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Macroprudential policy--taxonomy and challenges.

There is increasing recognition that prior to the global financial crisis financial regulation had lacked a macroprudential perspective. There has since been a strong effort to make a new macroprudential orientation operational, including through the establishment of new macroprudential authorities or 'committees' in a number of jurisdictions. These developments raise--and this paper explores--the following three questions First. what distinguishes macroprudential policy from microprudential policy and what are its key tasks? Second. what powers should be given to macroprudential authorities and what should be their mandate? Third, how can governance arrangements ensure that macroprudential policies are pursued effectively? While arrangements for macroprudential policy will to some extent be country-specific, we identify three basic challenges in setting up an effective macroprudential policy framework and discuss options to address them.

Keywords: Macroprudential policy; systemic risk: governance

JEL Classifications: E58; GI8; G28

I. Introduction

There is increasing recognition that prior to the global financial crisis financial regulation and supervision had lacked a macroprudential perspective. The absence of a macroprudential orientation had allowed macrofinancial vulnerabilities to grow unchecked, until they unwound dramatically and at considerable cost to advanced economies from the summer of 2007. In response, advanced economies have more recently redoubled their efforts to make a new macroprudential orientation operational, including by establishing new macroprudential bodies, such as the European Systemic Risk Board (ESRB) in the European Union, the Financial Policy Committee (FPC) in the United Kingdom and the Financial Stability Oversight Council (FSOC) in the United States.

These developments raise a number of questions. First, what distinguishes macroprudential policy from microprudential policy and what are its key tasks? Second, what powers should be given to macroprudential authorities and what should be their mandate? Third, what governance arrangements are needed to ensure macroprudential policies are pursued effectively?

This paper offers a discussion of these issues from first principles. We start by exploring the boundaries of the terms 'macroprudential' and 'microprudential', propose three 'tasks' of macroprudential policies and delineate the regulatory perimeter associated with each. Against this background, we identify three basic challenges for the design of a macroprudential policy framework and explore how governance arrangements can address these challenges.

2. Prudential policies: objectives, tasks, perimeters

Micro- and macroprudential policies

A clear understanding of the distinction between microprudential and macroprudential policies can be gained by tying these concepts to the fundamental objectives of financial regulation. There are two: (i) the

protection of consumers (investors) and (ii) the mitigation of systemic risk. (1)

Tying microprudential policies to a consumer and investor protection objective makes more precise the commonly articulated notion that microprudential policies seek to ensure "the safety and soundness of individual institutions". Properly understood, the safety and soundness of individual institutions is not an end in itself, but a means to ensure the protection of those consumers and investors who have claims on financial institutions. The main examples of such claims are deposits issued by commercial banks and insurance and pension policies held by the public and issued by insurance companies and pension funds.

The need for protection of claimholders arises when there is asymmetric information between the issuers and buyers of such claims, and in particular when claims are issued to retail customers. (2) By contrast, supervision of investment banks and other institutions that are funded in wholesale financial markets cannot as easily be justified from the point of view of consumer protection, since holders of claims on these institutions are meant to be sophisticated investors. Here therefore, the principle of caveat emptor applies and microprudential intervention is reduced in intensity or even deliberately absent, in a manner that is meant to favour the 'market discipline' of such firms.

The crisis has provided abundant evidence that a prudential approach that is geared mainly towards the protection of consumers (depositors) is insufficient to ensure mitigation of systemic risk. (3) For instance, protection of depositors is insufficient to prevent a wholesale run on financial institutions, such as that on Bear Steams and Lehman, which in turn can have serious repercussions on the financial system and the wider economy.

Macroprudential policies--objective

Tying the concept of macroprudential policies closely to the objective of mitigation of systemic risk is fairly standard. (4) It is useful both to develop a well-focused macroprudential agenda and to clarify the boundary of the term 'macroprudential', which is often used rather loosely.

Systemic risk can be defined as the risk of disruption to the provision of financial services (such as credit, payment and insurance services) that arises through the impairment of all or parts of the financial system, and has the potential to create a material adverse effect on the real economy. (5) Macroprudential policies, therefore, are those that aim to reduce the likelihood of disruptions to the provision of key financial services to the real economy. A disruption to the provision of credit to companies and households--a credit crunch--is the prime example of a disruption that can have such serious adverse effects on the economy. (6)

Systemic risk has two dimensions: (i) disruptions to the provision of financial services that arise from the aggregate weakness of the financial sector and its effect on the real economy and (ii) disruptions that arise from the effect of the failure or weakness of an individual financial institution on other financial institutions, and through such impacts potentially on the flow of financial services to the economy at large. (7)

Disruption from aggregate weakness arises when a number of financial institutions are exposed to common or correlated risks, including correlated credit risk, common exposure to market risks--including to changes in real estate prices and exchange rates--as well as common exposure to the risk of a drying-up of funding markets. Since the exposure is common or correlated across institutions, crystallisation of these risks puts pressure on all providers of financial services to the economy--or a large subset of these institutions--in turn reducing the level of key services provided.

Disruption from individual failure arises typically when the failure of an individual institution causes widespread disruption within the financial system. Such a disruption can occur through one or more of four channels of contagion: (i) direct exposures and contagious losses at other financial institutions, (ii) reliance of other financial institutions on the continued provision of financial services--such as credit and payment services--by the stricken institution, (iii) fire-sales of assets by the stricken institution that cause mark-to-market losses at other institutions, and (iv) informational contagion that sets off a loss of confidence in other institutions.

The two dimensions of systemic risk--aggregate weakness and disruption from individual failure--tend to interact dynamically. First, the realisation of an aggregate shock increases the odds of an individual failure. At the same time, the potency of the channels of contagion is increased when other institutions are already weakened by the aggregate shock. (8) The failure of Lehman in September 2008 provides a vivid example of both legs of this dynamic interaction.

