Due to the lessons from the globalfinancial tremors, countries are now involved in taking measures to supportingsustainable financial stability.
In the past conference in Seoul, there were significantresult towards the introduction of macroprudential policy-based financialregulation. This is to say, macroprudential directive is still in its earlystage. However, before now, financial organizations were controlled by thecombination of monetary policy and micro-prudential regulation. The goal ofmonetary policy is price stability which enhance economic growth, while micro-prudentialregulation is to alleviate individual institutions and to shield depositors.Tinbergen (1952) reasoned that, foreach effective policy objective there is a call for at least one capable policyinstrument.
In practice, the various policy instruments and objectives are interconnectedas shown in figure 1. To each policy there is a main effect on its directobjective and a lesser effect on the objective(s) next to it. The hard linesshow the main effect and the light-dark lines the lesser effect.According to Kremers andSchoenmaker (2010), it is suitable to reason in terms of a pyramid ofobjectives. Monetary and macroprudential objectives (i.e., price and financialstability) are similarly imperative in economic performance, whilemicroprudential objective aim to protect individual financial establishmentsand regulars. The financial system stability is more vital than individualcomponents such as banks and other financial mediators.
It has been said that monetarypolicy instruments can be effective on financial stability, since it can”affect the build-up of risk” in financial sector through the “risk-takingchannels”. This is because, low interest rates can inspire depositors to selectriskier assets to generate higher financial return over harmless assets thatyields low financial return. Depositors or investors may make this switch in expectationof achieving yields that suit their actions. Macroprudential policy instrumentson the other hand can also be effective on price stability as shown in figure1. However, macroprudential and microprudential policies have dissimilarobjectives and therefore distinct viewpoints (Borio, 2003). The main reasonfor macroprudential directive is to mitigate the risk of financial instability.It is a crucial device to fine-tune the space between macroeconomic policy andmicroprudential regulation of financial system. (Bank of England, 2008) Although,banking segments may be individually financially stable, but their activitiesmay cause instability within the economy and as a result the sector may beaffected by adverse shocks.
Moreover, if banks are not adequately robust duringfinancial fallout, problems in one bank can result to systematic banking trauma.(De Bandt and Hartmann, 2000)Since, manycountries have experienced financial contraction, the application ofmacroprudential policies are crucial to shield against systematic risks of exposureto financial instability. Market letdown and externalities are results of improperpolicy instruments, macroprudential policies tend to correct these failures andensure a smooth and effective economic operation. There are two pillars ofmacroprudential framework.
As illustrated in figure 2, the first pillar isfinancial disparities, for which macroprudential policy strategy is suitable.The second pillar is externalities, for which a structural policy method is suitable.Both the cyclical and structural pillars are somehow dependable to each other.Regulators must do a validation in examining financial stability process whenthe two-pillar approach is applied. In a more modification of the two-pillarapproach, De Bandt, Hartmann and Peydrö (2009) demonstrated the importance of totalshocks that can cause the unravelling of financial differences and “spread ofcontagion”.
Macroprudentialregulation rest on various pointers when measuring systematic risk. Accordingto Borio (2003), an important aspect is between measuring contributions to riskof individual institutions (the cross-sectional dimension) and measuring the growth(i.e., procyclicality) of systematic risk through time (the time dimension).The cross-sectional dimension of risk can be supervised by following balancesheet evidence on over-all assets, liability and capital structure, as well asthe worth of the institutions transaction securities and securities offered forsale. Also, other advanced financial gears and models have been established to weighthe interconnectedness across mediators (such as CoVaR), and each institution`srole to systematic risk (identified as “Marginal Expected Shortfall” in Acharyaet al., 2011). To discourse the time dimension of risk, a widespread ofvariables are used, for example: ratio of non-core to core liabilities of thebanking sector, ratio of credit to gross domestic product (GDP), monetaryaggregate and real asset prices.
Some initial threatening indicators have been establishedsurrounding these and other pieces of financial data (see, e.g., Borio andDrehmann, 2009). Besides, macro stress tests are active to detect exposures inthe wake of a simulated contrary consequence.In banking crisis concept, numerousconduit has been accessible as well as interconnectedness (Rochet and Tirole(1996)), macro-uncertainty (Chari and Jagannathan (1988)) and liquidity spirals(Brunnermeir and Pedersen (2009). Borror and Drehmann (2009) have proved thatit is probable to produce indicators by credit increase and asset prices thatcan aid the detection of accumulated risk of future banking disturbance thatcan arise from an ordinary source of private-sector spill over.
