Understanding Macro-Prudential Policy and Its Operation
The global financial crisis has led to strengthening of the importance of financial stability objective, hence highlighting also the importance of macroprudential policy designed to maintain financial stability. The main aim of this policy is to mitigate systemic risk, i.e. the risk of instability of the financial system as a whole.
This risk is called systemic because while individual financial institutions (for instance, banks) are stable, the risks can rise when we look at the financial system as a whole. There are two dimensions of systemic risks
- time dimension, when risks accumulate across the evolution of financial cycle. This happens, as during “good times”, economic agents tend to extend their optimistic expectations into the future and take more risks, than they really can handle.
- Cross sectional or systemic dimension, which refers to the potential of a spread of risks over the financial system. For example, a troubled bank can have tight interconnections in the financial system, due to which other banks, initially not troubled, may have problems.
This assumes considering and supervising the financial system as a whole, since a significant share of systemic risk has proven to arise from the system itself, independent of the risks to and stability of individual financial institutions. Thus, monitoring systemic risk is important for their early identification, impact assessment (in case of materialization), and macroprudential policy actions to mitigate these risks.
Systemic risk can stem from various sources, meaning that the choice and design of appropriate macroprudential instruments depend on key characteristics of the risk or, in other words, the intermediate objective we want to address. Intermediate objectives help identify where systemic risk might originate and categorize them according to main directions. They are mainly related to excessive credit growth, liquidity problems, concentration and systemically important financial institutiօns, etc.
To reach these intermediate objectives and mitigate possible risks, financial stability officials have a variety of tools. Macroprudential instruments are broadly classified into the following two broad categories: capital-based and borrower-based. Examples of such instruments include the countercyclical capital buffer, loan-to-value ratios, debt-service-to-income ratios, etc.
The macroprudential policy is the central policy that targets systemic risks and their impact on the economy through various instruments. Macroprudential measures focus on the overall financial system and its interaction with the economy – not on individual credit institutions.
The ultimate goal of macroprudential policy is to ensure financial stability, thereby increasing overall economic welfare in the long run․