Macroprudential tools, the great unknown

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September 10th, 2014

The vital signs of the world economy and especially the advanced economies are starting to stabilise. The serious economic and financial crisis that erupted in 2008 affected most countries, with a wide range of symptoms: unsustainable levels of debt, sharp drops in some assets and huge losses in output and employment terms. Some of the economies affected were immediately treated with large doses and got quickly back on their feet. Others, however, have needed intensive care to recover. The drip that has helped all of them to consolidate their recovery, albeit still at differing rates, is the ultra-accommodative monetary environment established by the central banks, cutting interest rates to their lowest ever levels and implementing unconventional monetary policies. This protective environment has been crucial for the administration of different treatments to remedy the imbalances of the economies affected, including restructuring the financial system, strict fiscal consolidation policies, private sector deleveraging and structural reforms to boost competitiveness.

Although this environment of ultra-lax monetary policy has undoubtedly helped the economic recovery, there may be harmful side effects for some sectors should it go on for too long, such as the overheating of financial or real assets (for example, real estate). Withdrawing the monetary stimulus could help to cool down overheated markets but today's recovery still needs an accommodative monetary context to boost consumption, keep financial markets calm and consolidate the growth in economic activity. Given this dilemma, and due to the need to prevent, or at least reduce the likelihood of such bubbles forming, macroprudential tools have appeared on the scene, largely unknown but increasingly important as it becomes clear they have the potential to complement the more commonly used monetary tools.

Let us start at the beginning. Macroprudential policy is the use of supervisory and regulatory instruments with the common goal of limiting any pro-cyclical impact1 the financial sector may have on the rest of the economy. Under certain circumstances, decisions regarding the most ideal banking strategy for each bank, if also implemented by a significant proportion of the industry, could affect the course of the economy as a whole. The current situation is a good example of this. Given that the quality of the demand for credit in several countries is still suffering from the  repercussions of the recession, a lot of banks need to implement a strict credit policy. However, this could slow down the recovery which, in turn, would also ultimately delay the recovery in credit.

For the first time, the new banking regulation, also known as Basel III,2 includes mechanisms that explicitly take such aspects into account. The most obvious example is the introduction of countercyclical capital buffers which increase at times of high credit growth and are relaxed during credit squeezes. In this way, during booms the banking system becomes strong enough to tackle any recessionary phases under better conditions. Moreover, this kind of policy limits how much the sector can amplify economic cycles. An increase in capital requirements may help to slow up a possible credit bubble while a relaxation in capital requirements during recessionary periods helps to cushion the drop in credit, thereby easing the crisis. Nevertheless, in the current contracting cycle the opposite happened and capital  requirements were tightened up, making the slump in credit even worse. A recent study3 highlights the importance of this tool, suggesting that, if it had been put into practice before the crisis, it would have saved almost all the fiscal costs incurred by Spain for bank recapitalisation and one fourth of these costs in Ireland.

There are other instruments that share the same philosophy but which, instead of acting on credit as a whole, allow action to be taken on certain assets in particular. This option can be very useful when bubbles are spotted in specific assets as direct action can be taken without affecting the rest of the sectors. For example, one option would be to modify the capital requirements for the type of credit in question. For the specific case of real estate which, as mentioned in the article «Are international property markets overheating?» in this Dossier, is once again becoming a concern in several developed countries, in addition to the aforementioned policies another option would be to limit mortgages for households throughout the cycle, either via loan-to-value restrictions, which limit the size of the mortgage compared with the value of the property, or via the debt-to-income ratio, which conditions the size of the loan on the borrower's income. These measures have already been extensively used both in emerging countries and also in advanced economies, Sweden and the United Kingdom being the most recent cases. In the Scandinavian country, banks' capital requirements in proportion to their mortgages were increased and new mortgages could not exceed 85% of the market value of the property being financed, with the aim of slowing down the rapid growth in mortgage loans and thereby making a property bubble less likely. The United Kingdom has also carried out similar measures. Specifically, the British macroprudential authority (Prudential Regulation Authority) has established that higher risk mortgages (those worth more than 4.5 times the customer's annual income) should not represent more than 15% of all new mortgages granted by British banks.

Going back to our medical analogy, an illness often needs to be tackled from different angles in order to be cured. The successful implementation of macroprudential policy depends on there being a good system of macroeconomic policies (fiscal and monetary) and a good financial regulatory and supervisory framework. It is therefore crucial to realise that such policies are complementary in order to get the maximum benefit from them.

Macroprudential policies and monetary policies are very closely related and, if not applied correctly, they could act against each other. A monetary policy that is too lax could affect financial stability and encourage participants to take greater risks (see «The temperature is rising in international financial markets: bubble or just a hot spell?» also in this Dossier). Similarly, a badly regulated macroprudential regulation might restrict the flow of credit to the economy too far. However, good coordination between both policies could be very useful. For instance, the harmful effects of a monetary policy that is too accommodative can be offset by a more restrictive macroprudential policy that cools down any sources of overheating in specific sectors. Given the important role of macroprudential policy, this requires a well-defined regulatory framework with a wide range of previously tested instruments that are ready to be implemented.

The role of macroprudential tools can therefore be vital. If regulatory institutions are capable of detecting the origin of vulnerabilities affecting financial stability and they have sufficient regulatory power to implement the tools required to smother systemic risk, the potential of combining both policies might be very great. The only drawback is the fact that these may need to be used before they have been properly designed and tested. Time is running out but we must be prudent.

Ariadna Vidal Martínez

European Unit, Research Department, "la Caixa"

1. See Jódar-Rosell, S. and Gual, J. (2014), «La prociclicidad del sistema financiero tras las reformas», Documents on Economics, "la Caixa" Research.

2. See Gual, J. (2011), «Capital requirements under Basel III and their impact on the banking industry», Documents on Economics, "la Caixa" Research.

3. See Annex III of the IMF staff paper «Key aspects of macroprudential policy» (2013).

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