Both dimensions of systemic risk are associated with externalities, which in turn are exacerbated by expectations of public sector support. Aggregate weakness will lead to a curtailment of credit and suboptimal levels of investment, affecting the real economy in ways that are unlikely to be internalised by the individual firm. The exposure of the system to aggregate shocks is therefore likely to be excessive relative to the social optimum. In response to aggregate weakness, moreover, public sector support is likely to be forthcoming. An expectation of public support will further distort incentives and lead institutions to increase their exposure to the aggregate shock--'too many to fail'. (9)

Similarly, an individual institution is unlikely to internalise the damage its own failure inflicts on other institutions and hence, potentially, on the level of financial services provided to the economy at large, reducing incentives for private risk management relative to the social optimum. Moreover, where this damage is severe, the institution is likely to count on public sector support, further distorting private risk management incentives and reducing the force of market discipline-'too important to fail'. (10) In addition, financial sector exposures to institutions that are deemed 'too important to fail' are likely to grow excessively large as financial institutions are unconcerned about their exposure to an entity that is expected to be supported.

Systemic risk externalities and the associated expectations of public support therefore create a strong rationale for intervention that is clearly distinct from the objective to protect retail claimholders, such as depositors and holders of insurance and pension policies, from the failure of financial institutions. And while the objectives of consumer protection and mitigation of systemic risk are often well aligned, they can also conflict, requiring the policymaker to manage trade-offs between the two. They can be well-aligned when deposit insurance and robust microprudential supervision prevent depositor runs and thus the provision of credit and payment services by commercial banks to the real economy. They can also conflict when, in a situation where aggregate risks crystallise, depositor protection may call for an increase in capital requirements and a tightening of lending standards, while mitigation of systemic risk may call for their relaxation, to sustain the flow of credit to the real economy.

When macroprudential policies are defined as those that aim to prevent or mitigate systemic risk, this results in a definition that is broad but not all-encompassing. This helps clarify the need for other economic policies to complement macroprudential policies and avoids overburdening macroprudential policy with expectations and responsibilities that cannot be discharged effectively. Asset bubbles and capital inflows can provide useful examples that are worth considering in some detail, as follows.

When an asset bubble is fuelled by rapid extension of credit--as was the recent housing bubble in the United States and elsewhere--action by the macroprudential policymaker is called for, since the bursting of the bubble is likely to put stress on intermediary balance sheets. When, by contrast, an asset bubble is driven in the main by euphoric expectations and does not involve a rapid extension of credit--as was the earlier dot.com bubble in the United States--such a bubble will not naturally be a concern for the macroprudential policymaker. To the extent that the bubble leads to a misallocation of resources, such as overinvestment in a particular sector, this may call for action in other policy areas, potentially including monetary and fiscal policy. (11)

When strong capital inflows lead to an overvalued exchange rate, an overheating economy and the build-up of unsustainable levels of debt in the private or public sector, this is a concern for the macroprudential policymaker to the extent that the inflows are intermediated by the financial sector, or significant parts of the financial sector are otherwise exposed to a reversal of flows. And while well-targeted macroprudential measures can help protect financial system balance sheets against a reversal, they need to be complemented by other economic policies, such as appropriate fiscal, structural, exchange rate and monetary policies to address underlying macroeconomic imbalances. Moreover, while these other policies may often be desirable, they are usefully distinguished from macroprudential policies that specifically target systemic risks.

Macroprudential policies--tasks

The role of macroprudential policy is to identify risks to systemic stability and to develop and implement a policy agenda so as to mitigate these risks. And, while macroprudential policies are unlikely on their own to be fully effective in preventing financial crises, they can play a strong role, by complementing other economic and financial sector policies. In this context the following three tasks are at the core of macroprudential policy: (i) to reduce the expected cost to the economy of aggregate weakness, (ii) to reduce the impact of individual failure, and (iii) to reduce the likelihood of failure of individual systemic institutions.

The first task of macroprudential policies is to complement appropriate macroeconomic policy, by reducing the expected costs to the economy of aggregate weakness in the financial system. A number of tools are currently under discussion that may help achieve this, and that address a range of sources of aggregate risks. These include dynamic capital buffers that address correlated exposures to credit risks, (12) loan-to-value (margin) requirements in markets for collateralised credit that address correlated market risks, (13) and charges levied on vulnerable wholesale funding that address correlated funding liquidity risks. (14) While these three tools differ in the primary source of risk being targeted, each can be deployed both to reduce the probability, of an excessive build-up and to cushion the impact of a realisation of risks on the provision of credit to the economy. (15) Box 1 provides further discussion of these tools in the context of the management of capital inflows.

The second task of macroprudential policies is to reduce the impact of individual failure on other financial institutions through the four channels discussed above (direct exposures, reliance on continued services, fire sales, and informational contagion). An important task within this agenda is to introduce measures that discourage excessive direct exposures between financial institutions. By taking on this task macroprudential policies can come to complement appropriate design and oversight of payment, settlement and clearing arrangements, which has long played a role in containing the impact of failure of financial institutions.

Box 1. Managing risks from capital flows

Macroeconomic imbalances and systemic vulnerabilities stemming from
large capital inflows have long been of concern to policymakers.
The macroeconomic effects of large inflows include overheating of
the economy and appreciation of the currency, which can reduce
competitiveness.

From a macroprudential perspective, the relevant concern is the
contribution of capital inflows to the build-up of systemic
vulnerabilities--direct or indirect financial sector exposures to
unsustainable private or public debt levels, asset price booms and
overvalued exchange rates--and liquidity and solvency pressure on
the financial sector as flows stop or reverse direction. Recent
research confirms that capital flows have contributed to the
build-up of financial sector imbalances over the period 1999-2007
across the OECD (Merrouche and Nier, 2010).

A number of macroprudential tools can reduce potential systemic
risks associated with capital inflows without targeting inflows per
se or discriminating between residents and non-residents (as do
capital controls). One example is a countercyclical capital buffer
linked to the build-up of credit, especially when triggered by a
broad indicator of credit growth that captures both domestic and
foreign provision of loans. A second example is variable caps on
loan-to- value ratios and debt-to-income ratios, which would
discourage an erosion of lending standards that tends otherwise to
be associated with an abundance of inflows into the financial
sector. In addition, a levy or charges on short-term wholesale
funding could also potentially discourage overreliance on
vulnerable wholesale funding, irrespective of whether that funding
is sourced domestically or from abroad.

A range of prudential measures can specifically address the risk of
excessive foreign exchange (fx) mismatches in the household,
corporate and banking sector that tends to be associated with
capital inflows. In some countries, such as Poland, the authorities
have introduced tighter loan-to-value ratios on fx mortgages. In
other countries, the central bank has imposed reserve requirements
to discourage strong increases in fx funding. And Korea recently
announced a macroprudential levy on fx-denominated liabilities of
the banking sector. Country experience with the effectiveness of
some of these measures is discussed in some detail in IMF (2010b).

