Macro-Prudential Policies: Putting the “Big Picture” into Financial Sector Regulation

By John Lipsky

The devastating impact of the global financial crisis created a consensus that pre-crisis financial regulation didn’t take the “big picture” of the system as a whole sufficiently into account and, as a result, supervisors in many markets “missed the forest for the trees.” In other words, they did not take into account the macro-prudential aspects of regulation, which has now become the focus of many authorities.

Consensus regarding the need for macro-prudential regulation is particularly striking—previously this type of regulation had been used relatively little and, at present, there are no agreed standards that can be applied internationally

Thus, each of the countries that have adopted a new structure for the macro-prudential approach following the global crisis – including the United States, the euro area, and the United Kingdom – have created somewhat different forms of organization.  In contrast, traditional micro-prudential regulations – that focus on the status of individual financial institutions and on the conditions prevailing in markets for specific financial instruments – long have been formed through cooperation in international standard-setting bodies. It is not surprising, therefore, that post-crisis reforms in traditional regulation already have made substantial progress, with improved international accords in many sectors being agreed in time for the upcoming summit for the leaders of the Group of Twenty industrialized and emerging market economies (G-20) in Seoul.

Macro-prudential conference in Shanghai

Recognizing the need to reach greater understanding about the potential roads to internationally-consistent and effective macro-prudential regulation—and in an effort to make sure that an appropriately broad range of views are taken into account—earlier this week, the Peoples’ Bank of China hosted an IMF-sponsored conference in Shanghai. The conference brought together central bankers and senior financial officials from Asia and around the world to examine and discuss key issues regarding macro-prudential policies. The conference, titled Macro-Prudential Policies: Asian Perspectives, allowed international participants as well as Fund staff attendees to benefit from the views of key Asian policymakers. And vice versa.

What are the aims?

At the conference, there was wide agreement that the first step in designing macro-prudential policies ought to be a convergence of views regarding the objectives of such policies.

Of course, the most basic objective is straightforward—to prevent a crisis like the one just experienced.

As the recent crisis unfolded, troubles in one institution spread quickly to related institutions as well as across national borders, rapidly and dramatically undermining the complex global web of financial relationships. The crisis thereby demonstrated that examining only the safety and soundness of individual financial institutions was inadequate. Supervisors need to be aware of, and respond to, the build-up in system-wide risks.

Thus, a key challenge is to put in place a regulatory framework that ensures the safety and soundness of the entire financial system, and captures how the economic and financial systems affect each other.

A basic objective of reform is to design and implement policies that will short-circuit cross-institution or cross-market knock-on effects that magnify problems. A second objective is to reduce the likelihood that the system as a whole will experience such knock-on effects. This means seeking to dampen the swings in credit and financial cycles that can produce financial system volatility that can damage both the stability of financial markets and the broader economy.

Means of implementation

A basic practical issue is how macro-prudential policies can be incorporated with the traditional set of policy tools.

One option would be some type of capital surcharge or levy based on the degree of systemic risk created by any specific financial institution. In addition to classic micro-prudential requirements for minimum capital to back individual institutions, the new approach would add a new capital layer that takes into account the systemic importance of an institution. The idea would be to modulate an institution’s behavior by making it more costly to pursue those activities that contribute to the build-up of systemic risk.

Other proposals to control systemic risk focus on quantity rather than price-based restrictions, including constraints on size or legal structure or certain activities by financial institutions. In general, however, price-based instruments tend to be more effective because quantity-based instruments may be more subject to gaming and regulatory arbitrage.

Because systemic risks refer not only to institutions but also to markets, new measures should be considered that would make key markets more resilient.

Effective Implementation through Cooperation

Like so many other policy challenges facing modern, globalized markets, a cooperative solution is required. Policymakers need to ensure that macro-prudential policies in differing countries—when designed and implemented—do not contradict or offset each other.

Supervisors also need to focus on cross-border exposures. The effective resolution of large and complex financial institutions that operate in multiple jurisdictions will need to rely on a clearly-designed cross-border framework to reduce moral hazard and support financial stability. On this point, the IMF has proposed a pragmatic approach. We hope a small set of countries that house the most interconnected firms will begin to make progress in this area.

