Macroprudential regulation

Macroprudential regulation is the approach to financial regulation that aims to mitigate risk to the financial system as a whole (or 'systemic risk'). In the aftermath of the late-2000s financial crisis, there is a growing consensus among policymakers and economic researchers about the need to re-orient the regulatory framework towards a macroprudential perspective. Macroprudential regulation is the approach to financial regulation that aims to mitigate risk to the financial system as a whole (or 'systemic risk'). In the aftermath of the late-2000s financial crisis, there is a growing consensus among policymakers and economic researchers about the need to re-orient the regulatory framework towards a macroprudential perspective. As documented by Clement (2010), the term 'macroprudential' was first used in the late 1970s in unpublished documents of the Cooke Committee (the precursor of the Basel Committee on Banking Supervision) and the Bank of England. But only in the early 2000s—after two decades of recurrent financial crises in industrial and, most often, emerging market countries—did the macroprudential approach to the regulatory and supervisory framework become increasingly promoted, especially by authorities of the Bank for International Settlements. A wider agreement on its relevance has been reached as a result of the late-2000s financial crisis. The main goal of macroprudential regulation is to reduce the risk and the macroeconomic costs of financial instability. It is recognized as a necessary ingredient to fill the gap between macroeconomic policy and the traditional microprudential regulation of financial institutions (Bank of England, 2009). Following Borio (2003), the macro- and microprudential perspectives differ in terms of their objectives and understanding on the nature of risk. Traditional microprudential regulation seeks to enhance the safety and soundness of individual financial institutions, as opposed to the macroprudential view which focuses on welfare of the financial system as a whole. Further, risk is taken as exogenous under the microprudential perspective, in the sense of assuming that any potential shock triggering a financial crisis has its origin beyond the behavior of the financial system. The macroprudential approach, on the other hand, recognizes that risk factors may configure endogenously, i.e., as a systemic phenomenon. In line with this reasoning, macroprudential policy addresses the interconnectedness of individual financial institutions and markets, as well as their common exposure to economic risk factors. It also focuses on the procyclical behavior of the financial system in the effort to foster its stability. On theoretical grounds, it has been argued that a reform of prudential regulation should integrate three different paradigms: 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. 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), when there are distortions in the economy (such as incomplete markets or imperfect information), 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. 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. 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. In order to measure systemic risk, macroprudential regulation relies on several indicators. As mentioned in Borio (2003), an important distinction is between measuring contributions to risk of individual institutions (the cross-sectional dimension) and measuring the evolution (i.e. procyclicality) of systemic risk through time (the time dimension).