For example, recent initiatives to establish central counterparties (CCPs) for the majority of over-the-counter (OTC) derivatives need to be complemented by the establishment of regulatory incentives to use the new infrastructures, especially when their use is viewed as costly by market participants. In addition, there needs to be a broader effort to reduce exposures between institutions, since these can arise not only through the trading of derivatives contracts but equally in short-term and long-term funding markets. The tools that can be used here are limits on the size of exposures between institutions as well as increased risk weights on exposures to other financial intermediaries. (16)

The third task of macroprudential policies is to reduce the probability of individual failure by applying prudential requirements that are sensitive to the systemic risk posed by individual institutions. In principle, appropriate financial infrastructure and prudential measures (described just above), supported by effective resolution mechanisms, can help avoid the disruptive effects of individual failure, thus diminishing the need for further measures 'to control the likelihood of failure. (17) In practice, the resolution of large and complex institutions poses challenges that are difficult to overcome. One is that in a crisis situation the resolution authority may struggle to find private bidders in a full or partial sale of such an institution. Another is that it is difficult to let losses fall on creditors when claims are held by other financial institutions, creating contagious knock-on defaults. A third is that different national regimes will apply to entities that form a cross-border financial group.

Where resolution, infrastructure and prudential measures are less than fully effective in avoiding disruptive effects of failure, measures will need to be taken that reduce the probability of failure of those institutions that remain 'too important to fail'. These may take the form of capital surcharges, limits on permissible levels of leverage and tight liquidity requirements that are commensurate with the disruption caused by the individual institution in the event of failure. They may also include restrictions on the permissible activities of systemic institutions, ensuring that core functions provided by the systemic institution to other financial intermediaries are insulated from business risks that arise from unrelated activities. (18)

Macroprudential policies--perimeters

Discussion of the perimeters of macroprudential policies often starts from the assumption that there is only one such perimeter or 'boundary' of regulation, often referred to as 'all systemically important institutions'. Few existing studies recognise explicitly that, as we have argued, there are as many as three clearly distinguishable tasks of macroprudential policies.

Greater headway can be made by developing suitable mappings from tasks to sets of institutions that need to be within the scope of macroprudential policy. For this exercise it is useful to think of the universe of all financial services providers and to recognise that within this universe there are two potentially overlapping sets: the set of all collectively systemic institutions and the set of all individually systemic institutions.

[FIGURE 1 OMITTED]

The set of all collectively systemic institutions is relevant for a discussion of the perimeter of those measures that are directed at reducing the expected cost of aggregate weakness. This set of institutions can be described further by recognising that the main goal of these measures is to prevent a reduction in the provision of credit to the economy that results from balance sheet pressure on the providers of credit.

This suggests that all leveraged providers of credit to the economy ought to be considered within the scope of these measures (figure 1). Importantly, leveraged providers of credit should be within the scope of measures independent of their size, since it is their weakness collectively that poses systemic risk. In practice, all commercial banks are clearly within the set of collectively systemic institutions. But, in addition, depending on the jurisdiction there may be important classes of non-bank institutions that are collectively systemic. In the United States, for instance, money market mutual funds are important providers of credit to corporations. (19)

A second important set is that of all individually systemic institutions. What characterises these institutions is that their individual failure can cause disruption to the financial system and the economy at large, through the four channels of contagion discussed above. These institutions may or may not be leveraged providers of credit to the economy; They may instead provide credit, insurance, and critical payment, clearing and settlement services to other parts of the financial system. AIG is an example of a firm that provided insurance--through the provision of credit default protection on mortgage related securities--to other financial firms. Central counterparties (CCPs) are an example of firms that provide critical clearing services to the financial system. It is important that the probability of failure of these institutions is effectively controlled.

As noted, the two sets can overlap. Indeed where institutions are very large providers of credit to the economy, this alone can make them individually systemic, even if their failure has little impact on other parts of the financial system. The institution is then individually systemic because a large part of the economy relies on the continued provision of its credit services. The government sponsored entities (GSEs) in the United States provide a good example here. Smaller banks, on the other hand, are not typically individually systemic, unless weaknesses in the national resolution regime or the payment systems are such that even the failure of a small bank can cause significant disruption to other parts of the system. The failures of Northern Rock (2007) and Herstatt Bank (1973) provide examples.

The two sets of firms--collectively systemic and individually systemic--relate to the two dimensions of systemic risk. They also map to the three tasks of macroprudential policies in a straightforward way. (20) Importantly, while measures to reduce contagious linkages between institutions should certainly aim to reduce such linkages between individually systemic institutions, they need in addition to consider exposures from collectively systemic institutions to individually systemic institutions. A case in point is US money market funds, which came under extreme pressure as a result of direct exposures to Lehman. (21)

3. Governance of macroprudential policies

First basic challenge--dynamic system requires powers

A basic challenge for the design of a macroprudential policy framework lies in the dynamic nature of the financial system. The financial sector evolves--continuously, and sometimes fast--to exploit profitable opportunities. Such profitable opportunities can flow from changes in technology--product innovations and innovations in the ways that basic services and products are bundled or unbundled to create new business models. More often than not, profitable opportunities flow from the macroeconomic and broader policy environment, such as changes in barriers to cross-border flows, changes its the tax environment and importantly, changes in financial regulations themselves.

This dynamic evolution of the financial sector has important implications for a macroprudential policymaker. First, the set of collectively important institutions can change, such as when credit is provided increasingly by non-bank institutions. Second, the set of individually systemic institutions can change, for example, when new and sizeable exposures emerge between institutions. Third, the level of systemic risk can change, it can change at the aggregate and sectoral levels, when asset prices are fed by an extension of credit to a particular sector, such as residential real estate. Systemic risk can also change at the level of individual institutions, when firms grow or shrink in size or change in their importance to the financial sector at large.

