Macroprudential policy is a novel way of looking into financial regulation. As defined by European Central Bank , macroprudential policies aim to:
- prevent the excessive build-up of risk, resulting from external factors and market failures, to smoothen the financial cycle (time dimension)
- make the financial sector more resilient and limit contagion effects (cross-section dimension)
- encourage a system-wide perspective in financial regulation to create the right set of incentives for market participants (structural dimension)
The onset of global financial crisis (GFC) and its persisting impact have put this new approach into limelight more than ever before.
Microprudential policy v/s Macroprudential Policy
Usually microprudential (regulations aimed at compliance by individual firms /entities) and macroprudential policies complement and reinforce each other in pursuit of their respective goals. The sound functioning of individual financial institution is a necessary, but not sufficient condition for the stability of the entire financial system. In certain situations, conflicts may occur because of overlapping policy mandates and the way in which policies are applied. Clarification of respective mandates, functions, and toolkits can help optimize synergies and limit the potentially negative consequences of policy interaction.
Pursuant to GFC, it is felt that microprudential financial regulations are too narrow in focus to avoid or manage any grave financial instability and hence they need to be supplemented, if not replaced, by macroprudential policies. The distinction between macroprudential and microprudential approach can best be drawn more in terms of objectives of the regulations and conception of the mechanisms influencing economic outcomes, than in terms of the instruments used for achieving these objectives (Crockett, 2000). The ultimate objective of microprudential regulations is to protect investors/ depositors, whereas for macroprudential it is to avoid/ limit the output cost of the economy due to financial distress. The proximate focus, therefore, for microprudential approach is the safety of individual financial institutions and for macroprudential it is the safety and soundness of the financial system as a whole (Borio, 2003).
Rationale of Macroprudential Regulation
What underlies macroprudential approach to financial regulation is some specific understanding of how modern financial system functions, eludes extant regulatory net, becomes fragile and causes some serious financial crisis to unfold in time. Therefore, as we try to study this novel regulatory approach, we necessarily come across concepts such as systemic risk, endogenous risk, amplification mechanism etc. Without referring to any specific understanding of financial crisis, we describe intuitively why we need a macroprudential oversight on financial system.
Shocks to the financial system can either be idiosyncratic in effect, limited to single institution/ market, or can be systemic in effect, capable of playing havoc with the entire financial system. Whether any shock limits itself to one institution/ market or propagates through a range of institutions/ markets is difficult to predict. This is because the risk, of a shock leading to a systemic crisis (i.e. systemic risk), develops ‘endogenously’ (i.e. within the system) and is hard to see until it gets manifested. Danielsson and Shin (2002) notes that endogenous risk surfaces when two things appear together: (i) agents reacting to their environment and (ii) environment getting affected by the agents’ reaction. We could say that risks develop endogenously when agents’ reaction to a shock gives rise to further shocks to the system in subsequent rounds. That the market distress feeding on itself drives the financial system away from equilibrium is the characteristic feature of endogenously developing risk. In fact, it is the interdependence among financial institutions, markets and their behaviour make risks endogenous to the modern financial system (Warwick Commission, 2009).
The real possibility that risks could emerge endogenously lays bare the fallacy of composition entailed in traditional microprudential regulatory approach. Then, by no means, the safety of individual financial institutions, guaranteed by microprudential regulations, ensures the safety and soundness of the entire financial system, particularly when a shock strikes. Even when individual financial institutions operate in compliance to the regulatory standards, risks could brew in the system due to collective behaviour of agents. The collective behaviour of agents is pro-cyclical and it makes the financial system pliable to the realisation of these risks, unfolding endogenously as and when a shock hits any institution/ market. When asset prices rise and measures of risk fall during upswing, all financial institutions increase their leverage, expand their balance sheets and try to lower the cost of funding. On the other hand, when asset prices fall and measures of risk rise, they shrink their balance sheet and start deleveraging. For a single financial institution it is prudent to do so; but all financial institutions following the suit mean collapse of the entire financial system (ICMB, 2009). Macroprudential policies are primarily designed to act as a countervailing force to these pro-cyclical tendencies of the financial system, which is the result of complex interactions and interdependencies, and buttress its resilience.