For many countries, an open question remains regarding which agency should design and implement macro-prudential policies – a new global body, a central bank, or the existing micro-prudential regulatory body? In general, participants in the Shanghai conference favored this job being awarded to central banks.

Whatever path is chosen, however, the regulators must be supported by good information gathering, clear mandates and powers, effective tools, and, perhaps most important, cooperation between authorities nationally, and across borders.

22 Responses

  1. [...] Une politique monétaire doit être guidée non seulement par la stabilité des prix, mais aussi par un niveau optimum de production, par la recherche de stabilité financière. A la liste des instruments habituels à sa disposition, il convient d’ajouter des mesures macroprudentielles. [...]

  2. [...] have since made significant progress in developing macroprudential policy measures aimed at containing system-wide risks in the financial sector. Yet progress has been uneven. [...]

  3. [...] have since made significant progress in developing macroprudential policy measures aimed at containing system-wide risks in the financial sector. Yet progress has been uneven. [...]

  4. [...] argue that more needs to be done to introduce macroprudential policies-ones that take into account the big picture of the financial system as a [...]

  5. [...] argue that more needs to be done to introduce macroprudential policies-ones that take into account the big picture of the financial system as a [...]

  6. [...] argue that more needs to be done to introduce macroprudential policies-ones that take into account the big picture of the financial system as a [...]

  7. [...] argue that more needs to be done to introduce macroprudential policies-ones that take into account the big picture of the financial system as a [...]

  8. [...] argue that more needs to be done to introduce macroprudential policies-ones that take into account the big picture of the financial system as a [...]

  9. [...] We don’t know how to do it and it would be unwise. We can, however, introduce gradually some macro-prudential tools, testing the water to see how they [...]

  10. [...] inflation stability, adding output and financial stability to the list of targets, and adding macro-prudential measures to the list of [...]

  11. Central bank of Brazil has been using, what it calls, macroprudential measures. But they do not even resemble the definition presented or the scope of discussion. There has been no clear statement of the aim of such measures and the central bank stated that macroprudential measures can help curb the credit growth supporting the monetary policy, which would therefore need to tighten less than otherwise. I reckon this is a big mistake because of a lack of clear target. At some point the aim is to cool credit, at other time is to prevent excessive FX inflows. What is your view about the use of macroprudential policies as an active policy to control inflation?
    best

  12. [...] inflation stability, adding output and financial stability to the list of targets, and adding macro-prudential measures to the list of [...]

  13. [...] inflation stability, adding output and financial stability to the list of targets, and adding macro-prudential measures to the list of [...]

  14. Mr. Lipsky:

    Thank you for expressing your concerns about practicability so clearly. I want to repeat them here in order to gain readers of this blog’s attention to an idea for implementing them:

    “A basic practical issue is how macro-prudential policies can be incorporated with the traditional set of policy tools.

    One option would be some type of capital surcharge or levy based on the degree of systemic risk created by any specific financial institution. In addition to classic micro-prudential requirements for minimum capital to back individual institutions, the new approach would add a new capital layer that takes into account the systemic importance of an institution. The idea would be to modulate an institution’s behavior by making it more costly to pursue those activities that contribute to the build-up of systemic risk.

    Other proposals to control systemic risk focus on quantity rather than price-based restrictions, including constraints on size or legal structure or certain activities by financial institutions. In general, however, price-based instruments tend to be more effective because quantity-based instruments may be more subject to gaming and regulatory arbitrage.”

    And I particularly hear your concern about gaming and regulatory arbitrage. Would you agree that virtually all gaming and regulatory arbitrage has to take place in HFT and in derivatives (which, for purposes of this discussion, I define as financial assets removed from the ordinary instruments by which real economy goods are traditionally owned)?

    If so, it might be a truism that systemic risks cumulate one financial transaction at a time, but stating this truism helps us recognize that gaming and regulatory arbitrage are given greater scope the further away from the inititation and resale of HFT and derivatives macro-prudential policies exert their influence. Ideally people like you and Per and I would like to be entitled to hope that the people whose behaviour our policies are designed to influence with macro-prudential rules aimed at institutional behaviour are by no means free from the temptations to game and exploit arbitrage. They too live in a world we all feel is growing too competitive for comfort!