A static set of rules and regulations risks being outpaced and eventually overwhelmed by a dynamically evolving financial sector. "The macroprudential policy framework must instead enable a flexible response. At a basic level, this requires the devolution of substantial powers to a macroprudential authority. Three types of powers are needed: (i) information collection powers, (ii) designation powers, and (iii) rulemaking and calibration powers. As discussed further below, the need for powers on the part of the macroprudential policymaker can translate into the need for powers to direct the actions of other policymakers.

(i) Information collection powers

Macroprudential policy must start from an assessment of systemic risks for the financial sector as a whole. To enable such an assessment the policymaker needs to have the power to collect information from all financial services providers, importantly including those that may not otherwise be subject to supervision and regulation. This is because information is needed to determine the appropriate perimeters of macro-prudential intervention, as well as to assess the level and distribution of any systemic risks within the financial sector as a whole. To enable these assessments the macroprudential authority may want to collect information ors exposures, business models and levels of leverage of individual firms. Preferably, it should have the power to request such information directly from firms, as has recently been provided under the US Dodd-Frank Act to the Office of Financial Research (OFR). To reduce the burden of reporting on individual firms, and to collect more high frequency data, the authority may in addition require access to regular supervisory data and data that are collected by commercial data warehouses.

(ii) Designation powers

The macroprudential authority needs to have the power to bring within scope of its policies all individually systemic institutions. Since there is no clear mapping from legal form (type of licence) to the degree of systemic importance, the authority needs to have the power to designate institutions as individually systemic, based on its analysis of the systemic risk posed by the institution. (22)

Equally, the macroprudential authority should have the power to bring within scope of its policies all collectively systemic institutions. This is so that these institutions can be included where necessary in the application of policies that reduce the cost of aggregate weakness and to manage interlinkages between this set of firms and those that are individually systemic. Again, these powers need to apply irrespective of the legal form to include important classes of non-bank financial intermediaries. (23)

(iii) Rulemaking and calibration powers

Finally, the macroprudential policymaker requires rulemaking and calibration powers. To be fully effective the stringency of macroprudential requirements needs to be a function both of the level of systemic risk--that can vary across individual firms and across time and sectors--and the costs that regulatory requirements impose on financial services providers and hence the level of financial services provided to the economy. When requirements are calibrated to the average level through time and across sectors of systemic risk they will be overly burdensome some of the time and insufficiently tight at other times. Likewise when requirements are calibrated to achieve internalisation of the level of systemic risk posed by the average firm, they will be overly burdensome for some firms and insufficiently tight for others.

A framework that enables the calibration of requirements to condition on the level of systemic risk both in the cross-section and through time is likely to be more efficient. Such conditioning can be achieved by establishing appropriate macroprudential policy rules. However, to be fully efficient and to effectively constrain a dynamically evolving financial sector, rules need to be complemented by judgement, taking in all available information.

(iv) Need for a strong mandate

The use of powers vested in the authority needs to be guided by a strong mandate that opens up and at the same time constrains the discretionary use of powers. This can be achieved by setting out in law the primary objective of the macroprudential authority, as well as its secondary objectives. Clearly, the primary objective needs to be safeguarding systemic stability--so as to reduce the probability and severity of financial crises.

Secondary objectives can be added to ensure the policymaker analyses and fully considers trade-offs when macroprudential action has costs as well as benefits. (24) For example, a secondary objective for the policymaker could be to have 'regard to the need to maintain a level of financial services conducive to the balanced growth of the economy'. In addition the policymaker can be given a secondary objective to have 'regard to interests of stakeholders, such as depositors', in case systemic risk mitigation conflicts with their interests. However, it is important that the law clearly subordinates these secondary objectives and requires that the primary objective of the macroprudential policymaker is mitigation of systemic risk.

Second basic challenge--biases towards inaction

A second basic challenge for the design of an effective macroprudential framework is that the benefits of specific macroprudential policies--reduction in the probability and severity of financial crises--are long-term and not easily measured. At the same time, macroprudential policies will almost always have an immediate and highly visible adverse effect on the profitability of financial intermediaries and may also sometimes have an effect on the availability and price of financial services to households and firms.

This can cause a bias towards insufficiently strong action for three related reasons. The first is the basic asymmetry of the policy problem faced by the macroprudential authority. When the costs of macroprudential policies are more certain and visible than the benefits, this makes it hard for the policymaker to develop the resolve to take actions. The second is that macroprudential policies are conducted under intense lobbying pressure on the part of the financial industry since macroprudential policies will inevitably hurt industry profits. The third is that macroprudential policies are exposed to strong political economy challenges. When electoral cycles cause short-term horizons on the part of elected politicians, the macroprudential policymaker may face political interference when its policies cause a reduction in the availability and an increase in the price of financial services to parts of the electorate.

Taken together these problems create strong biases in favour of inaction or insufficiently forceful intervention. These biases in turn put a premium on governance arrangements that increase the ability and the will to act on the part of the macroprudential policymaker, as discussed in some detail further below. (25)

Third basic challenge--the need for coordination

A third challenge is the need for coordination across regulatory agencies and policy areas. This arises when formal control over policies affecting systemic risk rests with authorities other than the macroprudential policymaker. The need for coordination is then likely to strengthen further the bias towards inaction, by reducing the ability to act on the part of the macroprudential policymaker. What is more, when cooperation fails and systemic risk remains unaddressed, no authority is fully responsible for the (crisis) outcome. The resulting lack of accountability can reduce incentives on the part of all agencies to invest in the development of appropriate policies to mitigate the build-up of systemic risk. (26) Systemic risk mitigation then 'falls through the stools'.

Cooperation between the macroprudential authority and prudential agencies is most important, since what matters for the efficiency of macroprudential policy is the final impact of all prudential policies. To facilitate coordination between the macroprudential policymaker and a separate prudential agency, a first useful step is a closer alignment of statutory objectives. This could be done by creating a hierarchy of policy objectives on the part of the prudential agency that mirrors that of the macroprudential policymaker, with mitigation of systemic risk becoming the primary objective of prudential agencies.

While likely to be helpful, an alignment of statutory objectives for the main prudential agency is not likely to be fully sufficient to ensure effective coordination. The need for coordination is, in any case, not limited to prudential regulation and supervision, but likely to extend also to securities regulation, as well as competition and fiscal policy. This is because actions in each of these domains can likewise have a bearing on systemic risk.

