Research Summaries: Market Failures and Macroprudential Policy

The Research Summaries in the December 2012 IMF Research Bulletin look at "Market Failures and Macroprudential Policy" (Giovanni Favara and Lev Ratnovski) and "Measurement Matters for House Price Indices" (Mick Silver). The Q&A column looks at "Seven Questions on Turning Points of the Global Business Cycle." The Bulletin also includes a listing of recent IMF Working Papers and Staff Discussion Notes, as well as a list of the top-viewed articles for the first three issues of IMF Economic Review in 2012. Information is also included on a call for papers for the conference "Asia: Challenges of Stability and Growth" to be held in Seoul in 2013.

Abstract

The Research Summaries in the December 2012 IMF Research Bulletin look at "Market Failures and Macroprudential Policy" (Giovanni Favara and Lev Ratnovski) and "Measurement Matters for House Price Indices" (Mick Silver). The Q&A column looks at "Seven Questions on Turning Points of the Global Business Cycle." The Bulletin also includes a listing of recent IMF Working Papers and Staff Discussion Notes, as well as a list of the top-viewed articles for the first three issues of IMF Economic Review in 2012. Information is also included on a call for papers for the conference "Asia: Challenges of Stability and Growth" to be held in Seoul in 2013.

The purpose of macroprudential policy is to reduce macroeconomic risks stemming from the operations of the financial sector. However, its economic rationale is not always well articulated, and there is no consensus on optimal instruments. This article argues that macroprudential policy can be analyzed through the prism of market failures that it is supposed to address. The relevant market failures are risk externalities across financial institutions and between finance and the real economy. The article then discusses how these externalities can be corrected by existing policy tools.

The purpose of macroprudential policy is to reduce “systemic risk.” While hard to define formally, systemic risk is understood as “the risk of developments that threaten the stability of the financial system as a whole and consequently the broader economy” (Bernanke, 2009). The concept is meant to include the types of financial imbalances that led to the 2007–2008 financial crisis.

It is common to focus on two key aspects of systemic risk. One is the “time-series dimension”: the procyclicality of the financial system that manifests in excess risk taking in booms and excess deleveraging in busts. Another is the “cross-sectional dimension”: the risk of contagion due to the concurrent state of weakness and failure of financial institutions. Accordingly, macroprudential policy is thought of as a set of tools that help reduce these two forms of risk (Borio, 2009; Bank of England, 2011).

Yet thinking about macroprudential policy by looking solely at these two dimensions of risk is unsatisfactory. First, this view, per se, does not provide a justification for regulatory intervention. For example, is it really desirable to avoid any form of cyclicality and have zero risk of contagion in the financial system? Second, it is not a priori clear what macroprudential policy can achieve that traditional microprudential regulation cannot.

A recent IMF study (De Nicolò, Favara, and Ratnovski, 2012) aims to tackle these questions. It starts by articulating that, as for any form of regulatory intervention, the objective of macroprudential regulation must be to address market failures.

The idea that macroprudential policy is needed to correct market failures, rather than to smooth financial cycles, is important, because prudential measures that restrict credit availability (and possibly bank profits) may encounter nontrivial political challenges. The identification and correction of market failures is a clearer, uncontroversial objective for a macroprudential regulator.

The emphasis on market failures also helps clarify why microprudential regulation, which focuses on the individual stability of financial institutions, is not enough for containing systemic risk. Clearly, having strong individual institutions is necessary to minimize systemic risk—but that is not sufficient. For example, microprudential policy may not take sufficient account of correlation risks. Likewise, a focus on maintaining high capital ratios of individual institutions during a recession may result in asset fire-sales, exacerbating existing vulnerabilities.

Externalities and Policies

De Nicolò, Favara, and Ranowski (2012) argue that important sources of market failures in the financial sector are the risk externalities across financial institutions and between the financial sector and the real economy. According to the available literature, such externalities are driven by 1) strategic complementarities (herding): the strategic interactions of financial institutions causing the build-up of vulnerabilities during the expansionary phase of a financial cycle; 2) fire sales: the generalized sell-off of financial assets causing a decline in asset prices and a deterioration of the balance sheets of intermediaries; and 3) interconnectedness: the risk of contagion caused by the propagation of shocks from systemic institutions or through financial networks.

“The idea that macroprudential policy is needed to correct market failures, rather than to smooth financial cycles, is important, because prudential measures that restrict credit availability may encounter non-trivial political challenges.”

