Macroprudential Policy
What Instruments and How to Use them? Lessons From Country Experiences1

This paper provides the most comprehensive empirical study of the effectiveness of macroprudential instruments to date. Using data from 49 countries, the paper evaluates the effectiveness of macroprudential instruments in reducing systemic risk over time and across institutions and markets. The analysis suggests that many of the most frequently used instruments are effective in reducing pro-cyclicality and the effectiveness is sensitive to the type of shock facing the financial sector. Based on these findings, the paper identifies conditions under which macroprudential policy is most likely to be effective, as well as conditions under which it may have little impact.

Abstract

This paper provides the most comprehensive empirical study of the effectiveness of macroprudential instruments to date. Using data from 49 countries, the paper evaluates the effectiveness of macroprudential instruments in reducing systemic risk over time and across institutions and markets. The analysis suggests that many of the most frequently used instruments are effective in reducing pro-cyclicality and the effectiveness is sensitive to the type of shock facing the financial sector. Based on these findings, the paper identifies conditions under which macroprudential policy is most likely to be effective, as well as conditions under which it may have little impact.

I. Introduction

This paper is prepared at the request of the IMF Board. Macroprudential policy is quickly gaining traction in international circles as a useful tool to address system-wide risks in the financial sector.2 Yet, the analytical and operational underpinnings of a macroprudential framework are not fully understood and the effectiveness of the instruments is uncertain. In April 2011, the Board initiated a discussion of these issues in the context of the paper “Macroprudential Policy: An Organizing Framework” (SM/11/54). In concluding, the Board asked for further work on several fronts.3 This paper responds to the specific request for a review of country experiences to better understand the design and calibration of macroprudential instruments, their interaction with other policies, and their effectiveness.

While macroprudential policy is widely seen as a useful policy response to changes in the global financial environment, views on the contours of macroprudential policy can vary substantially among policymakers. The IMF—in conjunction with the Bank for International Settlements and the Financial Stability Board—has characterized macroprudential policy with reference to three defining elements:4

  • Its objective: to limit the risk of widespread disruptions to the provision of financial services and thereby minimize the impact of such disruptions on the economy as a whole. Systemic risk is largely driven by fluctuations in economic and financial cycles over time, and the degree of interconnectedness of financial institutions and markets.

  • Its analytical scope: the focus is on the financial system as a whole (including the interactions between the financial and real sectors) as opposed to individual components.

  • Its instruments and associated governance: it primarily uses prudential tools that have been designed and calibrated to target systemic risk. Any non-prudential tools that are part of the framework need to be specifically designated to target systemic risk through their governance arrangements.

Against this organizing framework, the objective of the paper is to identify conditions under which macroprudential policy is most effective. The assessment uses data provided by the 2010 IMF Survey on financial stability and macroprudential policy, as well as an internal survey of desk economists.5 Relative to previous studies, this approach has the advantage of examining a much broader range of instruments,6 risks, and countries, taking greater account of the implications of cyclical disturbances and interconnectedness. The goal is to help policymakers make more informed decisions about macroprudential policy and to guide the Fund’s policy advice and technical assistance in this area.

The paper is structured as follows. Section II reviews country experiences with macroprudential policy, focusing on the objectives, types of instruments and how they have been chosen and applied. Section III presents the empirical analysis based on case studies and panel regressions. Section IV draws common lessons and policy messages, noting the conditions under which the instruments appear to have been most effective. Section V concludes with next steps for further research and analysis.

II. Country Experiences with Macroprudential Instruments

A. What Instruments Are Used?

Country authorities have used a variety of policy tools to address systemic risks in the financial sector. The toolkit contains mostly prudential instruments, but also a few instruments typically considered to belong to other public policies, including fiscal, monetary, foreign exchange and even administrative measures. The IMF survey identified 10 instruments that have been most frequently applied to achieve macroprudential objectives. There are three types of measures:

  • Credit-related, i.e., caps on the loan-to-value (LTV) ratio, caps on the debt-to-income (DTI) ratio, caps on foreign currency lending and ceilings on credit or credit growth;

  • Liquidity-related, i.e., limits on net open currency positions/currency mismatch (NOP), limits on maturity mismatch and reserve requirements;7

  • Capital-related, i.e., countercyclical/time-varying capital requirements, time-varying/dynamic provisioning, and restrictions on profit distribution.

There is usually a clearly stated policy objective when the instruments are applied. Specifically, the instruments have been used to mitigate four broad categories of systemic risk (Figure 2):8

  • Risks generated by strong credit growth and credit-driven asset price inflation;

  • Risks arising from excessive leverage and the consequent deleveraging;

  • Systemic liquidity risk; and

  • Risks related to large and volatile capital flows, including foreign currency lending.

Figure 2.
Figure 2.

Objectives of Macroprudential Policy Instruments

Citation: IMF Working Papers 2011, 238; 10.5089/9781463922603.001.A001

Source: IMF Financial Stability and Macroprudential Policy Survey, 2010.