There are two basic mechanisms to ensure that macroprudential policy gains traction across all of these policy fields. The macroprudential policymaker can (i) be given the power to direct the actions of other policymakers or (ii) be assigned direct powers over specific policy tools.

Coordination: direct powers or powers to direct

An increasing degree of influence over the actions of other authorities (power to direct) may range from an informal exchange of views in the context of a purely consensual approach, that can be enhanced by the requirement for formal consultations and the ability of the macroprudential policymaker to issue formal recommendations, to a set-up where some prudential agencies are made fully accountable to the macroprudential policymaker.

A purely consensual approach can be formalised by the establishment of a council that acts as a forum for discussion of macroprudential policy action. A greater measure of control can be achieved by empowering the macroprudential council to make recommendations to separate sectoral regulators and authorities. The force of such recommendations call be strengthened by formal mechanisms to ensure follow-up, such as 'comply or explain'. (27) Alternatively, or in addition, the law can require that separate regulators 'have regard' to recommendations issued by the macroprudential authority and consult the macroprudential policymaker when new rules and regulations are issued that may have a bearing on financial stability.

A strong power to direct can be established through close institutional integration between the macroprudential policymaker and the main prudential agency. The macroprudential authority then comes to function as the governance body for all prudential action, ensuring that prudential policies serve the overarching objective of mitigating systemic risk. Examples are the new structures in the United Kingdom and Malaysia (Box 2).

Some of these mechanisms can extend beyond prudential regulation. For example, for specific fiscal instruments, such as taxes and subsidies that affect incentives to take on leverage, the macroprudential authority could issue advice or formal recommendations. Similarly, for regulations and decisions issued by securities regulators and competition authorities that affect the structure of the financial industry; it is important for the macroprudential policymaker to be formally consulted, to ensure due account is taken of financial stability implications.

Box 2. The institutional set-up across countries--some recent
examples

European Union: The European Systemic Risk Board (ESRB) was
established in January 2011. It comprises the ECB, the national
central banks of the EU, the three new European authorities on
banking, insurance and securities, the European Commission, and the
Economic and Financial Committee (representing national
treasuries). Its role will be to conduct macroprudential
surveillance across the EU and to issue risk warnings and
recommendations, so as to contribute to the prevention and
mitigation of systemic risks. Recommendations can be issued to any
national or supranational authority. Monitoring of follow-up is
envisaged through an 'act or explain' mechanism and an option on
the part of the ESRB to publish its recommendations.

Malaysia: Under the 2009 Central Bank of Malaysia Act, the bank has
been given a financial stability mandate and broad powers to ensure
financial stability. In addition to powers to regulate and
supervise financial institutions and specific markets under its
purview, the bank can invoke powers on financial institutions
beyond its regulatory reach and make recommendations to any other
supervisory authority. Governance for these latter powers is
provided by a Financial Stability Executive Committee, chaired by
the governor and comprising one deputy governor, and three to five
other members appointed by the Treasury--which includes a treasury
representative in practice.

Mexico: In July 2010, a Presidential decree led to the creation of
the Financial Stability Council, with the aim of creating a formal
avenue to boost coordination and information exchange between the
country's financial authorities and to enable quick and accurate
identification of risks to the financial system. The council is
chaired by the Minister of Finance, and comprises the Bank of
Mexico, the Secretary of Finance and Public Credit. the National
Banking and Shares Commission, the National Commission of Insurance
and Finance, the National Commission for the Retirement Savings
System, and the Institute for the Protection of Bank Savings. While
decisions are expected to be taken by consensus, in the event of
policy disagreements within the council, a majority vote would
resolve the controversies. However, while each financial authority
is responsible for the implementation of the policies comprised
within the scope of its legal mandate, in case of disagreement with
the council, it cannot be forced into action if that would conflict
with its mandate. As part of its communication strategy, the
council will issue an annual report about its activities and the
state of the financial system.

United Kingdom: The UK government issued a Consultation Paper in
July 2010 with a view to establish a new Financial Policy Committee
(FPC) within the Bank of England, chaired by the governor, with
responsibility for macroprudential policy. A substantial degree of
cross-membership is envisaged with the existing Monetary Policy
Committee (MPC). A new Prudential Regulatory Agency (PRA) will be
established as a subsidiary of the Bank of England, with its chief
executive officer a deputy governor of the bank and member of the
FPC. The FPC will also include the head of the new consumer
protection and markets authority (CPMA) as well as the Treasury,
the latter as a non-voting member. Both the PRA and the CPMA will
be under a statutory obligation to consult the FPC on any rules
that would have material implications for financial stability. The
FPC will also be given a set of macroprudential instruments, yet to
be determined, and can make recommendations on the regulatory
perimeter.

United States: The 2010 Dodd-Frank Act establishes a new Financial
Stability Oversight Council chaired by the Treasury and assembling
the federal supervisory agencies and securities regulators,
including also the Federal Deposit Insurance Corporation (FDIC) and
the new Bureau of Consumer Financial Protection. The FSOC can issue
recommendations to constituent agencies, and plays a coordinating
role, while direct regulatory and supervisory authority lies with
constituent agencies. The act empowers FSOC to designate non-bank
financial companies as systemically important, subjecting such
companies to supervision and regulation by the Federal Reserve. It
also requires the Federal Reserve to establish enhanced prudential
standards for such institutions and establishes mechanisms to
resolve these institutions. A new Office for Financial Research
(OFR) is established within the Treasury, which is empowered to
collect information and whose role is to conduct analysis and
research for FSOC.

As an alternative to a power to direct, the macroprudential authority can be vested direct and binding powers in the calibration of specific regulatory tools that are assigned to the authority. When such tools are introduced through primary legislation, the law can task the macroprudential authority with their (dynamic) calibration, mandating that they be geared to reducing the level of systemic risk.

An example of direct power drawn from the fiscal sphere is the calibration of a levy on banks' non-deposit funding. (28) An example related to competition policy is the creation of powers to force the divestment of business lines on the part of systemically important institutions, so as to avert threats to financial stability, as established under the Dodd-Frank Act for the Federal Reserve. In securities market regulation direct powers can be established over margin requirements, whose dynamic calibration could be vested in the macroprudential authority. Likewise, direct powers can be established over the calibration of specific prudential tools. Examples here are the calibration of dynamic capital buffers as well as capital and liquidity surcharges for individually systemic financial institutions.

