Macro Prudential Policy and Financial Stability

Macro Prudential Policy and Financial Stability

Macro prudential regulation is the approach to financial regulation that aims to mitigate risk to the financial system as a whole (or "systemic risk"). In the aftermath of the late-2000s financial crisis, there is a growing consensus among policymakers and economic researchers about the need to re-orient the regulatory framework towards a macro prudential perspective.

Macro Prudential Policy

·         More flexible and can be targeted and the spots of the financial system that are creating distortions.

·         Instead of enhancing safety and soundness of individual institutions, macro prudential policies focus on the welfare of the system.

·         Attempts to reduce the risk and the macroeconomic cost of financial instability.

·         The conventional monetary policy is not well suited in handling distortions in financial systems.

·         Address the inter-connectedness of individual FIs and market, and their common exposure to economic risk factors.

Macro-prudential Approach

·         Strengthen the analytical tools to use to gauge the built up of systematic risk

·         Considerations of wide array of intermediaries and economic sectors whose behavior potentially have systematic implications for financial stability.

·         Relation between each financial institution and the real sector.

·         Interconnection between each financial institution and the system as a whole.

·         Supervisory activity envisages the used of micro early warning exercise

·         Cross fertilization between supervisory and macro prudential analysis.

Tools to Macro Prudential Policy

1. Use counter-cyclical capital requirement, cap on loan-to-assets value ratios and loan loss provision ratios, cap on debt-to-income ratio where potential bubbles is forming.

2. To prevent the accumulation of short-term debts

·         Liquidity coverage ration

·         Liquidity risk charges that penalized short term funding

·         Capital requirement surcharges proportional to size of maturity mis-match

·         Minimum haircut requirement on assets backed security

3. Designing procedure to deal with the failure of systematically important institutions and prevent damage to the system.

4. Designing intervention procedures to avoid large misalignment in real exchange rate.

5. Allow the issuance of contingent certifies.

difference between macro prudential policy and micro prudential policy

Base	Macroprudential	Micro prudential
Proximate objective	Limit financial system-wide distress	Limit distress of individual institutions
Ultimate objective	Avoid output (GDP) costs	Consumer (investor/depositor) protection
Characterisation of risk	Seen as dependent on collective behavior ("endogenous")	Seen as independent of individual agents' behavior ("exogenous")
Correlations and common exposures across institutions	Important	Irrelevant
Calibration of prudential controls	In terms of system-wide risk; top-down	In terms of risks of individual institutions; bottom-up

Stability Objectives in Crisis

· Contain the damage and limit the damage to the real economy

· Restore the clam in the financial market

· Reduce uncertainty and ensure proper functioning of market for short term credits

· Prevent the collapse of FIs due to liquidity restriction

· Prevent the collapse of the systematically important institutions even of they insolvent, to save the financial system.

Ingredient For Financial Stability

o Through analysis

o Better or robust regulation

o International cooperation

1. Through Analysis

· Consider different source of systematic risk

· Wider data coverage(both bank and non-bank FIs)

· More regular and timely information

· Integration of micro and macro information

· Use of financial stability analysis model: early warning system and stress tests to assess the resilience of the system

2. Robust Regulation

· Counter cyclic regulation

· Regulation aimed at reducing pro-typicality of financial inter-mediation

· On capital & liquidity specifically addressed by Basel iii

(liquidity coverage (LCR), net stable funding ratio (NSFR)

3. International Cooperation

· Ensure effective exchange of information among supervisor in different jurisdictions.

· Use of successful common actions to preserve financial integration but avoiding negative cross boarder spillovers.