Kohn: Challenges in implementing macroprudential policies

In the aftermath of the global financial crisis, macroprudential policy tools have received much attention, but central bankers have relatively little experience implementing these policies in highly developed markets, and challenges remain. In a recent speech at the European Central Bank, Donald Kohn, the Robert S. Kerr Senior Fellow in Economic Studies at Brookings and former vice chair of the Federal Reserve Board, discussed four challenges faced by the Bank of England’s Financial Policy Committee—of which he is a member—in designing and implementing macroprudential policies.

Risk Identification

“We are looking mostly for tail risks—unlikely events not fully reflected in market prices that might have systemic effects—events the financial system and its customers might not be fully prepared for” Kohn said, pointing to the Bank of England’s recent stress tests as useful tools in gauging the resilience of the financial system to these risks.

Identifying Externalities

“Macroprudential action to remove or reduce risk or build resilience should require a finding that materialization of the risk would be systemic—that it is a risk to the ability of the financial system or a significant part of it to exercise its critical functions and its materialization therefore would have important adverse effects beyond the parties directly involved,” Kohn noted. “We must ask what is the externality that macroprudential policy should require the private market to internalize—to incorporate into prices?”

Policy Design

How can policymakers most effectively mitigate these risks? “In general, having a wide choice of instruments will help in finding a policy that addresses the issues with benefits exceeding costs. Being able to target a specific risk or identified shortfall in resilience is more likely to minimize costs relative to benefits” Kohn argues.

Communication and Explanation

“Once the risk and its externality are identified and the policy decided upon, public communication of the decision, its rationale, and its expected effects is both difficult and necessary… political and public support will be critical. Effective countercyclical macroprudential policy will be pre-emptive—taking away the credit punch bowl as the party gets going and making sure it is full when the party dies down” Kohn said, adding “The absence of public support invites political interference.”