Representation of agencies on a macroprudential authority

In the overwhelming majority of countries multiple agencies, including the central bank and sometimes a multitude of others, are responsible for financial regulation and supervision of different parts of the financial sector. This begs the question which of these agencies should be represented on a macro-prudential authority or 'committee'.

There is by now almost universal consensus that central banks should play a strong role in macroprudential policy. Due to their existing roles in monetary policy, payment systems and as lender of last resort, central banks can bring expertise in the analysis of systemic risks that can inform the design of macroprudential policies. Central banks can bring expertise in the analysis of aggregate and sectoral developments to bear in the design of policies designed to reduce risks from aggregate weakness. Their roles in the oversight of payment systems, and as lender of last resort, generate additional insight regarding the design of macroprudential measures that reduce probability and impact of individual failure. Central banks' analytical expertise can thus help achieve greater clarity of benefits and costs of macroprudential policies.

Central banks also have strong institutional incentives to ensure the effectiveness of macroprudential policies, for two reasons. First, if macroprudential policies are ineffective, central banks may need to do more 'leaning', that is, to make more active use of monetary policy to control the build-up of risks. However, use of monetary policy in pursuit of financial stability may produce considerable collateral damage for the stability of aggregate demand and inflation, making such use costly for central banks. Second, if macroprudential policies are ineffective, this increases the frequency and severity of crisis, so that central banks will need to do more 'cleaning', again involving considerable costs to the monetary authority. (29)

Harnessing the institutional expertise and incentives of central banks can counteract the biases for inaction inherent in macroprudential policy, achieving a greater ability and willingness to act in the face of asymmetric uncertainty and industry pressure. A strong role of the central bank will at the same time reduce the influence of the treasury on prudential policies, creating greater de facto independence of prudential policies from the political process.

The macroprudential authority needs also to include the main prudential agency, whether or not it is otherwise organisationally linked with the central bank. This allows an integrated approach to prudential policy, where policy trade-offs can be discussed and internalised. It can create ownership of any policy action taken by the macroprudential authority when this needs to be implemented by the prudential agency. Finally, inclusion of the prudential authority is important to make full use of all available information, e.g. as regards systemically important institutions.

Whether a macroprudential authority should include additional regulators is a more open question. For example, including the securities market regulator may be useful where securities markets play a major role in providing financial services to the economy. It may be less critical in those emerging markets where the financial system remains essentially bank-based. A potential downside of including too many agencies is that tiffs can slow decision-making on the part of the authority. It may also dilute accountability and particular attention would need to be paid to mechanisms that can increase accountability, as further discussed below.

Separate governance for monetary and macroprudential policy functions

Strong involvement of central banks in macroprudential policy begs the question how this relates to the role of central banks in monetary policy. An important principle is that when different policy functions have different objectives, separate governance arrangements may be called for.

The primary, objective of monetary policy needs to remain the maintenance of price stability, with financial stability at most a secondary objective. While monetary policy can contribute to financial stability, monetary policy is a blunt tool that cannot be specifically targeted at reducing systemic risk. (30) Its use in pursuit of financial stability will also often conflict with the primary price stability objective. Visibly different governance arrangements for monetary and macroprudential policies are useful, finally, to protect the integrity of existing governance arrangements for monetary policy and, in particular; to preserve operational independence of the latter. Indeed, the success of central banks in anchoring inflation expectations over the past two decades or so is arguably owed in no small part to strong and independent governance arrangements. (31)

However, macroprudential policymakers may want to take account of financial stability risks that flow from the monetary policy stance, while monetary policymakers, in turn, may want to take account of policies on the part of the macroprudential authority when deciding on monetary policy. Mutual internalisation of policy action that is conducive to an optimal policy mix can be more readily achieved when the central bank plays a strong role on both the rate setting committee as well as on the macroprudential authority. (32) The new institutional framework in the United Kingdom provides an example of such arrangements, with a Financial Policy Committee established alongside the existing Monetary Policy Committee (MPC). See also Box 2. (33)

Crisis management and the role of the treasury

One can argue that treasury departments have an important stake in financial regulation that flows from their role to provide fiscal back-up in a crisis situation. Treasury departments have also played a strong part in driving the regulatory reform agenda since the crisis broke. This begs the question how strong a role the treasury should play in the development of macroprudential policies and what place they should assume on a macroprudential policy 'committee' or 'council'.

Benefits from their involvement on a macroprudential committee include the ease of discussion of any legislative changes that may be required to mitigate systemic risks. Treasuries can also play a mediating role when there are differences between other agencies represented on a macroprudential council. The main cost of involving the treasury is a reduced degree of independence from the political process. The nature of macroprudential policies is to take the 'punch bowl' away in good times. Treasuries may be reluctant to do so when this reduces tax revenues or the availability of credit to constituencies. One way to resolve this trade-off is to have treasuries participate, while ensuring they do not dominate decision-making on the committee.

On the other hand, as the guardian of taxpayers' money, treasury departments will naturally have a strong interest in ensuring that crisis management and resolution of individual firms minimises losses for taxpayers. Indeed, a leading role of the treasury in this policy area is probably unavoidable, even when it is usefully balanced by a role of independent agencies, such as the central bank or a separate resolution agency, in a manner that avoids decisions becoming unduly politicised.

Overall, the costs and benefits of involvement of the treasury may vary across policy functions, with the benefits strongest for crisis management and resolution and weakest for monetary policy. It may therefore be useful in many cases to create as many as three separate committees to govern different policy functions:

* a monetary policy committee, involving in the main the central bank, potentially complemented by independent members, but excluding the treasury;

* a macroprudential policy committee, chaired by the governor of the central bank, but also involving the heads of separate supervisory agencies, with the treasury having limited voice or an observer status only; (34) and

* a crisis management committee, chaired by the treasury and involving the central bank as well as other agencies that have a role in the resolution of individual firms, such as a deposit insurance .fund.

Accountability and communication

For both monetary and macroprudential policies, political economy considerations favour a strong operational independence from the political process. However, the macroprudential policymaker manages a tail risk rather than a continuous outcome, and the benefit of macroprudential policies--reduction of the probability and severity of a future crisis--cannot be measured with precision. This means that accountability mechanisms for macroprudential policy cannot fully mimic those developed for monetary policy, where an inflation target serves as a quantifiable and symmetric yardstick for judging the performance of the policymaker.