The recent financial crisis has prompted an increasing number of countries to use the instruments, and with greater frequency. According to the IMF survey, two-thirds of the respondents have used various instruments for macroprudential objectives since 2008. Emerging market economies have used the instruments more extensively than advanced economies, both before and after the recent financial crisis. Elements of a macroprudential framework existed in some emerging market economies in the past, when they started to use some of the instruments to address systemic risk following their own financial crises during the 1990s. For these countries, the instruments are part of a broader “macro-financial” stability framework that also includes the exchange rate and capital account management.9 The recent crisis has also led to an increase in the number of advanced countries that deploy the instruments within a more formal macroprudential framework. The work of the European Systemic Risk Board is an example (Box 1).

Macroprudential Instruments in the European Union10

Work on selecting and applying macroprudential instruments is a priority in the European Union (EU), both at a national and at a Union level. The European Systemic Risk Board (ESRB) was established as of January 1, 2011, in order to provide warnings of macroprudential risks and to foster the application of macroprudential instruments.

Macroprudential instruments have a particular relevance in the EU context, given the constraints on macroeconomic and microprudential policies and their coordination, including the absence of national monetary policies and policies to harmonize capital standards. The ESRB has an additional role to foster “reciprocity” through its “comply or explain” powers amongst the national authorities, so that all banks conducting a particular activity in a country will be subject to the same macroprudential instrument irrespective of the bank’s home country.

The European Commission has been focusing on countercyclical capital as the main macroprudential instrument. Other agencies, as well as some national authorities, propose casting the net much wider, to take account of regional, national, sub-national, or sectoral conditions. For instance, with real estate lending having been central to past financial crises, there is likely to be a focus on instruments such as the loan-to-value ratio.

B. Why Use Macroprudential Policy and What Affects the Choice of Instruments?

Macroprudential policy has several advantages compared with other public policies to address systemic risk in the financial sector. In their survey responses, country authorities indicate that macroprudential instruments are less blunt than monetary tools, and are more flexible (with smaller implementation lags) than most fiscal tools. Many instruments (e.g., caps on the LTV, DTI, foreign currency lending, and capital risk weights) can be tailored to risks of specific sectors or loan portfolios without causing a generalized reduction of economic activity, thus limiting the cost of policy intervention. Some countries have imposed caps on foreign currency lending, for example, because these target excessive lending in foreign currency directly in a way that no other policies can. These instruments are especially useful when a tightening of monetary policy is not desirable (e.g., when inflation is below target).

Country authorities indicate that they choose instruments that are simple, effective, and easy to implement with minimal market distortions. They consider it necessary that the choice of macroprudential instruments be consistent with other public policy objectives (fiscal, monetary, and prudential). They also believe it important to choose macroprudential instruments that minimize regulatory arbitrage, particularly in advanced economies with large nonbank financial sectors and complex and highly interconnected financial systems.

A number of factors seem to influence the choice of instruments. The stage of economic and financial development is one such factor (Figure 3). In general, emerging market economies have used macroprudential instruments more extensively than advanced economies. This may reflect a greater need to address market failures where financial markets are less developed and banks usually dominate relatively small financial sectors. Emerging market economies are more concerned about systemic liquidity risk and tend to use liquidity-related measures more often. Advanced economies tend to favor credit-related measures, although more of them are beginning to use liquidity-related measures after the recent crisis.11

Figure 3.
Figure 3.

Use of Macroprudential Policy Instruments

(% of countries in each group using each type of instruments)

Citation: IMF Working Papers 2011, 238; 10.5089/9781463922603.001.A001

1/ The ratio of credit/financial claims to GDP. Countries with the ratio at or above the medium are classified as “large,” otherwise “small.”2/ The ratio of net capital inflow to GDP. Countries with the ratio at or above the medium are classified as “large,” otherwise “small.”Sources: IMF Financial Stability and Macroprudential Policy Survey, 2010.

The exchange rate regime appears to play a role in the choice of instruments. Countries with fixed or managed exchange rates tend to use macroprudential instruments more since the exchange rate arrangement limits the room for interest rate policy. In these countries, credit growth tends to be associated with capital inflows as the implicit guarantee of the fixed exchange rate provides an incentive for financial institutions to expand credit through external funding.12 Credit-related measures (e.g., caps on the LTV and ceilings on credit growth) are often used by these countries to manage credit growth when the use of interest rates is constrained. They also tend to use liquidity-related measures (e.g., limits on NOP) to manage external funding risks.

The type of shocks is another factor that may influence the choice of instruments. Capital inflows are considered by many emerging market economies to be a shock with a large impact on the financial sector, given the small size of their domestic economy and their degree of openness. Some Eastern European countries have used credit-related measures (e.g., caps on foreign currency lending) to address excessive credit growth resulting from capital inflows. In Latin America, several countries (e.g., Argentina, Brazil, Colombia, Peru, and Uruguay) have also used liquidity-related measures (e.g., limits on NOP) to limit the impact of capital inflows. In the Middle East, some oil exporters with fixed exchange rates have also used credit-related measures to deal with the impact of volatile oil revenue on credit growth. Unlike other policy tools aimed at the volume or composition of the flows (e.g., taxes, minimum holding periods, etc.), macroprudential instruments are more directly aimed at the negative consequences of inflows, i.e., excessive leverage, credit growth and exchange rate induced credit risks that are systemic.

