To understand macroprudential regulation, we must first contrast it to the more traditional microprudential regulation. We can then begin to examine the breadth of tools that are available, the way in which they function, and how they can be best used by regulatory authorities.
Before 2008, most financial regulation could be classified as microprudential in nature, the objective being to protect against idiosyncratic risk. The costly failure of individual firms could then be prevented, thereby protecting depositors. Several economists have since noted that this approach was both expensive and less effective than it could have been.
Central banks and regulators around the world have decided that a wider approach is needed to ensure the resilience and stability of the financial system, and this brings us to macroprudential regulation.
In contrast to microprudential regulation, a macroprudential framework aims to reduce systemic risk and to limit the cost of the financial sector to the economy as a whole. It does this by prioritising the stability of the financial system as a whole over the survival of individual firms.
The most commonly used macroprudential tools broadly fit into four categories: restricting lending to individuals, regulating the assets of financial institutions, regulating the liabilities of institutions, and building buffers.
Restricting Lending to Individuals
Mortgage loan-to-value (LTV) caps and consumer debt-to-income (DTI) limits are two of the most common macroprudential tools that target lending to individuals.
- LTV caps place a limit on the percentage of a property’s value that can be mortgaged. In theory, this means that homeowners cannot over-leverage their property during a house price bubble, and then face insolvency when property prices crash. LTV caps have been shown to dampen the boom and bust effect in housing markets, thereby shielding the financial system as a whole from the cost of property bubbles.
- DTI limits aim to reduce the availability of credit to individuals once their total debts reach a certain percentage of their income. In theory, this reduces the total amount of lending to individuals who are already heavily indebted, again protecting the financial system as a whole. In the UK this has been implemented by The Bank of England in such a way that loans at or above 4.5 times an individual’s yearly income could only make up 15% of a bank’s new lending each year.
Both LTV and DTI regulations place significant liquidity constraints on individuals and they work on the assumption that financial institutions systematically take on a greater amount of risk than is socially optimal.
Regulating the Assets of Financial Institutions
Credit growth caps and foreign currency lending limits are two of the most commonly used macroprudential regulations that specifically target the assets of financial institutions.
- Credit growth restrictions place a direct cap on the additional amount of credit that financial institutions are allowed to issue year on year. This prevents banks from lending “too much” to firms and individuals; this level is set by regulatory authorities.
- Foreign currency lending limits are designed to protect domestic institutions from global financial contagion by restricting the extent to which they can lend to firms and individuals in foreign currency. This increases the cost to individuals who wish to take out foreign currency loans but limits an economy’s exposure to currency fluctuations.
Both of these policies have an adverse effect on GDP growth, and a foreign currency lending limit can act as a one-sided trade barrier that can be used in currency manipulation or protectionism by governments.
Regulating the Liabilities of Financial Institutions
As one of many regulations on the liabilities of financial institutions, minimum reserve requirements are macroprudential in nature.
- Reserve requirements set the minimum percentage of customer deposits that must be held by a bank in the form of liquid assets. The aim of this regulation is to ensure that banks will be able to pay off their liabilities to depositors without having to liquidate otherwise illiquid assets. This reduces the risk of the fire sales that are caused when assets are simultaneously liquidated by many firms at once.
Minimum reserve requirements place liquidity constraints on lenders, and there is also an opportunity cost in the form of returns that could be made if the reserves could be put to use rather than held.
Dynamic loan-loss provisioning requirements and counter-cyclical capital requirements both use different mechanisms requiring banks to build a buffer of assets that can be used in the event of a downturn.
- Loan loss provisioning forces banks to set aside a certain amount of assets specifically for the purpose of offsetting loans that are not paid back. These funds do not appear on the asset side of the balance sheet, as they cannot be lent out, exchanged, or used to pay off liabilities. They are dynamic in the sense that stocks should be built up when the system is doing well and used during a downturn.
- Capital requirements ensure that a percentage of a bank’s assets are held in capital; this is usually risk-weighted, so if a bank lends to risky borrowers it must hold more capital than if it lends to safe borrowers who are less likely to default. This is often counter-cyclical, so capital is built up in the good times and released in the bad.
The fact that both of these tools are discretionary regulations means that their proper implementation relies on regulators being able to accurately judge business cycles.
The Regulatory Role
One common effect of the macroprudential regulations discussed above is the reduction of liquidity available to both individuals and institutions. It is this trade-off between liquidity and financial stability that is at the heart of macroprudential regulation; regulators are expected to strike a balance between the two.