A useful element that can be 'borrowed' from monetary policy frameworks is a clear communication of policy decisions to the public. Such communication can set out in detail the reasons for taking a particular course of action and give a detailed account of the analysis and deliberations undertaken by the authority, including an assessment of benefits and costs. Communication of particular decisions may be complemented by a periodic report to parliament, perhaps in the form of an annual or biannual report, or a financial stability report issued to the public. (35)

Communication of risk warnings and assessments can increase both effectiveness and accountability, it can increase policy effectiveness when warnings are backed up by a credible threat on the part of the authority to take macroprudential action. In this case, the publication of risk warnings can in and of itself lead to changes in behaviour of markets and institutions, potentially reducing the need for more intrusive intervention. Communication of risk warnings can also increase accountability, since they serve to create commitment on the part of the macroprudential authority or its constituent agencies to take follow-up action.

Such risk warnings should, however, aim to avoid the impression that the authority was attempting to predict crises. First, when assessed imperfectly, communication of the overall level of systemic risk can lead to counterproductive market responses that amplify prediction errors. (36) Second, general risk assessments are of limited use in formulating a policy strategy. Risk warnings may need instead to point to specific risks and vulnerabilities, in this way aiding the formulation of policy priorities.

Public accountability can be further increased by creating transparency of internal decision-making processes in two main ways, again drawing on the example of monetary policy. (37)

First, where formal advisory bodies are set up it can be useful to ensure transparent communication of their analysis and recommendations to the main macroprudential authority. This ensures the main policy committee needs to explain its subsequent action or inaction carefully in light of the advice provided.

Second, there may be a benefit in creating transparency on positions taken (votes cast) on major policy decisions within a macroprudential committee, ensuring clarity over the positions of constituent agencies. Nonetheless, in the absence of an easily quantifiable measure by which to judge the performance of, the macroprudential authority, the devolution of substantial powers and establishment of a high degree of independence require a strong political consensus and a high degree of trust in the ability and integrity of the macroprudential policymaker.

International cooperation

International and regional cooperation can increase the effectiveness of policies taken at the national level. Cooperation in macroprudential policies can reduce the scope for international arbitrage that may otherwise undermine the effectiveness of national policies. A key example is the principle of reciprocity embedded in the new countercyclical buffers agreed by central banks and supervisory authorities under Basel III. (38) International cooperation is needed also to contain the risks posed by systemically important institutions that operate across borders, including through the new supervisory and resolution colleges for cross-border firms.

International and regional cooperation can also buttress the governance of national macroprudential policies by increasing the 'willingness to act' on the part of the national macroprudential authority, through minimum standards and guidance, as well as surveillance of national action.

First, internationally agreed minimum standards and guidance developed under the auspices of the Financial Stability Board (FSB) can strengthen the hand of national macroprudential authorities and bolster their resolve to take action. Since minimum standards cannot be fully tailored to the specific circumstances of individual countries, they are usefully complemented by comprehensive guidance on additional factors that should be considered by national authorities and that are not captured by the standard itself. A good example here is the Basel III framework for an increase in dynamic capital buffers when credit growth is strong relative to its trend, where a minimum standard is complemented by comprehensive guidance. (39)

Second, minimum standards and guidance issued by international standard setters can be complemented by international surveillance of macroprudential policy. Such surveillance can ensure that national

macroprudential policies 'add up' to produce greater global financial stability. But international surveillance can also strengthen the resolve of a national macroprudential authority to take action, complementing the governance of national policy frameworks. It can ensure proper implementation of international minimum standards and complement general guidance by specific advice on policy options that takes full account of country-specific circumstances. The IMF is well-placed to take a leading role in both regards, through its Article IV surveillance and Financial Sector Assessment (FSAP) work.

4. Conclusions

The crisis has shown that prudential policies that are focused in the main on the protection of consumers (depositors) are not sufficient to mitigate systemic risks. This requires a reorientation towards policies that explicitly aim to mitigate these risks.

Establishing a fully effective macroprudential policy framework faces a number of challenges. The first is that the financial system is constantly in flux, as profitable opportunities are exploited that arise not least from the regulatory environment itself. The macroprudential policy framework needs to counter this challenge by assigning strong powers and unambiguous mandates to the macroprudential authority, clarifying the primacy of the mitigation of systemic risk, while ensuring that the policymaker takes adequate account of the costs of action taken.

Moreover, the benefit of macroprudential policy is uncertain and realised only over the long term, while the costs of action are more visible and felt immediately. This asymmetric structure of the macroprudential policy problem can cause a strong bias towards inaction or insufficiently forceful action that is further exacerbated by short-term political considerations and forceful lobbying on the part of the financial industry, as well as the need for policy coordination, including but not confined to prudential regulation.

Governance arrangements are needed that are conducive to increasing the ability and willingness to act on the part of the macroprudential policymaker while ensuring that macroprudential policy gains traction across policy fields that have a bearing on systemic risk.

DOI: 10.1177/0027950111411375

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NOTES

(1) See Borio (2003) and Nier (2009). Goodhart (2008) points out that a third objective of regulation, to constrain the use of monopoly power and the prevention of distortions to competition, is rarely relevant in the regulation of the financial sector.

(2) Dewatripont and Tirole (1994). Where safety nets are established to protect retail claimholders (such as depositors), the objective of microprudential policy can extend to the protection of the insurance fund from the need to make payouts to retail investors as the result of the failure of individual institutions.

(3) This is not to say that before the crisis systemic risk has not been a concern for prudential agencies. Prudential regulators often have multiple objectives, typically including consumer (investor) protection and, in some cases, financial stability. However, financial stability has not often been given primacy over other objectives of prudential agencies, and is sometimes viewed instead as the domain of central banks (IMF, 2011a).

(4) Crockett (2000), Borio (2003), CGFS (2010), IMF (2010a, 2011a).

(5) IMF, FSB, BIS (2009).

(6) Nier and Zicchino (2008) provide an overview of the literature and evidence on the interplay between losses and initial capital buffers in driving reductions in the provision of credit. Manning, Nier and Schanz (2009) discuss the effect of a disruption of payment services on the real economy. Evidence on the effect on the real economy of a disruption of insurance services to households or firms is scarce.