C. How Are Instruments Applied?13

Country experiences show that a combination of several instruments is often used to address the same risk. Caps on the LTV and DTI, for instance, are frequently applied together by country authorities to curb rapid credit growth in the real estate sector. Sometimes a range of measures are implemented (Figure 4). On the other hand, using a single instrument to address systemic risk is rare.14 The rationale for using multiple instruments seems simple—to provide a greater assurance of effectiveness by tackling a risk from various angles. While this may be true, there may be a higher regulatory and administrative burden of enforcing multiple instruments.

Figure 4.
Figure 4.

How Instruments Are Used

Citation: IMF Working Papers 2011, 238; 10.5089/9781463922603.001.A001

Sources: IMF Financial Stability and Macroprudential Policy Survey, 2010.

Many instruments, particularly credit-related, are calibrated to target specific risks. Macroprudential instruments are generally more targeted than monetary and fiscal policy tools, and they are frequently further differentiated for specific types of transactions. Caps on the LTV and DTI, for example, have been applied according to the loan size, the location and the value of the property (Hong Kong SAR and Korea). Reserve requirements used for macroprudential purposes have been differentiated by currency, types of liabilities, and applied within a band or on a marginal basis, or if credit growth exceeds the official limit (Argentina, Chile, China, Indonesia, Peru, Russia, Serbia, and Turkey). Sometimes social and other developmental aspects are taken into account when the instruments are calibrated (Canada). Many countries apparently find it useful to take full advantage of the targeted nature of macroprudential instruments, but others also apply the instruments broadly with no further differentiation.

Making countercyclical adjustments of macroprudential instruments is a common practice. Instruments aimed at credit growth, such as caps on the LTV, the DTI and reserve requirements, are adjusted most frequently. The adjustments are usually made to give the instruments a progressively larger countercyclical impact, but in some cases they also reflect the need to proceed cautiously on a trial and error basis. Capital-related measures, such as countercyclical capital requirements and dynamic provisioning, are designed to work through the cycle by providing a buffer, but some countries have adjusted them at different phases of the cycle to give them a more potent countercyclical impact.15

The design and calibration of the instruments are usually based on discretion and judgment, as opposed to rules. The use of rules-based instruments has the advantage of less regulatory uncertainty, preventing political economy pressures and overcoming policy inertia when systemic risk is building up.16 However, most countries that participated in the IMF survey have used judgment almost entirely when designing and calibrating the instruments. The implementation of the instruments is a learning-by-doing process, in which judgment on how to calibrate an instrument is often formed by trial and error, depending on the type of shock the system is facing. A few exceptions include dynamic provisioning as used in Spain and several Latin American countries, where the amount of provisioning is based on a formula and varies with the economic cycle.

Macroprudential instruments are sometimes applied in conjunction with other macroeconomic policies. Some Asian and Latin American country authorities have used macroprudential instruments such as caps on the LTV with other policies, for example, monetary and fiscal policies.17 Some Eastern European countries have kept fiscal policy loose, but tightened monetary policy and attempted to contain banks’ foreign currency lending through various macroprudential measures. The combined use of policy tools typically occurs when the credit cycle coincides with the business cycle and there is a generalized risk of excessive credit growth and economic overheating. In such cases, macroprudential instruments are implemented as part of a larger policy action to curb excess demand and the build-up of systemic risk, so they play a complementary role to macroeconomic policies.18 Figure 5 summarizes the intensity of use of the instruments.

Figure 5.
Figure 5.

Intensity of Use

Citation: IMF Working Papers 2011, 238; 10.5089/9781463922603.001.A001

Sources: IMF Financial Stability and Macroprudential Policy Survey, 2010.

III. Effectiveness of Macroprudential Instruments

Macroprudential instruments may be effectively applied to address specific risks if used appropriately. According to the IMF survey, most country authorities who have used macroprudential instruments believe that they are effective. To assess the effectiveness of macroprudential instruments more thoroughly, this paper uses three different approaches. The first is a case study, involving an examination of the use of instruments in a small number of countries to see if they have achieved the intended objectives. The second is a simple approach, involving an examination of the performance of the target (risk) variables before and after an instrument is introduced. The third is a more sophisticated approach, which uses panel regression to assess the effect of macroprudential instruments on various target risk variables by comparing the introduction of an instrument with a “counterfactual” scenario where no macroprudential instrument is implemented.

The usual caveats, of course, apply to the evaluation. First, data availability and quality present challenges. Firm level data are preferable since many of the macroprudential instruments are aimed at the balance sheet of financial institutions, but these are not readily available or consistent over time or across countries. Moreover, the number of countries that have used macroprudential instruments in a systematic way is small since macroprudential policy frameworks have been put in place only recently, limiting the degree of confidence in any statistical analysis. In addition, establishing causality is not straightforward, or even feasible in some cases, with a selection bias that favors high risk countries where policies are implemented in reaction to adverse economic or market developments. The empirical analysis also does not take into account issues such as costs and distortions, important factors to consider when using the instruments. These caveats notwithstanding, the evaluation still provides valuable insights into the effectiveness of macroprudential instruments.