    Given that, then it seems to me that a solution you and Mr. Strauss-Kahn might try to have included in some hopefully binding way in the final Seoul G20 communique is what many people are now calling a SMART FTT. A smart FTT recognizes that the systemic risks in HFT can be managed by an FTT that is differentiated by contract length. It also recognizes that systemic risks in derivatives generally can be managed by an FTT that is differentiated not only by contract length but also by an additional factor that reflects the number of ordinary instruments synthesized into them.

    A paper that suggests how you and other G20 participants might shape the structures of a smart FTT is available at:

    http://www.authentixcoaches.com/dsFCTFinReg.html .

  15. In the Financial Times of October 26, Vikram Pandit, the chief executive of the Citigroup, shames all development economists when he is quoted saying “Under Basel, the ‘sweet spot’ business model for banks in the developed world will be to take retail deposits from mom and pop – small but stable customers – and lend only to big business and the wealthy. I do not believe this is the banking system we want”

    All development economists who have kept silence on the issue of the arbitrarily, discriminatorily and lousily calculated capital requirements for banks based on the perceived risk of default, should also join the Basel Committee members in wearing a cone of shame!

  16. “At the conference, there was wide agreement that the first step in designing macro-prudential policies ought to be a convergence of views regarding the objectives of such policies.

    Of course, the most basic objective is straightforward—to prevent a crisis like the one just experienced.”

    Can the convergence of views only be expressed in the lowest common denominator of preventing another 2008 crisis? I for one believe that the monetary system can be used to combat climate change and advance low carbon, carbon-resilient development by basing it upon a carbon standard. Such standard would make currencies convertible and would remove the costly global reserve system. Curious, how that can be done? Go to http://conference.unitar.org/yale/environment-sustainable-development

  17. Mr. Lipsky, if you and I were going to design some capital requirements for banks based on the risk of default of borrowers as measured by the credit rating agencies, would we use the default rates those credit ratings generally imply, or would we use the default rates suffered by the banks after the bankers received that credit rating information? I am sure you and I would agree on using the second alternative, since the first really makes no sense as it would imply that bankers do not take notice of the credit ratings, something that with the capital requirements based on these ratings, we are really making sure they do.

    If we so then use the default risk for banks after credit rating information, would we also adjust our risk-weights to the fact that those perceived as riskier are charged much higher interest by the banks than those perceived as less risky? I am sure we would definitely consider that important risk mitigation factor and apply it, since otherwise we would be perceived as foolishly assuming that all borrowers paid the bank the same interest rate.

    But since we now know that our bank regulating chaps at the Basel Committee did nothing of the sort, they just used gross default rates unfiltered by the bankers applying their own credit analysis criteria, and they completely ignored the mitigation of a higher default risk provided by higher interest rates, isn´t it time we call them home so as to have a serious man to man conversation about what they are up to? I mean before they go on to tackle even much bigger problems like counter-cyclicality and systemic risk. I mean so as to inform them about the fact that they, in their own right, are becoming our greatest source of systemic risk.

    I believe we should. Just consider the mess they did by making the banks stampede after some lousy securities just because these were rated triple-A; and all the small businesses and entrepreneurs who have seen their access to bank credit curtailed or made more expensive just because their odious regulatory discrimination against perceived risk.

    A verse of a Swedish Psalm reads: “God, from your house, our refuge, you call us out to a world where many risks await us. As one with your world, you want us to live. God make us daring!”

    “God make us daring!” That is indeed a prayer that the members of the Basel Committee do not even begin to understand the need for.

    • Per tells us we should be talking truth to the powers in Basel:

      “Just consider the mess they did by making the banks stampede after some lousy securities just because these were rated triple-A; and all the small businesses and entrepreneurs who have seen their access to bank credit curtailed or made more expensive just because (of) their odious regulatory discrimination against perceived risk.”

      IMO we can scarcely overstate the necessity for reversing the damage Per describes, IMO accurately. Do we want the brightest minds in banks devoted to inventing ingenious derivative clauses or do we want them listening and learning to the real small and medium entrepreneurs who will lead us out from doing the unhealthy things we all know “the economic system we live in” is doing, or do we want them working in their shirtsleeves shoulder to shoulder in the new more organic economy we are all learning every day we must move toward?