Generally, macroprudential policy is devised to address the time and cross-section dimensions of systemic risk. The time dimension essentially refers to the earlier mentioned pro-cyclical behaviour of agents, which propagates and amplifies the shock received by any part of the financial system. That means agents increase their risk position during upswing and become extremely risk averse in times of downturn. Closely related to this is the cross-section dimension of systemic risk, which implies the ‘distribution of risks in the financial system at a point of time’. Vulnerability of the financial system, viewing from this dimension, depends upon the size of the institutions, concentration and substitutability of their activities and interconnectedness among them (IMF, 2011). Identifying and regulating systemically important financial institution (SIFIs) is quite critical from this perspective.
Governance of Macroprudential Regulations and Tools Adopted
Macroprudential approach to financial regulation is conceptually sound and appealing, but operationally challenging (Gopinath, 2010). Just as monetary policy, the effective implementation of macroprudential policy also hinges on specifying a clear mandate, instrument/s, intermediate target/s and having an independent agency responsible for the execution of the policy. The mandate of macroprudential policy - maintaining financial stability- is too broad to have a uniform definition or single measurable indicator. Nevertheless, at functional level, the macroprudential policy focuses to strengthen the resilience of financial system and dampen the financial cycle (Caruna and Cohen, 2014).
Though several instruments and operational targets have been identified towards these ends, a strict one-to-one correspondence between instruments and intermediate targets, following Tinbergen’s principle, has neither been feasible nor possible in case of macroprudential policy. Often, in order to meet one intermediate target the use of more than one instrument is warranted (Caruna and Cohen, 2014). The commonly used macro-prudential policy instruments across the economies are counter-cyclical capital buffer (CCB), dynamic provisioning, time-varying caps on loan-to-value (LTV) ratio, debt-to-income (DTI) ratio, large exposure restrictions, minimum margin and reserve requirements, limits on maturity mismatches, capital surcharges to SIFIs etc. (Claessens, 2014). These policy tools are not very different from hitherto used microprudential tools; but in their use and focus they do differ from the latter. Similarly, the intermediate targets generally recognised are excessive credit growth & leverage, excessive maturity mismatches & illiquidity, correlated exposures & risks, misaligned incentives etc. (Noyer, 2014; Knot, 2014).
Making use of these instruments to increase the resilience of financial system and dampen the operation of financial cycle is fraught with several difficulties. Caruna and Cohen (2014), based on evidences, suggest that the use of macroprudential policy instruments is more effective to enhance the resilience of financial system than temper financial cycles per se. That means use of macroprudential policy alone will not moderate financial cycles; rather a combined use of fiscal, monetary and macroprudential policies is needed. Another problem is that use of macroprudential instruments can potentially conflict with monetary and fiscal policies. And this stems from the observed fact that financial cycle is longer than business cycle (Borio, 2012). For instance, a restrictive macroprudential policy adopted during the upswing of financial cycle could constrain the aggregate demand if the business cycle is in moderating phase. From the vantage point of fiscal and monetary policies and their goals of aggregate demand management, perhaps, macroprudential policy appear as either too restrictive or too lax. These issues necessarily open-up a stage for co-ordination before the application of any macroprudential instruments. The other level of co-ordination required is among the various stakeholders of macroprudential policy itself. This is because of the fact that the final effect and transmission channels of macroprudential policy instruments are less certain or precise unlike monetary policy. Measures of financial stability/ systemic risk at the best could only indicate the build-up of risks in the system, but not much about their source, trajectory and quantum. Macroprudential policy decisions, therefore, need to be supplemented by qualitative considerations as well and hence discretion play a fair role in decision-making regarding the selection of tools to be used, modalities of their use such as its timing and magnitude (Knot, 2014). Co-ordination among various agencies that directly share the responsibility of macroprudential policy implementation, then, becomes indispensable.
While the benefits of macroprudential policy get reflected over a course of time, the associated costs of its use become perceptible in the short-run. Given that the short-run costs is felt across the entire financial system and benefits in offing, it is very likely that an ‘inaction bias’ could creep in the authority implementing macroprudential policies and postpone the policy actions. The bias could also be due to transmission channels’ ambiguity, uncertain outcomes/ benefits of macroprudential policy and the involvement of complex co-ordination. The operational independence of authority responsible for macroprudential policy is suggested to tide over this ‘inaction bias’ (Knot, 2014).