(7) The Bank for International Settlements (BIS) has referred similarly to the 'time dimension', also known as the 'procyclicality' dimension, and the 'cross-sectional' dimensions of systemic risk (Caruana, 2010). Nier (2009) uses the term 'macro-systemic' to refer to disruptions from aggregate weakness and the term micro-systemic to refer to disruptions from individual failure.

(8) Nier et al. (2007).

(9) Acharya and Yorulmazer (2007).

(10) Nier and Baumann (2006) provide evidence that expectations of public support reduce incentives for banks to hold capital buffers.

(11) Whadwani (2008) discusses the case for monetary policy to take account of asset bubbles. When bubbles are encouraged in part by tax incentives, this may call for a fiscal response so as to correct these incentives. IMF (2011b) provides evidence that housing booms and busts are driven in part by tax distortions.

(12) BCBS (2010a).

(13) Geanakoplos (2010), Kashyap, Berner and Goodhart (2011).

(14) Perotti and Suraez (2010), Shin (2010).

(15) A whole range of other tools has historically been employed in this domain, primarily by central banks in emerging markets, including reserves requirements, caps on loan growth and increases in risk weights on particular portfolios. The experience in Croatia as well as a number of other countries is reviewed in IMF (2010b). Borio and Shim (2007) and CGFS (2010) also provide useful overviews of these tools. Saurina (2009) and Wezel (2010) provide discussion of the experience with dynamic provisions in Spain and Latin America, respectively.

(16) While discussion in the main text focuses on reducing direct exposures, a broader effort is needed that reduces the force of other channels of contagion, complementing the central bank's lender-of-last-resort tool in dealing with fire-sale externalities and informational contagion ex post. Tools to achieve this may lie in the areas of liquidity regulation, e.g., forcing institutions to hold a sizeable pot of assets that are liquid in (almost) all states of the world, as envisaged by Basel III, and increases in transparency and disclosure of portfolios held by institutions.

(17) Resolution and restructuring of financial institutions is crisis management, rather than crisis prevention, and hence outside the scope of the macroprudential policymaker. Where there are deficiencies in the resolution regime that render financial institutions too important to fail, the macroprudential policymaker may still want to recommend legislative change to address these deficiencies.

(18) Manning, Nier and Schanz (2009) provide a discussion of the management of business risk for important providers of settlement and clearing services.

(19) Because money market mutual funds promise a fixed claim. they can also be viewed as leveraged institutions (President's Working Group. 2010).

(20) As noted, policies to reduce aggregate weakness need to be directed at all firms that are collectively systemic, while policies to reduce probability of failure need to be directed at firms that are individually systemic.

(21) It is worth noting that appropriate resolution procedures, including special resolution frameworks and access to a lender-of-last-resort facility, need to be considered for both collectively important and individually important financial institutions.

(22) In the United States, the FSOC is empowered to designate non-bank financial companies as systemically important, subjecting such companies to supervision and regulation by the Federal Reserve.

(23) In the United Kingdom, the FPC will be empowered to make recommendations to the treasury on any changes the FPC believes necessary to the regulatory perimeter (HM Treasury 2010).

(24) A sizeable literature analyses the benefits and costs of raising capital and liquidity standards, eg Barrell et al. (2009) and Macroeconomic Assessment Group (2010).

(25) Similar considerations apply for the supervision of individual firms (Vitals et al., 2010).

(26) Nier (2009).

(27) Recommendations and 'comply or explain' are key features of the coordination mechanisms established for the European Systemic Risk Board (ESRB). The ESRB is special in that it is a supranational body, with no legal personality, complicating the establishment of stronger coordination mechanisms under the EU Treaty.

(28) As suggested by Goodhart (2010). This may not be desirable when the impact of changes in tax rates on the overall fiscal budget is substantial and may not be feasible when the constitution reserves for Parliament the ability to raise taxes. On the other hand, in many countries, a deposit insurance agency is provided with similar powers to charge and vary a levy on insured deposits, which typically flows into a dedicated fund, rather than the general revenues.

(29) In line with these arguments, Merrouche and Nier (2010) provide evidence that the build-up of financial imbalances ahead of the crisis was less pronounced where the central bank was fully in charge of regulation and supervision. See also Nier (2009) for further discussion.

(30) See IMF (2010a). Recent research also suggests that the impact of policy rates on the build-up of imbalances within the financial system is weak, e.g., Merrouche and Nier (2010). This calls for the use of macroprudential tools that specifically target systemic risks.

(31) IMF (2010a).

(32) A number of central banks, especially in emerging markets, have been making active use of variation in reserve requirements, Gray (2011). While active use of reserve requirements has sometimes had monetary policy objectives, e.g., to mop up excess reserves created through central bank balance sheet expansion, use of reserves requirement has also often been explicitly linked to financial stability objectives, e.g., to control the growth of domestic credit. It is then an open question whether variation in reserves requirements should be controlled by the macroprudential or the monetary committee. This becomes a real issue only when the central bank is unable to veto the use of reserve requirements for macroprudential purposes.

(33) HM Treasury (2010).

(34) The macroprudential policy committee may double up to provide governance for the central bank's policies in the oversight of payment systems. This is useful since these policies are closely linked to the second task of macroprudential policies, the reduction in the force of contagious linkages between firms.

(35) Regular reports to the public and parliament are a feature of the accountability mechanisms in the EU, the United Kingdom, and the United States.

(36) When risk is erroneously assessed as low, communication can lull market participants and stimulate a further build-up of risks. When risk is erroneously assessed as high, communication can provoke market responses that precipitate a crisis.

(37) In the context of monetary policy, central banks issue inflation reports and voting patterns on rate setting committees are also often made public.

(38) BCBS (2010b).

(39) BCBS (2010b).

Erlend W. Nier, International Monetary Fund, e-mail: ENier@imf.org. This article is a revised version of a paper given at the IMF/Federal Reserve Bank of Chicago conference on 'Macroprudential Regulatory Policies: The New Road to Financial Stability' in September 2010. I would like to thank the editor, Ray Barrell, for his comments, and Karl Habermeier, Luis Jacome and Jacek Osinski for stimulating discussion. The views contained in this paper are those of the author and do not necessarily represent those of the IMF, its management or executive board.

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