Macroprudential regulation

On theoretical grounds, it has been argued that a reform of prudential regulation should integrate three different paradigms:[4] the agency paradigm, the externalities paradigm, and the mood swings paradigm. The role of macroprudential regulation is particularly stressed by the last two of them.

The agency paradigm highlights the importance of principal–agent problems. Principal-agent risk arises from the separation of ownership and control over an institution which may drive behaviors by the agents in control which would not be in the best interest of the principals (owners). The main argument is that in its role of lender of last resort and provider of deposit insurance, the government alters the incentives of banks to undertake risks. This is a manifestation of the principal-agent problem known as moral hazard. More concretely, the coexistence of deposit insurances and insufficiently regulated bank portfolios induces financial institutions to take excessive risks.[5] This paradigm, however, assumes that risk arises from individual malfeasance, and hence it is at odds with the emphasis on the system as a whole which characterizes the macroprudential approach.

In the externalities paradigm, the key concept is called pecuniary externality. This is defined as an externality that arises when one economic agent's action affects the welfare of another agent through effects on prices. As argued by Greenwald and Stiglitz (1986),[6] when there are distortions in the economy (such as incomplete markets or imperfect information),[7] policy intervention can make everyone better off in a Pareto efficiency sense. Indeed, a number of authors have shown that when agents face borrowing constraints or other sorts of financial frictions, pecuniary externalities arise and different distortions appear, such as overborrowing, excessive risk-taking, and excessive levels of short-term debt.[8] In these environments macroprudential intervention can improve social efficiency. An International Monetary Fund policy study argues that risk externalities between financial institutions and from them to the real economy are market failures that justify macroprudential regulation.[9]

In the mood swings paradigm, animal spirits (Keynes) critically influence the behavior of financial institutions' managers, causing excess of optimism in good times and sudden risk retrenchment on the way down. As a result, pricing signals in financial markets may be inefficient, increasing the likelihood of systemic trouble. A role for a forward-looking macroprudential supervisor, moderating uncertainty and alert to the risks of financial innovation, is therefore justified.

Several aspects of Basel III reflect a macroprudential approach to financial regulation.[17] Indeed, the Basel Committee on Banking Supervision acknowledges the systemic significance of financial institutions in the rules text. More concretely, under Basel III banks' capital requirements have been strengthened and new liquidity requirements, a leverage cap and a countercyclical capital buffer have been introduced. Also, the largest and most globally active banks are required to hold more and higher-quality capital, which is consistent with the cross-section approach to systemic risk.

Macroprudential tools such as sector-specific capital buffers, loan-to-value limits or reserve requirements on deposits in local currencies are found to affect bank lending in the euro area. More specifically, a tightening in these tools in the country of residence of a foreign branch’s parent is found to be associated with an increase in lending by the foreign branch, with this finding applying to 16 euro-area countries. Additionally, euro-area domestic banks increase lending to the real sector, when loan-to-value limits are tightened abroad.[18] Saurina (2009) argues that dynamic loan loss provisions (introduced in July 2000) are helpful in Spain to deal with procyclicality in banking, as banks are able to build up buffers for bad times.[19]

In the US, a foreign country’s tightening of loan-to-value ratios and local-currency reserve requirements is found to be associated with increased lending by US branches and subsidiaries of foreign banks. Moreover, tighter capital requirements outside the US shift domestic lending by US banks to the US and to other countries, while tighter US capital requirements reduce lending by US banks to foreign residents.[20]

Using data from the UK, Aiyar et al. (2012) find that unregulated banks in the UK have been able to partially offset changes in credit supply induced by time-varying minimum capital requirements over the regulated banks. Hence, they infer a potentially substantial "leakage" of macroprudential regulation of bank capital.[21]

For emerging markets, several central banks have applied macroprudential policies (e.g., use of reserve requirements) at least since the aftermath of the 1997 Asian financial crisis and the 1998 Russian financial crisis. Most of these central banks' authorities consider that such tools effectively contributed to the resilience of their domestic financial systems in the wake of the late-2000s financial crisis.[22]

In pursuing their goal of preserving price stability, central banks remain attentive to the evolution of real and financial markets. Thus, a complementary relationship between macroprudential and monetary policy has been advocated, even if the macroprudential supervisory authority is not given to the central bank itself. This is well reflected by the organizational structure of institutions such as the Financial Stability Oversight Council and European Systemic Risk Board, where central bankers have a decisive participation. The question of whether monetary policy should directly counter financial imbalances remains more controversial, although it has indeed been proposed as a tentative supplementary tool for addressing asset price bubbles.[27]

On the international level, there are several potential sources of leakage and arbitrage from macroprudential regulation, such as banks' lending via foreign branches and direct cross-border lending.[28] Also, as emerging economies impose controls on capital flows with prudential purposes, other countries may suffer negative spillover effects.[29] Therefore, global coordination of macroprudential policies is considered as necessary to foster their effectiveness.