Filling the Gap in Financial Regulation

The recent severe financial crisis which led to the “Great Recession” represented a serious failure of economic management and financial regulation. Post mortem analysis of the crisis has brought to the fore a set of ideas for the use of “macroprudential” tools to improve regulation. This awkward term refers to an approach to financial regulation that fills the gap between conventional macroeconomic policy and traditional “prudential” (or “safety and soundness”) regulation of individual financial institutions. The concept is to manage factors that could endanger the financial system as a whole, even if they would not be obvious as serious threats when viewed in the context of any single institution. Risks that are common to many financial institutions simultaneously, such as excessive exposure to housing credit, can combine with a high degree of interconnections between financial institutions to create systemic risks even when each individual institution appears sound, absent the potential for financial contagion.

As Paul Tucker, Deputy Governor of the Bank of England for Financial Stability, put it, “there is a missing set of instruments. The big question is whether a set can be devised that stack up not only in theory but in practice; instruments that can be used in the real world. ” This paper explains that missing set of instruments and how they might work. The first section makes the case for macroprudential policy, with particular emphasis on counter-cyclical capital requirements as the key tool. The remainder of the paper provides an extended primer, in question and answer format, with considerably more detail on the key questions that need to be addressed in regard to macroprudential policy.