What are macroprudential tools?

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To reduce the risks of a repeat of the global financial crisis of 2007-09 which revealed the  inadequacy of the capital, liquidity, and transparency of banks and other big financial firms governments around the world have embraced “macroprudential policies” to supplement traditional “microprudential policies.This primer explains what macroprudential policies are and why they are important now, examples of how they have been used, and evidence of their effectiveness

1. What are macroprudential policies? And how do they differ from microprudential policies?

Macroprudential policies are financial policies aimed at ensuring the stability of the financial system as a whole to prevent substantial disruptions in credit and other vital financial services necessary for stable economic growth. The stability of the financial system is at greater risk when financial vulnerabilities are high, such as when institutions and investors have high leverage and are overly reliant on uninsured short-term funding, and interconnections are complex and opaque. High vulnerabilities increase the likelihood that a firm’s failure or other negative shock would cause distress at other financial institutions because of direct exposures and through fire sales, contagion, or other negative externalities arising from the initial shock. Macroprudential policies aim to reduce the financial system’s sensitivity to shocks by limiting the buildup of financial vulnerabilities. 

One example of a macroprudential policy is the higher capital charge applied to Global Systemically Important Banks (G-SIBs), banks that pose more risk to the system. The G-SIB capital surcharge is based on five types of characteristics viewed to increase a bank’s systemic risk: size, complexity, interconnectedness, lack of substitutes, and cross-jurisdictional activity. Higher capital charges reduce the likelihood that a G-SIB would fail because they will have thicker capital cushions to absorb losses. 

In contrast, microprudential supervision and regulation focus on the safety and soundness of individual financial institutions, not the financial system as whole. Macroprudential supervision and regulation assess how a financial institution is connected with the rest of the financial system and real economy. It assesses the risk that a firm’s distress could have on the financial sector and economy, and feedback effects to that firm. (Think Lehman Brothers in 2008.) 

“While financial stability requires a strong microprudential framework to ensure that individual firms are safe and sound, relying only on microprudential oversight could make the system less stable.”

While financial stability requires a strong microprudential framework to ensure that individual firms are safe and sound, relying only on microprudential oversight could make the system less stable. For example, if there were only microprudential supervision, a central (clearing) counterparty (CCP), such as the Options Clearing Corporation or the Chicago Mercantile Exchange, might seem well prepared to cope with an exogenous shock because it has a default fund which it can replenish when needed by drawing on funds from its members. But actions one  CCP takes to replenish its fund will not only affect the buffers that its members have for adverse events they may face on their own but also the resources available to other CCPs to which its member banks belong. Thus microprudential policies on their own could increase system-wide risks because the behavioral responses of all of the CCP’s clearing members and the effect on other CCPs are not considered.  

As another example, in a microprudential framework, the ability of a bank to increase its capital to meet regulatory requirements is seen as favorable, without regard to how this is accomplished. But a bank that needs to increase its capital ratio (measured as a percentage of its asset) can either raise new capital or decrease assets (loans). When bank losses are increasing because the economy is weak and bank capital ratios are falling, the difference between the two approaches is consequential. If every firm were to decrease assets instead of raise capital, that action would lead to a substantive contraction of credit and cause the economy to weaken further. A macroprudential approach, in contrast, would assess and control for the mechanism that banks would implement to reach their required capital ratio, essentially encouraging them to raise capital rather than pull back on lending.  

The annual supervisory bank stress tests performed by the Federal Reserve have both microprudential and macroprudential elements. At their core, they ensure that each bank has sufficient capital to survive a very deep recession. But banks also are required to assume they will continue to lend in that recession and cannot plan to meet capital requirements by shrinking their assets. Moreover, the stress tests specify macroeconomic scenarios to be more severe when the economy is expanding to offset a natural tendency to predict losses will be low because recent default rates have been low. A recent paper looks at how the macro scenarios and assumptions about dividends and share repurchases in the stress tests work to reduce procyclicality of capital requirements. 

2. Why are macroprudential policies important now?

Limiting material vulnerabilities in the financial system is especially important now in the U.S. as economic expansion continues, asset prices are high, and interest rates are low as monetary policy is working to push up inflation to its 2 percent target. Monetary policy works by increasing borrowing, but it may also incentivize greater risk-taking by banks and other lenders as rising asset prices and low volatility relax capital requirements and risk management standards. When protections against the costs of excessive risk-taking are in place, monetary policymakers have more freedom to set policy without raising the risk that they may be contributing to an unraveling of the financial system and a deep recession down the road.

