Macro Prudential Policy and Its Tools

 

Macro prudential policy and its tools

The macroprudential regulatory changes in terms of risk weight, provisioning requirements and Loan-to-Value ratio (LTV) occurred with respect to some specific sectors of the credits class viz., housing loans, commercial real estate, capital market and other retails in emerging markets. The tightening of prudential norms made the credit to targeted sectors costlier, thereby operating the flow of credit to these sectors. There is evidence that moderation in credit flow to these sectors was also in part due to banks becoming cautious in lending to these sectors on the signaling effect of the Central Bank’s perception of build-up of sectoral risks. Now the question arises as to how to test the impact of macroprudential policies on the loan supply in these specific sectors and to identify whether the changes in the loan is due to the monetary policy shock or macroprudential shock and further, whether it is demand driven or supply driven. ‘macroprudential’ approach to safeguard the financial system as a whole. Accordingly, the IMF initiated the framework for Financial Soundness Indicators comprising aggregated micro prudential indicators, financial market indicators and macroeconomic indicators. In the aftermath of the recent global crisis, the new Basel III framework has embraced macroprudential approach with emphasis on systemic risk and stability. However, the benefits of introducing macroprudential policy tend to be sizeable when financial shocks, which affect the supply of loans, are important drivers of economic dynamics.

The macroprudential norms enabled banks to withstand some of the adverse impacts when macroeconomic conditions changed especially when the global financial crisis hit. First, the countercyclical prudential requirement relating to investment fluctuations reserve enabled banks to absorb some of the adverse impact when interest rates began moving in the opposite direction in late 2004. When capital charge for market risk was introduced, banks did not face any difficulty in meeting the same.

Second, banks’ capital to risk-weighted assets ratio increased every year from 2007 to 2011. The

improved capital to risk weighted assets ratio was due to improved profitability as well as also to the decline in the gross non-performing assets ratio. This enabled banks to plough back increased profits. The increase in risk weights for lending to certain sectors and increased provisioning requirements against standard assets also enabled banks to improve their capital adequacy ratio.

Macroprudential policy measures fall into the following three broad categories (Table 4): (i) Credit controls including caps on ratios of LTV and of debt-to-income (DTI) and on foreign currency lending as well as ceilings on credit or credit growth; (ii) liquidity regulations that place limits on net open currency positions or currency mismatches and on maturity mismatches while establishing reserve requirements; and, (iii) capital requirements including countercyclical capital requirements, time-varying and dynamic provisioning, and restrictions on profit distribution. Macroprudential tools such as minimum capital ratios and LTV ratios have been used for some time. Reserve requirements could provide liquidity cushions while dynamic provisioning could help build capital buffers during upturns.

Conceptual Basis of Macroprudential Policy Instruments

Instrument	Conceptual Basis
Caps on the loan-to-value ratio (LTV)	The LTV imposes a down payment constraints on household capacity to borrow. In theory, the constraint limits the procyclicality of collateralized lending since housing prices and household capacity to borrow based on the collateralized value of the house interact in a procyclical manner. Set at an appropriate level, the LTV address systematic risk whether or not it is frequently adjusted, however, the adjustment of the LTV makes it a more potent countercyclical policy instrument.
Caps on the debts to income ratio (DTI)	The DTI represents prudential regulation aimed at ensuring banks asset quality when used alone. When used in conjunction with the LTV, however, the DTI can help further dampen the cyclicality of collateralized lending by adding another constraint on household capacity to borrow. As with the LTV, adjustments in the DTI can be made in a countercyclical manner to address the time dimension of systematic risk.
Caps on foreign currency lending	Loans in foreign currency expose the unhedged borrower to foreign exchange risk with, in turn, subject the lender to credit risks. The risks can become systemic if the common exposure is large. Caps (or higher risk weights, deposit requirements, etc.) on foreign currency lending may be used to address this foreign exchange induced systemic risk.
Ceiling on credit/credit growth	A ceiling may be imposed on either total bank lending or credit to a specific sector. The ceiling on aggregate credit or credit growth may be used to dampen the credit/assets price cycle--in the time dimension of systemic risk. The ceiling on credit to a specific sector, such real estate, may be used to contain a specific type of asset price inflation or limit common exposure to a specific risk—the cross-sectional dimension of systemic risk.
Reserve requirement	The monetary policy tools may be used to address systemic risk in two senses. First, the reserve requirement has a direct impact on credit growth, so it may be used to dampen the credit/assets price cycle—the time dimeson of systemic risk. Second, the required reserves provide a liquidity cushion that may be used to alleviate a systemic liquidity crunch when the situation warrants.
Countercyclical reserve requirement	The requirement can take the form of a ratio or risk weights raised during an upturn as a restraint on credit expansion and reduced during a downtown to provide a cushion so that banks do not reduce assets to meet the capital requirement. A permanent capital buffer, which is built up during an upturn and deleted during a downturn, serve the same purpose. Both can address the cyclicality in the risk weights under Basel ii based on external rating that are procyclical.
Provisioning	Traditional provisioning is calibrated historical bank-specific losses, but it can also be used to dampen the cyclicality in the financial system. The provisioning requirement can be raised during an upturn to build a buffer and limit credit expansion and lowered during a downturn to support bank lending. It may be adjusted either according to a fixed formula or at the discretion of the policy maker to affect bank lending behavior in a countercyclical manner.
Restriction on profit distribution	These prudential regulation requirements are intended to ensure the capital adequacy of banks. Since undistributed profits are added to bank capital, the restrictions tend to have a countercyclical effect on bank lending of used in a downturn. The capital conservation buffer of Basel III has a similar role.
Limits on net open positions/currency mismatch	These prudential regulation tools may be used to address systematic risk since the choice of asset/liability maturity creates an externality—fire sale of assets. In a crisis, the inability of a financial institution to meet its short-term obligations due to maturity mismatches may force it to liquidated assets thus imposing a fire sale cost on the rest of the financial system. The funding shortages of a few institution could also result in a systemic liquidity crisis due to the contagion effects.