A. The Case Study

Experiences of a few countries suggest some success in using the instruments to achieve their intended objectives. The case study covers a small but diverse group of countries, including China, Colombia, Korea, New Zealand, Spain, the United States and some Eastern European countries. While small, the sample seems representative. Some countries use the instruments singly while others in combination (and in coordination with other policies); instruments are both broad-based and targeted; some keep the instruments fixed while others make adjustment (both rules-based and discretionary). Their experience suggests that, to various degrees, the instruments may be considered effective in their respective country-specific circumstances, regardless of the size of their financial sector or exchange rate regime. Appendix II presents the case studies, which are summarized briefly below.

  • In China, the authorities managed to lower credit growth and housing price inflation by taking a series of steps in 2010 that also included fiscal and monetary measures.

  • In Colombia, the authorities took measures in 1999 to limit banks’ exposure to default risk. The measures seem to have been effective. Non-performing loans declined and remained low while credit to the private sector recovered after an initial reduction.

  • In Eastern Europe, the authorities adopted several measures to curb bank lending in foreign currency. The instruments appear to have been effective in slowing credit growth and building capital and liquidity buffers, although they were circumvented partly as lending activity migrated to nonbanks (leasing companies) and to direct cross-border lending by parent banks.

  • In Spain, the authorities introduced dynamic provisioning as a macroprudential tool in 2000. The instrument appears to have been effective in helping to cover rising credit losses during the global financial crisis, but the coverage was less than full because of the severity of the actual losses.

  • In Korea, the authorities adopted measures after the financial crisis to deal with the build-up of vulnerabilities associated with capital flows. They appear effective in curbing banks’ short-term external borrowing, which remained some 30 percent below its pre-crisis levels as of 2010.

  • In New Zealand, the authorities introduced two liquidity mismatch ratios and a core funding ratio in 2010 to limit banks’ liquidity risk. The ratios had an effect even before they were formally implemented—banks began to lengthen their wholesale funding structure after the ratios’ announcement.

  • In the United States, the authorities adopted a minimum leverage ratio for banks in 1991. The requirement was not adjusted over time in response to changing circumstances, but a key weakness was the fact that it did not apply to investment banks after 2004. As result of the divergence in regulatory requirements, leverage rose noticeably at investment banks but remained lower at commercial banks.

B. The Simple Approach

Some targeted risk variables show a change of course after the instruments are introduced. An examination of the performance of the target risk variables during the periods before and after the implementation of an instrument indicates that a number of them may have had the intended effect. Some instruments, e.g., caps on the LTV, caps on the DTI, dynamic provisioning, and reserve requirements, seem to have an impact on credit growth (Figures 6), but the effect of other instruments is less obvious.19 Specifically,

  • Caps on the LTV: credit growth and asset price inflation decline after its implementation in more than half of the countries in the sample.

  • Caps on the DTI: credit growth decline but asset price inflation does not.

  • Dynamic provisioning: credit growth and asset price inflation, and to a lesser extent, leverage growth, decline.

  • Reserve requirements: both credit growth and asset price inflation decline.

Figure 6.
Figure 6.

Change in Credit Growth After the Introduction of Instruments

Citation: IMF Working Papers 2011, 238; 10.5089/9781463922603.001.A001

Notes:1/ Average of sample countries’ y/y growth in credit (detrended).2/ t denotes the time of the introduction of instruments.3/ For details, see charts in Appendix III.Source: International Financial Statistics.

Macroprudential instruments seem to have been effective in reducing the correlation between credit and GDP growth. In countries that have introduced caps on the LTV, DTI and reserve requirements, the correlation is positive but much smaller than in countries without them, as shown by the flattening of the curve in Figure 7. In countries that have introduced ceilings on credit growth or dynamic provisioning, the correlation between credit growth and GDP growth becomes negative as shown by an inverted curve. The difference in the correlations is also statistically significant, except in the case of caps on foreign currency lending and restrictions on profit distribution. A more sophisticated analysis is described below to try to demonstrate causality and to disentangle the effects of other macroeconomic policies.20

Figure 7.
Figure 7.

Credit Growth and GDP Growth

Citation: IMF Working Papers 2011, 238; 10.5089/9781463922603.001.A001

Source: IFS.

C. The Panel Regression

A panel regression analysis suggests that macroprudential instruments may have an impact on four measures of systemic risk—credit growth, systemic liquidity, leverage, and capital flows.21 Specifically, eight instruments22 are estimated to see if they limit the procyclicality of credit and leverage—their tendency to amplify the business cycle. Procyclicality is captured in this case by the respective correlation of growth in credit and leverage with GDP growth. This specification has the advantage of showing the effect of the instruments in both the expansionary and recessionary phases of the cycle without “timing” the cycle. In addition, the effects of the other two instruments23 on common exposure are estimated, using proxies for risks related to liquidity and capital flows, although the scope is limited by data availability. Dummy variables for factors such as the degree of economic development, the type of exchange regimes and the size of the financial sector are used to see if the instruments are effective across countries. The regressions use data from 49 countries during a 10-year period from 2000 to 2010 collected in the IMF survey.