The policy debate has suggested a number of macroprudential policy tools: procyclical and systemic risk-based capital surcharges, dynamic provisioning, liquidity regulation (including dealing with the risks of wholesale funding), lending limits (loan-to-value and debt-to-income caps), restrictions on activities (Volcker and Vickers rules), and different forms of corrective taxes.

The paper analyzes how these policy tools can correct the three identified externalities. A summary of the main discussion is depicted in the following table (page 3).

One important result of the analysis is that each of the externalities can be corrected by multiple policy tools. For example, both capital requirements and limits on bank asset allocation can correct the externalities associated with strategic complementarities of banks. Capital requirements induce banks to internalize more of the cost of engaging in risky lending; restrictions on asset allocation prevent banks from taking large risk exposures.

However, since capital requirements may become less effective in booms (when capital ratios increase due to buoyant asset prices), direct quantity restrictions, such as debt-to-income (DTI) or loan-to-value (LTV) ratios, can also be useful complements. These restrictions affect directly the asset side of a bank’s balance sheet and are meant to limit the fall in lending standards during boom times.

Externalities and Macroprudential Policies

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Similarly, capital and stable funding measures are complements in addressing the risk of fire sales since they focus on vulnerabilities stemming from different sides of a financial institution’s balance sheet. The externalities associated with fire sales arise because banks fail to internalize the consequences of not taking precautionary measures in normal times, and thus need to adjust by shedding assets ex-post in the event of a negative aggregate shock. Capital and liquidity requirements provide buffers that reduce the risk of fire sales

Also, capital surcharges can weaken the incentives of banks to become systemic, ensuring they dispose of a larger buffer in case of distress. Complementary restrictions on the composition of bank assets (as envisioned e.g., by the Volcker rule) serve to limit banks’ exposure to excessive risk.

The second result, a corollary, is that since the alternative policy tools are often complementary, this is not a “silver bullet” policy instrument. Since each tool has different advantages and limitations, a combination is likely to provide a better solution to the problem of correcting the same externality. Goodhart and others (2012) reach similar conclusions using a theoretical model of financial instability.

The third result is that capital surcharges, more than any other tool, can be effective in dealing with any of the externalities. For this reason, and because they are closely linked to microprudential regulation and are part of the Basel III framework, capital requirements (surcharges) are likely to form the core of any macroprudential policy framework. The other instruments can be seen as complements in cases when capital surcharges are less effective.

In conclusion, even though the mapping from externalities to policy tools helps identify the pros and cons of alternative policy interventions, a major challenge in the

implementation of macroprudential policy rests on the calibration of instruments. Despite recent evidence on the effectiveness of some tools, little is known quantitatively (Dell’Ariccia and others, 2012). For example, it is far from clear how high should capital surcharges be or what should be the optimal LTV ratio. Accordingly, further fundamental and applied research on the optimal choice and calibration of macroprudential policy tools is required to justify policy intervention and avoid regulatory discretion.

References

  • Bank of England, 2011, “Instruments of Macroprudential Policy,” Discussion Paper.

  • Bernanke, Ben, 2009, “Letter to the U.S. Senator Corker,” http://blogs.wsj.com/economics/2009/11/18/bernanke-offers-broad-definition-of-systemic-risk/.

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  • Borio, Claudio, 2009, “Implementing the Macroprudential Approach to Financial Regulation and Supervision,” Banque de France Financial Stability Review, Vol. 13.

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  • De Nicolò, Gianni, Giovanni Favara, and Lev Ratnovski, 2012, “Externalities and Macroprudential Policy,” IMF Staff Discussion Note 12/05 (Washington: International Monetary Fund).

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  • Dell’Ariccia, Giovanni, Deniz Igan, Luc Laeven, and Hui Tong, 2012, “Policies for Macrofinancial Stability: Options to Deal with Credit Booms,” IMF Staff Discussion Note 12/06 (Washington: International Monetary Fund).

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  • Goodhart, Charles, Anil Kashyap, Dimitrios Tsomocos, and Alexandros Vardoulakis, 2012, “An Integrated Framework for Multiple Financial Regulations,” Working Paper presented at the conference “Central Banking: Before, During, and After the Crisis,” sponsored by the Federal Reserve Board and International Journal of Central Banking, Washington, DC, March 23-24, 2012.

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