3. What macroprudential policies are commonly used?

Macroprudential tools can be structural or cyclical. Structural policies are implemented to build lender or borrower resilience to adverse events at any point in the business cycle. For example, the additional capital charges for G-SIBs are a structural tool.  In other countries, limits on loan-to-value ratios (LTVs) or debt servicetoincome ratios (DSTIs) for mortgage borrowers are examples of structural tools that have been applied to borrowers. These limits can be macroprudential when they are intended to not only protect an individual borrower from too much debt, but to protect home values in neighborhoods from falling sharply because many borrowers have trouble making their payments at the same time. The Hong Kong Monetary Authority, for example, sets the LTV ratios for borrowers based on the value of the property. Bank borrowers for properties with high values could get mortgages with LTV ratios ranging from 40 percent to 60 percent, while they could get mortgages with higher LTV ratios, up to 70 percent, for properties with low values. 

Cyclical policies are aimed at increasing resilience in anticipation of an economic downturn to lessen the reduction in the supply of credit once the downturn materializes. The countercyclical capital buffer (CCyB) is an example of a cyclical policy. The CCyB works by requiring banks to increase their capital cushions during an economic expansion when systemic risks are rising, and then release them in an economic downturn to absorb losses. Reducing the capital constraint by releasing the buffer when the economy slows helps to insure against deleveraging, which if not counteracted could deepen the downturn by restricting credit.  

Historically, macroprudential policies have been used more often in emerging market economies than in advanced economies. But since the global financial crisis, both advanced economies and emerging market economies have been using macroprudential measures more frequently, as illustrated in the chart below taken from a Bank for International Settlements (BIS) report on macroprudential policies. 

Increasing use of macroprudential measures over time - 2

According to a survey of macroprudential policies conducted by the International Monetary Fund, emerging market economies tend to use tools focused on managing liquidity and foreign exchange mismatches. For example, smaller open economies may adjust their U.S. dollar reserve requirement the percent of reserves that must be held in dollars to counter fluctuations in dollar flows and credit that could lead to financial instability. A high dollar reserve requirement could mitigate rapid domestic credit growth in dollars and reduce future risks if dollar inflows were to fall and the exchange rate were to depreciate relative to the dollar.     

On the other hand, advanced economies tend to use tools focused on limiting risky exposures of financial firms to the household and business sector. Sectoral risk weights are used to shield financial firms against excessive exposure to risky households and businesses. For example, regulators could require that banks assign a higher capital charge for higher-risk mortgages. An alternative to higher sectoral risk weights would be to set a limit on the percentage of higher-risk mortgages in a bank’s total portfolio, such as was done by the Bank of England’s Financial Policy Committee. In 2014, it set a limit of 15 percent of new mortgages to have loan-to-income ratios of above 4.5 percent in an attempt to reduce increasing debt burdens and rapidly rising house prices.   

A more complex example is Spain’s prior use of dynamic loan loss provisioning at banks. This policy recognized that borrowers generally can stay current on their loan payments during an economic expansion but begin to go delinquent when the cycle turns down. This pattern typically led banks to record less loan loss provisions during an expansion and to increase them during a downturn. The aim of dynamic loan loss provisioning was to smooth provisions through the business cycle so that buffers are created during the expansion, and provisions will not need to be increased as much in downturns. Spain accomplished this by dynamically changing the percent of provisions that could be claimed during the business cycle every quarter. The concept of dynamic loss provisioning is similar to that underlying how countercyclical capital buffers can help offset the procyclicality of capital constraints and credit provision.  

4. Are macroprudential policies effective?

Evaluating whether macroprudential policies are effective is challenging, not least because of difficulties in setting a criterion for “financial stability.” In its 2018 Annual Economic Report, the BIS measures effectiveness “by the change in the rate of credit growth or the increase in the banking system’s capital or liquidity buffers.” There is a developing consensus that macroprudential measures have been generally successful in increasing the financial system’s resilience. By design, capital and liquidity requirements increase buffers available to absorb losses and periods of illiquidity, and studies indicate they have reduced banks’ risks, which strengthens the financial system’s resilience.  