The specification of the panel regressions addresses several challenging issues, including:

  • How to disentangle the effect of macroprudential instruments from that of other policies. For monetary policy, an interest rate variable is introduced, and for fiscal policy, GDP growth is used as a proxy. Using fiscal deficit has the disadvantage of introducing multicollinearity given its high correlation with GDP growth, and there seems no direct linkage between fiscal policy and procyclicality of credit or leverage. Any indirect linkage would be captured by interest rates and GDP growth.24

  • How to infer the general effect of macroprudential instruments in the context of country-specific characteristics. This is addressed by introducing dummy variables to control for the type of exchange rate regime, the size of the financial sector and the degree of economic development. The panel regressions’ fixed effect takes into account other unobserved country-specific characteristics.

  • How to avoid estimation biases to ensure a correct quantification of the effect of macroprudential instruments.25 This is addressed by using the System Generalized Method of Moments,26 widely used to deal with panel data with endogenous explanatory variables.

Results of the panel regressions suggest that the majority of the 10 instruments may be effective. The empirical analysis finds no evidence to suggest that the degree of economic development, the type of exchange rate regimes or the size of the financial sector affects the effectiveness of the instruments—the estimated coefficients of their dummy variables are all statistically insignificant—even though these factors may influence their choice. The results also show that the instruments remain effective after controlling for macroeconomic policies. As indicated by an impulse response analysis of an open economy DSGE model, a combination of policies may have lower welfare costs than monetary or macroprudential policy used alone (Box 2). In addition, instruments that are rules-based have a larger effect, although there is not enough evidence to indicate whether individual or multiple instruments are more effective due to the lack of granular data. Results of the regressions are summarized as follows:

  • On credit growth (yoy change in inflation-adjusted claims on the private sector), the coefficients of five of the 10 instrument dummy variables (caps on the LTV, DTI, ceilings on credit growth, reserve requirements and time-varying/dynamic provisioning) are statistically significant (Table 1).27 This indicates that these instruments may reduce the correlation between credit growth and GDP growth. Caps on the LTV, for example, reduce the procyclicality of credit growth by 80 percent.28 This is in line with findings of previous studies that associate higher LTV ratios with higher house price and credit growth over time.29 The coefficient of the dummy variable for a subgroup of countries that have adjusted the LTV caps over time is also significant.

  • On systemic liquidity, credit expansion funded from sources other than deposits (credit/deposit) is used as a proxy for wholesale funding in the estimation of the effectiveness of limits on maturity mismatch. The estimation is intended to see if this instrument limits wholesale funding, considered a source of systemic risk with a cross-sectional dimension. The coefficient of the dummy variable for limits on maturity mismatch is statistically significant, and the credit/deposit ratio is 5 percent lower in countries with the instrument than in countries without it.

  • On leverage (assets/equity), the coefficients of six of the 10 instrument dummy variables (caps on the DTI, ceilings on credit growth, reserve requirements, caps on foreign currency lending, countercyclical/time-varying capital requirements30 and time-varying/dynamic provisioning) are statistically significant (Table 2). This indicates that, while capital-related measures are expected to reduce the procyclicality of leverage, other instruments aimed at limiting credit growth may also have an impact on leverage growth. Dynamic provisioning appears to reduce the procyclicality of both credit growth and leverage. The effect of other capital-related measures is not obvious probably because the number of observations available is limited as only a few countries have implemented them in the last two years.

  • On capital flows and currency fluctuation, external indebtedness (foreign liabilities/foreign assets) is used as a proxy for common exposure to risks associated with them. The only dummy variable that has a statistically significant coefficient is limits on NOP. The results suggest that for every dollar of foreign assets held, the foreign liabilities of countries with this instrument are 15 percent lower than those without it (Table 3).

Table 1.

Effectiveness of Macroprudential Instruments in Reducing the Pro-cyclicality of Credit

article image
***, **, * indicate statistical significance at 1%, 5%, and 10% (two-tail) test levels, respectively.

The dependent variable is credit growth, the log change in the real level of credit. Credit is measured as claims on private sector from both bank and non-bank financial institutions (source: IFS). The interest rate is the nominal long-term interest rate on prime lending, from the IMF’s International Financial Statistics. The estimation period is 2000–2010. The sample is composed of 48 countries. The regression includes dummy variables to correct for different degrees of flexibility in the exchange rate regime, individual (country) effects, a time trend (year effect) and a dummy variable for the use of other MPP instruments. Instrumental variables for the policy instrument and the GMM Arellano-Bond estimator are used to address selection bias and endogeneity.

Non-Significant Results w hen Interest Rate included.

The coefficient corresponds to the interaction term between GDP growth and a dummy for the respective macroprudential instrument.

Source: IMF staff estimates.
Table 2.

Effectiveness of Macroprudential Instruments in Reducing the Pro-cyclicality of Leverage

article image
***, **, * indicate statistical significance at 1%, 5%, and 10% (two-tail) test levels, respectively.