  18. “Whatever path is chosen, however, the regulators must be supported by good information gathering, clear mandates and powers, effective tools, and, perhaps most important, cooperation between authorities nationally, and across borders.”

    You forgot to add that new regulators must also be democratically accountable to the constituent and transparent in their actions. Otherwise you keep reaffirming the widely held belief that the IMF is just a secretive group in place to represent powerful global interests.

  19. Please excuse my perplexed state, but I remain so mainly because of the shallowness of ideas being bandied about.

    So far, two years into this evolving and continuing major crisis, we seem to agree that we need to come to agreement on the definitions of what the problem is and what the solution is going to be, but whatever it is we will call it supra-national, macro-prudential super-regulation.

    Maybe that should be a big confidence builder, but it isn’t.
    First problem I have with the notion presented here is the indication that nobody in power anywhere is actually working on the exit strategy from the debt-money system.

    So with a whole lot of talk about public policy and financial, economic and monetary STABILITY, there is no action to make it happen.

    So, your homework this week is to review the systems dynamic macro-economic modeling of Dr. Kaoru Yamaguchi from Doshisha University in Kyoto on the effects of alternative macro-economic monetary structures, notably a switch to a system of direct debt-free government issuance of money, as proposed in the American Monetary Act.

    The results of Dr. Yamaguchi’s work are available here:

    http://bs.doshisha.ac.jp/download/files/activity10/discussion/DBS-10-01.pdf

    Just in case there’s a group inside the IMF that is secretly thinking along the lines of ‘This thing isn’t going to end good”, you should give this to them first. Cause they’re right.

    Yours for financial, economic and monetary stability,

    Joe Bongiovanni
    Harborton, Virginia
    The Kettle Pond Institute

  20. Taking a look, Mr. Lipsky, at the report linked by your statement “IMF has proposed a pragmatic approach”, I noticed that it includes a section calling for “Robust Supervision”. Did anyone’s heart sink when reading that phrase?

    Mine sank quite a bit because robust supervision of the quick-silver innovation for which the financial industry once was famous and recently has become sordidly infamous requires a degree of dedication and urgency that is rarely seen outside a national war of survival. We may get to that one day, but thank God or the IMF, we’re not there yet.

    In contrast to the eminently reasonable pragmatic logic of a macro-prudential framework stand proposals for a smart and practicable FTT. A smart FTT is capable of making very unlikely that events like Goldman’s proprietary desk traders being picked up by KKR in a legal structure outside the new Dodd-Frank legislation will be our breakfast fare in perpetuity as regulations are refined to the finest, finest decency humans can devise. But can you honestly tell us that the report you refer to is likely to bring us urgently to a place when the desire to make money for money’s sake fades and the want to make a real contribution grows in its stead. Because if it can’t, then I think you and your IMF colleagues must ramp up your ingenuity and political courage to get G20 countries to install a smart FTT ASAP.

    A paper on the subject is available at the following URL:

    http://www.authentixcoaches/dsFCTFinReg.html .

    And a letter is in the process of being drafted to help you help Mr. Strauss-Kahn interest G20 leaders in this approach to weaning chremastatic addicts whose names we see every day in the financial-economic news media every day off the more perverse of their Ponzi derivative contract schemes.

  21. Since only what is perceived as having a low risk of default, like that which is triple-A rated, can grow into signifying a systemic threat, why do they just not start by eliminating those utterly stupid capital requirements for banks that so excessively discriminate in favor of what is perceived as having a low risk of default… and of course made the banks stampede after the AAAs, which later turned out to be only ‘Potemkin’ AAAs

    Had it not been for the Basel Committee refusing listening to some old fashion common sense, from people who know how life is out there in the real world, these experts would most probably not even have had the need to discuss these issues.

    You want to know what a systemic risk implies? That a whole generation of our youngsters can be lost studying the wrong kind of subjects at school… but that it will not disappear in anything risky like a collective bungee-jumping! A perceived high risk is in fact something quite unattractive to humans… no matter what desktop theoreticians would want us to think.

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