Other studies find evidence indicating that macroprudential measures can affect credit growth. One comprehensive study evaluated the effectiveness of a number of different measures in 57 countries during 2000 to 2013 based on their impact on bank credit growth, house credit growth, and house prices. They find that macroprudential policies could significantly reduce growth in bank credit, housing credit, and house prices. In addition, targeted policies aimed specifically at housing, like LTVs and DSTIs, are more effective than general policies, such as higher capital requirements  

“The effectiveness of certain measures has also been shown to depend on whether the policy is aiming to tighten or loosen…”

The effectiveness of certain measures has also been shown to depend on whether the policy is aiming to tighten or loosen, according to the 2018 BIS Annual Economic Report. For example, tightening LTV and DSTI ratios lessen housing credit and house price growth, but loosening those same ratios does not appear to have any impact on housing credit and price growth. This difference in effectiveness for tightening versus loosening measures generalizes beyond housing; tightening measures dampen credit growth but loosening does not encourage much.  

These effects, however, can also spill over and impact other areas of the financial sector and economy, calling into question their “effectiveness.” Policy actions taken to reduce corporate credit were associated with significant increases in housing, consumer, and household credit in the quarter immediately following the implementation of those measures, according to the 2018 BIS report. This finding is supported by evidence at individual institutions, where if one type of credit, housing credit for example, is tightened, the institution increases other types of creditSimilarly, there are studies that document international spillovers from macroprudential measures. Implementing strict and tightening measures in one country can lead to intense capital inflows and looser lending standards elsewhere.  

All in all, although the research on effectiveness of macroprudential policies is limited, largely because the use of these policies in many countries is relatively new, multiple studies find that macroprudential policies can limit credit growth and improve resilience.   

5. Who regulates and governs these policies?

Since the global financial crisis, countries have set up new institutional arrangements for macroprudential policies. Many countries now have multi-agency financial stability committees (FSCs). Of the 58 countries covered in a recent Hutchins Center working paper by Rochelle M. Edge and Nellie Liang, 12 countries had FSCs before the global financial crisis, but the number increased to 47 countries by 2018. These committees almost always include prudential regulators and central banks, but a feature of many of the new FSCs is representation of the elected government, such as the ministry of finance. The broad set of members reflects the nature of macroprudential policies, which affect the overall financial system.   

The powers that FSCs have vary widely across countries. Only about one quarter are able to take actions. The others appear to serve mainly to facilitate information sharing and policy coordination across the multiple agencies, and the agencies retain the power to set policies. 

In the U.S., the Financial Stability Oversight Council (FSOC) was created in 2010 by the Dodd‐Frank Wall Street Reform and Consumer Protection Act. The FSOC is led by the Secretary of the Treasury, and its members include the leaders of the financial regulatory agencies, including the Federal Reserve, Federal Deposit Insurance Corporation, Securities and Exchange Commission, Commodity Futures Trading Commission, and others. It is responsible for “identifying risks and responding to emerging threats to financial stability.”   

6. How does the U.S. compare to other countries in terms of available macroprudential tools?

The U.S. does not utilize the range of macroprudential tools as much as other countries. The Fed as the bank holding company regulator applies the G-SIB capital charges and assesses the level of the CCyB, consistent with the international Basel III capital requirements. So far, it has maintained the CCyB at zero. The Fed also conducts annual stress tests of the largest bank holding companies which incorporate some macroprudential elements, such as scenarios designed with system-wide financial risks.  But other financial regulators may have mandates for only individual firms and markets and not for risks they could pose to the broad financial system.   

The FSOC has designated certain financial market utilities, such as the Chicago Mercantile Exchange and the Clearing House Payments Co., as systemically important. However, it recently indicated it would not designate a nonbank financial firm as systemically important without first evaluating whether the systemic risks could be addressed through more stringent regulations of activities by the primary regulator. In addition, the FSOC can make formal “comply or explain” policy recommendations to individual regulatory agencies, which it did to the Securities and Exchange Commission to issue new regulations to reduce the risk of systemic investor runs on prime money market funds.  But this process takes considerable time and is not likely to be effective for implementing cyclical policies.   

For housing, which has been at the center of many financial crises, FSOC does not have the authority to use macroprudential tools such as limits on loan-to-value or debt-to-income ratios for mortgage borrowers. While the FSOC could make formal comply or explain recommendations to regulators including the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, and bank and credit union regulatorsit is unclear whether those regulators have the authority to take actions to reduce financial stability risks beyond those to ensure the safety and soundness of individual firms