The dependent variable is leverage growth, the log change in the level of leverage. Leverage is measured as assets over capital (source: IMF FSIs). The interest rate is the nominal long-term interest rate on prime lending, from the IMF’s International Financial Statistics. The estimation period is 2000–2010. The sample is composed of 48 countries. The regression includes dummy variables to correct for different degrees of flexibility in the exchange rate regime, individual (country) effects, a time trend (year effect) and a dummy variable for the use of other MPP instruments. Instrumental variables for the policy instrument and the GMM Arellano-Bond estimator are used to address selection bias and endogeneity.

The coefficient corresponds to the interaction term between GDP growth and a dummy for the respective macroprudential instrument.

Source: IMF staff estimates.
Table 3.

Effectiveness of Macroprudential Instruments in Reducing Cross-Sectional Risks

article image
***, **, * indicate statistical significance at 1%, 5%, and 10% (two-tail) test levels, respectively.

The dependent variables are the ratio of financial system liabilities with foreign residents to claims on foreign residents (1) and the ratio of banking institutions claims to deposits (2), obtained from the IMF’s International Financial Statistics. The interest rate is the nominal long-term interest rate on prime lending, also from IFS. The estimation period is 2000–2010. The sample is composed of 48 countries. The regression includes dummy variables to correct for different degrees of flexibility in the exchange rate regime, individual (country) effects, a time trend (year effect) and a dummy variable for the use of other MPP instruments. Instrumental variables for the policy instrument and the GMM Arellano-Bond estimator are used to address selection bias and endogeneity.

The coefficient corresponds to a dummy variable with a value of 1 for countries with limits on net open positions in foreign currency, and zero otherwise.

The coefficient corresponds to a dummy variable with a value of 1 for countries with limits on maturity mismatches, and zero otherwise.

Source: IMF’s staff estimates.

The regression results are independently confirmed by other studies. A separate study that focuses more on the structural determinants of credit growth corroborates the initial findings of the panel analysis. This study uses a different model and assumption on endogeneity, and the coefficients of caps on the DTI, caps on foreign currency lending, reserve requirements and time-varying/dynamic provisioning have a negative sign on credit to GDP and are statistically significant.31

This paper’s finding that the effectiveness of the instruments does not depend on the type of exchange rate regime is also independently confirmed by a structural model used in IMF (2011h), which shows that the impact of macroprudential instruments is virtually identical in economies with either fixed or floating exchange rates. The regression results need to be interpreted with caution. Statistically, the coefficients of the dummy variables for the instruments are averages of country performances. Their magnitude is affected by the number of countries in the sample that have used the instruments as well as the effectiveness in individual countries, and their statistical significance is not an indication that the instruments are equally effective in all countries. Country-specific circumstances, such as the quality of supervision, the phase of the credit cycle in which the instruments are implemented, the extent to which circumvention and arbitrage are possible, the ability of the authorities to take coordinated policy actions to limit circumvention and their responsiveness to changed conditions are among factors that determine whether an instrument is effective when applied in a particular country.

While the panel regression yields promising results, more work is needed to confirm its findings. The use of macroprudential instruments is still relatively new. The short experience with macroprudential policy limits the number of observations available for a more comprehensive evaluation of its effectiveness. Further research with longer time series and better quality data is therefore necessary to corroborate the initial assessment and to evaluate an instrument’s effectiveness in country-specific contexts. Factors such as the costs involved in using macroprudential instruments, the degree of calibration, and the potential for regulatory and cross-border arbitrage, which can easily circumscribe the effectiveness of macroprudential policy, should be taken into account in future analysis.

Monetary and Macroprudential Policy: Are They Mutually Reinforcing? 1/

Should macroprudential measures be used in conjunction with monetary policy to mitigate risks associated with large capital inflows? To address this question, an open-economy, New Keynesian DSGE model is used to assess whether a combination of the two policies is superior to stand-alone policies.

In the model, firms can finance their investment through retained earnings or borrowing from domestic or foreign sources. Macroprudential policy is assumed to impose a higher cost of borrowing for firms, defined as an additional “regulation premium” to the cost of borrowing. Monetary policy is assumed to follow a Taylor rule, with the central bank reacting to changes in inflation and output gaps. An initial shock, modeled as a decline in investors’ perception of risk, triggers capital inflows, leading to a decline in financing costs; firms borrow and invest more. Eventually, higher leverage triggers an increase in risk premium, and financial conditions normalize. But both monetary and macroprudential policies have a nontrivial role in mitigating the impact of the shock.

uA01fig01

Dynamic Responses to a Positive Financial Shock (percent deviations from steady state)

Citation: IMF Working Papers 2011, 238; 10.5089/9781463922603.001.A001

Source: IMF staff analysis.

The simulations suggest that macroprudential measures could be a useful complement to monetary policy in stabilizing the economy after the initial shock. When policymakers adopt macroprudential measures that directly counteract the increase in leverage and the easing of underwriting standards, the responses of domestic and foreign debt to the shock become more muted. Output and inflation therefore respond less, and the welfare loss, computed as the sum of inflation and output volatilities in percent of steady state consumption, decreases by almost half (1.3) compared with the simple Taylor rule (2.5), where only monetary policy is implemented. In the scenario where macroprudential measures alone are implemented and the policy interest rate is kept unchanged, output and inflation become more volatile, and the welfare loss is large (31.5).

