Objectives and toolkit of Macro-prudential policy
Systemic risks can come from various sources, meaning that the choice and design of appropriate macro prudential instruments depends on intermediate objectives.
These intermediate objectives help identify where systemic risks might come from. In simpler terms, policymakers first look at potential risk sources. Based on that, they set intermediate objectives for the macro prudential policy and choose the right tools to manage those risks.
To explain it more simply, let's use some easy examples.
For instance, financial institutions, often banks, might have to keep aside extra money (capital) to handle unexpected events or shocks. The amount of this extra money can change over time (or, put another way, over the financial cycle) and might be more for "bigger" banks. Alternatively, constraints may be imposed on the operations of financial institutions or their clients, such as defining conditions for mortgage lending. The amount someone can borrow might depend on things like the property's value or their income.
Each country can set different intermediate objectives, taking into account the specifics of the country and the financial system.
Considering the primary sources of vulnerability and risks within the financial system, the subsequent intermediate objectives are generally identified.
- Mitigate or prevent excessive credit growth and financial leverage risk,
- Mitigate or prevent maturity mismatch, liquidity risk,
- Mitigate or prevent concentration risk,
- Mitigate or prevent systemically important institutions risk,
- Limit the systemic impact of false stimuli and reduce the risk of moral hazard.
In simple terms, the listed objectives cover different possible sources of risk. These risks can come from within the financial system or from outside it. Examples include credit, interest rate, liquidity, currency, operational, reputational, legal, asset price, contagion, economic, political, and emergency risks, etc.
To reach these intermediate objectives and mitigate possible risks, financial stability officials have a variety of tools. Check out the table below for the main macroprudential tools grouped by different objectives.
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Intermediate objectives
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Macroprudential Policy Tools
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Mitigate or prevent excessive credit growth and financial leverage risk
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- Capital buffers.
- Maximum credit limits for specific sectors.
- Maximum debt service-to-income ratio, debt-to-income ratio.
- Loan-to-value ratio, etc.
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Mitigate or prevent maturity mismatching, liquidity and market risks
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- Liquidity coverage ratio (LCR).
- Net Stable funding ratio (NSFR).
- Maximum limit for the tenor mismatch.
- Maximum limit for open positions in foreign currency as a percentage of capital base, etc.
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Mitigate or prevent concentration risk
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- Maximum limits assigned for concentration on client/sectoral level.
- Additional capital buffers to mitigate concentration on client/sectoral level, etc.
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Mitigate or prevent systemically important institutions risk / Limit the systemic impact of false stimuli and reduce the risk of moral hazard.
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- Additional capital buffer for domestic systemically important institutions (for example D-SIBs), etc.
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Broadly speaking, macroprudential instruments can be categorized according to their primary impact area: are they targeting the resilience of lenders (capital-based instruments) or the ability of the borrowers to repay the debt (borrower-based instruments). Third block of macroprudential instruments targets the systemic liquidity of the financial system.
An example of such a tool is a countercyclical capital buffer (CCyB)․ It is aimed at increasing resilience in anticipation of an economic downturn to lessen the reduction in the supply of credit once the downturn materializes.
Countercyclical capital buffer
As mentioned earlier, one of the key tools of macroprudential policy is the countercyclical capital buffer (CCyB). It's commonly used when there's too much borrowing and risk-taking— loans are growing faster than people's incomes. The goal of increasing the CCyB is to increase the resilience of the financial system and slow down the excessive borrowing risk accumulation.
If the economy is hit by adverse shocks, the people not being able to repay their debts, banks might face losses. To avoid a further economic mess, banks might stop extending loans, causing a potential disruption. This is what we mean by systemic risks becoming real. In such situations, we can reduce the countercyclical capital buffer. This helps banks absorb losses and still lend money during tough times. This move, guided by macroprudential policy, ensures a steady flow of credit, preventing even worse scenarios like a severe credit crunch.
The CCyB is just one example of capital-based tools influencing bank finances to reduce overall risks. There are also other tools in this group, like sectoral capital buffers, limits on leverage ratios, and rules on lending in specific areas.
Borrower-based instruments (LTV, DSTI)
Another set of tools focuses on borrowers, aiming to prevent people from borrowing too much and getting into financial trouble. These tools set stricter rules on how much people can borrow or the conditions for loans. For instance, if someone wants to buy a house, the bank might ask for a larger down payment. Tools in this category include requirements for loan-to-value (LTV), debt service-to-income (DSTI), debt-to-income(DTI) ratios, etc..
The LTV ratio limits how much someone can borrow compared to the property's value. For instance, with a 90% limit, the borrower must cover the remaining 10% as a down payment. This rule is meant to prevent people from taking out huge mortgages that could lead to more defaults during a housing market downturn.
On the other hand, the debt-service-to-income ratio (DSTI) checks if a borrower can handle their debts by comparing their payments to their income. If the limit is 30%, borrowers can't spend more than 30% of their income on repayments. This helps ensure responsible borrowing, reducing the risk of default and financial stress.
In a nutshell, these macroprudential tools keep the financial services flowing smoothly in the economy, aiming for stability and preventing problems before they become severe.