Global Institutional Architecture for Macroprudential Regulation
The aforesaid characteristic features of macroprudential policy provide the basis for adopting various institutional structures for its governance. The aspects of independence, expertise in identifying financial cycles and dealing with financial markets give credence to Central Bank as the sole authority responsible for macroprudential policy. On the other hand, the aspect of co-ordination favours a council/ committee arrangement, where all financial sector regulators are members besides the Government, to implement macroprudential policy. In case of a single agency, say the Central Bank, the level of consultation needed would be the least. In a council arrangement, responsibilities of each member, macroprudential tools and their intended target/s and modalities of their use, including the co-ordination required, have to be specified. Noyer (2014) notes the use of four models globally. One model assigns this role solely to the Central Bank, for instance Central Banks of Czech Republic and Ireland handle both micro and macroprudential policies with little interaction with Finance Ministry. Another model is a committee under Central Bank, where Finance Ministry is included but with a passive role; UK is an example to this. Yet another model is the one that is followed in case of United States, France and Germany, where the Finance Ministry presides macroprudential authority with the Central Bank playing an active role. In a few cases, as in Sweden, no such responsibility is given to the Central Bank. Notwithstanding the model differences, the idea is to create “institutional incentives and mechanisms to ensure that the authorities implement macroprudential policy tools in a timely and sufficient manner” (Knot, 2014).
Macroprudential Policy in India
India adopted a council-form of organisation for the pursuit of financial stability mandate. Under Financial Stability and Development Council (FSDC), functioning since 2010, the mechanism of maintaining financial stability has been institutionalised and strengthened. Prior to FSDC, financial stability was understood as one of the three objectives of monetary policy and considered “mutually reinforcing” the other two objectives, price stability and growth (Mohanty, 2010).
The creation of FSDC has been motivated by the recommendations of several committees to adopt a system view for addressing the issue of systemic stability. Among these contributions of two committees were significant. The High Level Committee of Financial Sector Reforms (CFSR- 2008) has recommended establishing an entity called Financial Sector Oversight Agency (FSOA), which focuses exclusively on macroprudential policy. Financial Sector Legislative Reforms Commission (FSLRC- 2013) had thoroughly redefined the role of FSDC and recommended to perform its mandate of financial stability/ systemic risk management with a legal footing, by making it a statutory body. To assist the Council in performing its mandate, the Commission also suggested a data centre called Financial Data Management Centre (FDMC) that will work within FSDC. In the Budget Speech 2016-17 , Hon’ble FM has announced setting up of FDMC under the aegis of the FSDC to facilitate integrated data aggregation and analysis in the financial sector.
As a non-statutory organisation, FSDC presently works in a two-tier structure. While FSDC functions under the chairmanship of Finance Minister, its Sub-Committee (FSDC-SC) that replaced the erstwhile High Level Coordination Committee on Financial Markets (HLCCFM) operates as an executive arm of the main Council under the chairmanship of Governor, RBI. Under the aegis of the Sub-Committee, there are four inter-regulatory groups in areas of financial inclusion/ literacy, regulation of financial conglomerates, regulatory co-ordination and early warning, which meet more frequently than the Council and its Sub-Committee. The mandate of financial stability, in this structure, is seen as a shared goal for all financial sector regulators along with the Government to pursue and achieve. Given that banks dominate India’s financial system, RBI has a larger/ lead role to play at operational level.
Although India has institutionalised financial stability mechanism, an explicit macroprudential policy framework is yet to develop. However, RBI has been using various macroprudential tools for more than a decade without christening them so, particularly those adopted during the expansionary phase since 2004. Risk weights to loans extended to housing, commercial real estate and capital markets have been raised; so as the general provisioning requirement on standard advances to these sectors (Gopinath, 2010). RBI has been regulating financial conglomerates (FCs) since 2004 through offsite surveillance and regular reviews of a technical group in which other financial sector regulators were members along with FCs. These macroprudential type regulations undertaken by RBI were mostly judgemental, not based on any disaggregated data, sector-specific and acted as complementary to monetary policy (Gopinath, 2010, Chakrabarty, 2014). Lately in 2015, RBI notified guidelines on counter-cyclical capital buffer (CCB) and in 2016 developed framework for identifying systemically important financial institutions (SIFIs) in the banking sector. Though these measures, undoubtedly, have laid more obvious emphasis on the time and cross-section aspects of macroprudential policy than before, the absence of a comprehensive macroprudential framework is still a lacuna to further the mandate of financial stability.
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