In conclusion, the combination of monetary and macroprudential policies are superior to stand-alone policies.

1/ See Unsal (2011).

IV. Lessons and Policy Messages

A number of instruments may be effective in addressing systemic risks in the financial sector. The effectiveness does not seem to depend on the stage of economic development or type of exchange rate regime. Emerging market economies with fixed or managed exchange rates, where room for interest rate policy is limited, facing large capital inflows or having thin financial markets and a bank dominated financial system tend to use macroprudential instruments more extensively, but the instruments seem equally effective when used by countries with flexible exchange rate regimes and by advanced economies. However, there are costs involved in using macroprudential instruments, as is the case with regulation more generally, and the benefits of macroprudential policy should be weighed against these costs. Moreover, calibrating the instruments may be difficult, which could lower growth unnecessarily or generate unintended distortions if not done appropriately. These issues are not addressed in the paper but are important considerations to take into account when using macroprudential instruments.

Underpinning the assessment of effectiveness is the assumption of a sound regulatory framework and high quality supervision. These are the foundation for the effective application of macroprudential instruments.32 In addition, institutional arrangements for macroprudential policy need to ensure a policymaker’s ability and willingness to act—including clear mandates; control over instruments that are commensurate with those mandates; arrangements that safeguard operational independence; and provisions to ensure accountability, supported by transparency and clear communication of decisions and decision-making processes.33

While care is needed to avoid one-size-fits-all approaches, there are common lessons on what instruments should be used to address specific risks that are considered systemic:

  • To address systemic risks generated by credit growth or asset price inflation, credit-related instruments may be useful. Of these, LTV and DTI caps can be kept in place, adjusted counter cyclically or targeted at specific sources of risk. They may be supplemented by reserve requirements or capital-related instruments, such as dynamic provisioning, should the credit boom become more generalized; these in turn can be targeted by currency if foreign currency lending proves to be the source of risk.

  • To address systemic liquidity risk, liquidity-related instruments such as limits on liquidity mismatch may be used, or limits on the net foreign currency position if the liquidity risk stems from foreign currency funding. A core (or stable) funding ratio, or a levy on non-core liabilities, which are not examined by this paper, could also be good candidates if wholesale funding is a significant funding source. The ratio or levy can be kept in place to prevent the buildup of systemic liquidity risk, or adjusted in response to a sudden liquidity shock.

  • To address risks arising from excessive leverage, capital-related instruments may be a good choice. These measures provide a buffer that can be made countercyclical through adjustments in the capital requirement, the risk weights of assets or the provisioning requirement, and can thus help curtail excessive growth in leverage. If leverage growth stems from banks’ drive to expand credit, capital-related measures can be supplemented by credit-related instruments to go to the source of the risk.

  • If the above mentioned risks arise due to capital flows, all three types of instruments can be used. Liquidity-related instruments, like limits on net open positions in foreign currency, are shown to be effective in limiting the financial sector’s dependence on foreign sources of funding. These instruments can be supported by credit-related instruments if excessive credit growth is what drives banks to borrow abroad. In this context, capital-related instruments may also be useful by limiting credit growth and providing a buffer.

Several considerations are relevant for the successful design and calibration of instruments. Countries have tailored the design and calibration of the instruments to their specific circumstances, taking into account the type and source of risk, the ability of the financial system to circumvent the measure, or bear the cost of additional regulation, the quality of supervision and enforcement, and the governance and accountability arrangements regarding macroprudential policy.34 The following five considerations are important (Table 4):

  • Single versus multiple

  • Broad-based versus targeted35

  • Fixed versus time-varying

  • Rules versus discretion

  • Coordination with other policies

Table 4.

Use of Macroprudential Instruments Some Considerations

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Source: IMF Staff Analysis.

The use of multiple instruments has the advantage of tackling the same risk from various angles. A combination of instruments also reduces the scope for circumvention and provides a greater assurance of effectiveness by addressing different sources of the risk. Caps on the LTV and the DTI, for example, complement each other in dampening the cyclicality of collateralized lending, with the LTV addressing the wealth aspect, and the DTI the income aspect, of the same risk.36 In general, when credit-related instruments are used to address risks generated by excessive credit growth, it may also be useful to limit funding risks with liquidity-related instruments and to provide a cushion by using capital-related instruments. Nevertheless, the use of multiple instruments may impose a higher cost on banks and are harder to calibrate and communicate, so it is important to choose instruments that minimize the cost and plan the implementation carefully to avoid an unnecessary burden on the financial sector.

Some instruments can be used to target specific risks, although the targeted approach has its limits. Macroprudential policy is already more targeted than monetary policy, and the ability of macroprudential instruments to target specific types of activities is another advantage that makes them more precise and potentially more effective. A lower LTV cap on more expensive houses helps limit the risk to banks since such exposure tends to be riskier while a higher LTV cap on less expensive houses may be desirable from a social perspective as well. However, the targeted approach requires more granular data, has a higher administrative cost and may be more susceptible to circumvention. Excessive targeting may also result in micromanagement, which would increase the cost of policy actions. The additional benefit of targeting should be weighed against its cost.

