Macroprudential Policies In Response To External Financial Shocks

This paper examines how countries use Macroprudential Policies (MaPs) to respond to external shocks such as US monetary policy surprises or fluctuations in capital flows. Constructing a model of a small open economy with financial frictions and a MaP authority that adjusts loan to value (LTV) ratio limits on borrowers and capital adequacy ratio (CAR) limits on banks, we show that using MaPs where stochastic external financial shocks are present entails a trade-off between macro-financial volatility and GDP growth. The terms of the trade-off are a function of a few country characteristics that amplify financial channels of external monetary shocks. Estimating MaP reaction functions for a panel of 41 countries in the period 2000–2017, we find that countercyclical macroprudential policy in response to surprise US monetary tightening is more likely for countries with net short currency mismatches (that is, foreign currency denominated liabilities larger than foreign currency denominated assets), consistent with the model’s predictions. The paper also finds that domestic credit and interest rates are more insulated from US monetary tightening for countries that employ MaPs countercyclically.

The countercyclical capital buffer (CCB) was proposed by the Basel committee to increase the resilience of the banking sector to negative shocks. The interactions between banking sector losses and the real economy highlight the importance of building a capital buffer in periods when systemic risks are rising. Basel III introduces a framework for a time-varying capital buffer on top of the minimum capital requirement and another time-invariant buffer (the conservation buffer). The CCB aims to make banks more resilient against imbalances in credit markets and thereby enhance medium-term prospects of the economy—in good times when system-wide risks are growing, the regulators could impose the CCB which would help the banks to withstand losses in bad times.

We explore optimal monetary and macroprudential policy rules for a small open economy. Delegating 'lean against the wind' squarely to macroprudential policy provides a more robust policy mix to shock uncertainty—(i) if macroprudential measures exist, there are no significant welfare gains from monetary policy reacting to credit growth under a financial shock; and (ii) monetary responses to financial markets could generate bigger welfare losses than macroprudential responses under different shocks. The source of outstanding liabilities also plays a role in the choice of policy instrument— macroprudential policies are particularly effective for emerging markets where foreign borrowing is sizeable.

We analyze the effects of macroprudential policies through the lens of an estimated dynamic stochastic general equilibrium (DSGE) model tailored to developing markets. In particular, we explicitly introduce informality in the labor and goods markets within a small open economy embedding financial frictions, nominal and real rigidities, labor search and matching, and an explicit banking sector. We use the estimated version of the model to run welfare analysis under optimized monetary and macroprudential rules. Results show that although informality reduces the efficiency of macroprudential policies following a convex fashion, combining the latter with an inflation targeting objective could be beneficial.

We show that macroprudential regulation can considerably dampen the impact of global financial shocks on emerging markets. More specifically, a tighter level of regulation reduces the sensitivity of GDP growth to VIX movements and capital flow shocks. A broad set of macroprudential tools contribute to this result, including measures targeting bank capital and liquidity, foreign currency mismatches, and risky forms of credit. We also find that tighter macroprudential regulation allows monetary policy to respond more countercyclically to global financial shocks. This could be an important channel through which macroprudential regulation enhances macroeconomic stability. These findings on the benefits of macroprudential regulation are particularly notable since we do not find evidence that stricter capital controls provide similar gains.

We identify current challenges for creating stable, yet efficient financial systems using lessons from recent and past crises. Reforms need to start from three tenets: adopting a system-wide perspective explicitly aimed at addressing market failures; understanding and incorporating into regulations agents’ incentives so as to align them better with societies’ goals; and acknowledging that risks of crises will always remain, in part due to (unknown) unknowns – be they tipping points, fault lines, or spillovers. Corresponding to these three tenets, specific areas for further reforms are identified. Policy makers need to resist, however, fine-tuning regulations: a “do not harm” approach is often preferable. And as risks will remain, crisis management needs to be made an integral part of system design, not relegated to improvisation after the fact.

MCM conducted a survey in December 2010 to take stock of international experiences with financial stability and the evolving macroprudential policy framework. The survey was designed to seek information in three broad areas: the institutional setup for macroprudential policy, the analytical approach to systemic risk monitoring, and the macroprudential policy toolkit. The survey was sent to 63 countries and the European Central Bank (ECB), including all countries in the G-20 and those subject to mandatory Financial Sector Assessment Programs (FSAPs). The target list is designed to cover a broad range of jurisdictions in all regions, but more weight is given to economies that are systemically important (see Annex for details). The response rate is 80 percent. This note provides a summary of the survey’s main findings.

The crisis has underscored the costs of systemic instability at both the national and the global levels and highlighted the need for dedicated macroprudential policies to achieve financial stability. Building on recent advances, this paper provides a framework to inform the IMF’s country-specific advice on macroprudential policy. It recognizes that developing macroprudential policy is a work in progress, and addresses key issues to help ensure its effectiveness.