deepen and lengthen the recession. By smoothing the path of lending over the business cycle, macroprudential policy is thought to reduce the severity of the business cycle.
The counter-cyclical buffer is primarily a lender-side regulation, limiting the leverage of banks and systemic financial institutions, but macroprudential policymakers have also targeted borrowers directly through loan-to-income and loan-to-value ratio limits. These policies limit the sizes of mortgage loans that could be granted to a retail borrower, conditional upon their income or the value of the property respectively. These borrower-side regulations show clearly the distinction between micro- and macroprudential policy. While an individual mortgage default would not typically motivate a direct cost to the taxpayer in the form of a bailout, widespread homeowner financial stress could generate or amplify a severe recession.
Institutional challenges of conventional macroprudential policy
The macroprudential policymaker could achieve an increase in financial stability through a mix of countercyclical buffers for banks and loan-to-income and loan-to-value limits for households and firms. However, they must be mindful of the potentially dramatic effects that a given combination can have on inequalities between different groups in society.
It is helpful to contrast this strategy with (conventional) monetary policy. When a monetary policymaker (e.g. the US Federal Reserve) is held accountable to an inflation target and is provided with only a single policy instrument (e.g. the US Fed Funds rate), it has very little scope in which to make trade-offs about inequalities between different groups of society, or between different policy objectives that might be favored by one political party over another. This limit on the monetary policymaker’s ability to influence wider economic outcomes beyond its mandate supports the legitimacy of operationally independent central banks.
In the UK, the conflict between macroprudential policymakers and the elected government has raised tensions. In 2015, the UK’s Financial Policy Committee (the FPC) was granted the power to limit the loan-to-value ratio for household mortgages. At the same time, the government was operating a mortgage guarantee scheme supporting 5% deposit mortgages by guaranteeing a portion of the potential losses accruing to lenders. Thus, the FPC’s power to limit household leverage would have meant acting in opposition to government policy.
Limits of conventional macroprudential policy
This is not the only example of conflict between financial stability and other government policy objectives. In the wake of the global financial crisis, the UK government introduced the bank levy, a tax targeted at banks and other lenders to reflect the risks that banks’ excessive leverage and risk taking pose to the wider economy. Initially, the bank levy was contingent on banks’ debt liabilities, it was a tax on leverage. Later, the bank levy was changed to a bank profit surcharge, becoming a tax that encouraged leverage and worked counter to the stated aim of promoting financial stability.
If macroprudential policy measures were not in conflict with other government policies, then macroprudential policy interventions could be less heavy-handed and would likely be more effective. Current institutional structures do not facilitate the scrutiny of government policies by macroprudential authorities, scrutiny that could improve financial stability in the long run while limiting the scope for unintended consequences of macroprudential policy interventions.
Macroprudential policy in the current crisis
During the current economic crisis resulting from measures taken to tackle COVID-19, the most popular macroprudential policy change has been cutting the countercyclical buffer. Since other components of banks’ capital requirements are more difficult to manipulate, policymakers have turned to supplementary measures—unconventional macroprudential policies, if you will. In particular, regulators around the world have eased—temporarily, they claim—how some rules are enforced.
For example, along with other measures associated with forbearance, on 12 March 2020, the European Central Bank (ECB) announced it was releasing its “Pillar 2G” stress test buffer in full until further notice, substantially reducing the required Common Equity Tier 1 (CET1) capital requirement. The ECB is also bringing forward rules allowing banks to meet a larger proportion of their minimum capital requirement with contingent-convertible bonds and subordinated debt instruments, further reducing their CET1 requirements. The Australian Prudential Regulatory Authority has made clear that if banks meet minimum requirements, it will take a more flexible approach to banks’ capital positions for the period of the crisis. Similarly, the Canadian prudential regulator announced a number of policy changes all directed at reducing capital and liquidity rules so as to boost lending. In the US, the Federal Reserve announced that reserves and Treasuries would be exempted from the supplementary leverage ratio until March 2021, reducing CET1 capital requirements by around 2%. The Federal Reserve also announced a more lenient approach to measuring the exposure in derivative contracts.
In addition to these interventions, many regulators have reduced risk-weightings on loans to businesses where government-backed loan schemes have been introduced. In some jurisdictions, favorable funding terms are available to banks who participate in such schemes to further boost lending. Finally, the Basel Committee on Banking Supervision has moved to ease regulatory rules on loss provisioning, again to boost capital ratios and hence support lending.
The effectiveness of, and risks associated with, these conventional and unconventional macroprudential policies are difficult to evaluate. In the UK at least, these policies certainly haven’t been sufficient to maintain bank lending at the levels demanded by policymakers. In order to support lending, the UK government has introduced loan guarantees for up to 100% of small business loans. The Bank of England has also introduced business lending schemes that bypass the banking sector.
In a recent paper, we discuss in more length a key issue that emerges from the sorts of issues we have outlined here: How do you balance macroprudential policy, with potentially a very wide purview and range of responsibilities, capable of impacting on citizens’ lives in important ways, with democratic legitimacy? We came to some tentative conclusions which we conclude by summarizing here.
Summary of recommendations
- Macroprudential policy is about more than ensuring the effectiveness of monetary policy in crisis periods. Macroprudential policy needs to have a wider concern for the efficiency and stability of the financial sector throughout the entire business cycle.
- Macroprudential oversight may not be best situated within central banks, as it currently exists in many countries. The composition of the macroprudential regulator should reflect expertise on tax, accounting, law, corporate governance, and other areas that can impact on the efficiency and stability of the financial system. Macroprudential actions have consequences for the distributions of wealth and income and that should be acknowledged and reflected in any associated decision-making powers.
- Macroprudential policymakers should generate policy recommendations for other areas of public policy. These areas would be likely to include in many countries tax policies that increase leverage, housing, planning or land use policies, and the incentive structure of private sector pay and governance. “Comply or explain” powers would strengthen the weight of these recommendations while limiting the ability of macroprudential policymakers to act unilaterally. In other words, it may be better to have macroprudential policymakers generate policy recommendations that others—including elected politicians—may accept or reject. That way, a wide purview can be reconciled with democratic accountability.
- Macroprudential policymakers’ performance should be checked against a set of intermediate targets. These targets should be informed by economic research, which has identified reliable predictors of financial crises (for example, medium run credit growth). Appropriate intermediate targets are likely to vary across countries, and will also need to be updated as research moves forward from identifying predictors of financial crises to identifying the causal pathways linking macroprudential policy to financial stability outcomes.
Macroprudential policies and institutions are still in their infancy and much is still unknown about the extent of their efficacy. Thoughtful institutional design has the potential to further integrate macroprudential considerations into public policy to manage the current crisis and improve long-term financial stability.
Alfred Duncan is a Lecturer in Economics at the University of Kent.
Charles Nolan is the Bonar MacFie Chair in Economics at the University of Glasgow.
This post is adapted from their recent paper, “Reform of UK Financial Policy Committee”, which is published in the Scottish Journal of Political Economy (Vol. 67, Issue 1).