It isimperative to say that US banks may have been affected during the crisisbecause of large correlation holdings (Acharya and Richardson (2009). As studyon systematic risk goes on, one need to be sure that the measures of systematicrisk are healthy to a variety of diverse roots that may have triggered theupset in financial institutions. Moreover, non-banking activities needto be taken into consideration because during the 2007-2008 financial crisis,AIG, one of the major insurance company in the US, had to be rescued withbillions in loans. All the classic studies of financial meltdown, such asRogoff and Reinhart (2009b), have only emphasized on banks. Future study shouldalso develop the literature by considering systematic risk connected with majornon-bank financial companies. These non-bank institutions may also contributeto systematic risk but are often less controlled.After recognizingsystemic risk, regulators can use suitable tools to mitigate the negative impacts.Countercyclical shields can be regarded as the most important macroprudentialtool to prevent systematic risk.
However, in a crisis, a wide choice ofmonetary policy tools and supervisory measures can be macroprudential innature. Different kinds of instruments have been presented; however, there isno instrument that is assigned to play the key role in the application ofmacroprudential policy in US. The various instruments are illustrated in figure3.Capital toolsBanks are required toembrace high quality capital against various risks. It aims to avoid extremebalance sheet shrinkage from banks in distress (countercyclical capitalrequirement). It is aiming to address structural issue such as common exposuresor the structure of the banking sector.Liquidity toolsMacroprudential liquiditytools aim to prevent the buildup of unnecessary short-term debt.
Quantity-basedinstruments such as liquidity coverage ratio (LCR), net stable funding ratio(NSFR), loan-to-deposit (LTD), and price-based instruments such as (general)liquidity surcharge for systemically important institutions can reduce thereliability of non-soft funding.Other balance sheet tools – large exposure limitsLarge exposures are defined inthe Capital Requirements Directive “as exposures that are 10 per cent or moreof a bank’s capital base and require monitoring”. The limit on large exposuresto a single counterparty/group of connected counterparties is 25% of a bank’scapital. These instruments monitor contagion risks by preventing banks’exposures to a particular area. ECB (2013) observed that there is a decrease incontagion loss in an interbank system, when the exposure bound of 25% isreduced. Despites improvement in the resilience of theU.S.
financial system, there are challenges that still exist. Firstly, newregulations may lead to changes in the institutional position of certainfinancial activities, which can possibly counterbalance the awaited effects ofthe regulatory reforms. Changes in regulation have emphasized significantly onlarge banks, since it is the most interrelated and compound institutions.
However,potential change of activity from more regulated to less regulated institutionscould contribute to new threats. For example,there have been observation of reduced liquidity in fixed-income markets. Observershave related this disturbance to new regulations that have increased the costsof market making. Moreover, the relocating of activities in response toregulation is a possible impairment to the success of macroprudential policy.
Secondly, macroprudentialpolicy in the U.S. faces limitations in cyclical buildup of financial stability.Since the crisis, there have been development to position some countercyclicaltools to prevent systematic risk, such as the “analysis of salient risks inannual stress tests for banks, the Basel III countercyclical capital buffer,and the Financial Stability Board (FSB) proposal for minimum margins onsecurities financing transactions”.
However, the proposal of the Financial StabilityBoard (FSB) is yet to be enforced, and many instruments used in other nationsare either unavailable to U.S. authorities or are far from being implemented.For instance, new instruments, such as the countercyclical capital buffer,remains untested in the United States.Thirdly, financial stability issuesare difficult to measure in practice. It may be difficult to distinguish betweenefficient and inefficient market arising from market failures or externalities.As a result, it can be difficult to know when macroprudential policies need tobe hired, loosened, or tightened.
Designing macroprudential policies involves defininghow huge a buffer should be made up in periods of financial stability and whenand how much it can be released freely during financial distress. Due tolimited experience, regulators may misjudge the outcome of macroprudentialpolicies on productivity, which may give rise to policy errors. For example,regulators may misjudge the level to which reserve requirements reduce total demandand inflation, and as a result may select too little interest rate response.