It is useful to adjust macroprudential instruments at different phases of the cycle to smooth out cyclicality. Some macroprudential instruments counter the cyclicality in the financial system as an “automatic stabilizer.” Dynamic provisioning and the capital conservation buffer under Basel III fall into this category, whose buildup during the upturn and depletion during the downturn help limit the severity of the cycle. However, other instruments, such as caps on the DTI, ceilings on credit growth and reserve requirements, may need to be adjusted during different phases of the cycle to minimize cyclicality. In addition, adjustments in the LTV cap and capital requirements can make them more potent in smoothing out the cycle, as indicated in Section III. While necessary, the adjustments should be based on sound and transparent principles and ad hoc and frequent changes that are disruptive to financial activities should be avoided.

Instruments that vary through the cycle based on rules have clear advantages and should be used to the extent possible. Dynamic provisioning and the capital conservation buffer are two examples of such instruments. The use of rules-based instruments helps overcome policy inertia and provides greater predictability in the regulatory environment. However, these two instruments may be rare exceptions, most other instruments, such as caps on the LTV, DTI, ceilings on credit growth and reserve requirements, may need to be adjusted at the discretion of the policymaker because designing rules for their adjustment may be difficult or even impossible, especially when it is necessary to use multiple instruments in combination. When discretion is necessary, it is useful to make the adjustment on a trial and error basis in a learning-by-doing process. Still, even when discretionary action is necessary, macroprudential policymakers should base their decisions on formal methods of analysis, and explain the rationale behind their actions publicly to enhance policy transparency and effectiveness.

The need for the discretionary use of the instruments calls for a framework to guide the conduct of macroprudential policy. This framework should include a mechanism to identify and monitor systemic risk, procedures for using macroprudential instruments, and careful choice of specific objectives macroprudential policy actions are to achieve. The criteria for the choice of instruments and methodology for the evaluation of their effectiveness should also be important elements in the framework. In addition, since many fiscal and monetary tools may be used to address systemic risk, a clear communication strategy and a set of principles and rules regarding the use of other public policy tools for macroprudential objectives are essential for transparency and the credibility of the macroprudential authority.

Well coordinated policy actions are a necessary condition for a successful response to systemic risk. The combined use of macroprudential instruments with monetary and fiscal policy tools in addressing systemic risk tends to be more effective when financial sector risks intertwine with those in other sectors or the financial cycle coincides with the business cycle. In general, macroeconomic policies should always be the primary tool to use when the source of systemic risk is domestic demand imbalances. In particular, macroprudential policy should be used only as a complement to monetary policy, which is more blunt and potent in addressing excess demand. On the other hand, macroprudential policy is better suited to target specific sectors, and should be used primarily to increase the resilience of the financial system. In any event, mechanisms should be established to address coordination challenges and limit any potential policy conflicts.

V. Next Steps

This paper has examined the use of macroprudential instruments to mitigate systemic risk in the financial system. The analysis focuses on the factors affecting the choice of the instruments, the circumstances in which the instruments are used, and the effectiveness of the instruments in achieving their intended objectives by drawing on the experience of a sample of 49 countries that have actively applied macroprudential instruments in the past 10 years. Several common lessons and policy messages, on conditions for macroprudential policy to be effective and situations to avoid, are derived from country experiences and econometric analysis. The broad guidelines set out in this paper should contribute to the international debate on how to make macroprudential policy operational and help guide the Fund’s policy advice in surveillance and technical assistance.

The findings are preliminary and more work is needed in several areas. The paper has assessed mostly the time dimension of systemic risk, and largely with experiences from emerging market economies. The analysis of the cross-sectional dimension of systemic risk has been more limited, and data availability has been the main constraining factor. In analyzing the interconnectedness of global systemically important institutions, more granular data would be required. Filling the data gaps would also help to develop mechanisms to identify and monitor systemic risk, which is essential to make macroprudential policy operational.

A deeper understanding of design and calibration issues and how they shape effectiveness is needed. The paper has shown that some approaches have advantages over others, but whether instruments would be more effectively used strictly as a form of insurance against future crisis or as a tool to correct imbalances is unclear. Another issue not addressed in this paper but may warrant further research is whether price-based or quantity-based instruments are more effective. Effectiveness may also vary with the degree of complexity (e.g., as instruments become more targeted), or if the instrument is used to pursue more than one objective.

The cost of implementing macroprudential instruments is another issue that needs further exploration. Although these issues are beyond the scope of this paper, it will be important to consider costs related to the regulatory burden, distortions, or other unintended consequences when making macroprudential policy operational. Most notably, macroprudential instruments may cause a migration of systemic risk to other parts of the financial system, and care is needed to mitigate such “leakages.”

The relationship between macroprudential policy and microprudential regulation also needs to be further clarified. Many of the macroprudential instruments cited in this paper are traditional prudential regulation tools. These instruments are assumed to be “readily” available for use as macroprudential instruments. However, it is important to clarify when the prudential tools begin to serve macroprudential purposes so that the implementation of macroprudential policy can be well coordinated with microprudential objectives.

Macroprudential Policy: What Instruments and How to Use them? Lessons From Country Experiences
Author: International Monetary Fund