Aurora Borealis
1 November 2013 CFA Institute Journal Review

Macro-Prudential Policies to Mitigate Financial System Vulnerabilities (Digest Summary)

  1. Priyank Singhvi, CFA

Individual bank–level data for a large sample of emerging and advanced countries indicate that macroprudential policies are effective in reducing bank risks during upswings, in terms of the buildup of leverage, assets, and noncore liabilities. These policies are ex ante in nature and are not as effective in downswings. They also need to be selected and calibrated to the characteristics of a country.

What’s Inside?

The authors review the principles of the macroprudential policy toolkit, illustrate the use of these policies, and discuss the effectiveness of various policies based on a survey of existing literature. They then offer descriptions of the data, regression model, regressions performed, and results. They find that macroprudential policies are effective in dealing with the buildup of vulnerabilities in up cycles but not in down cycles. The authors also recommend which policies are best suited for a country given the country’s specific conditions and conclude with suggestions for future research.

How Is This Research Useful to Practitioners?

Macroprudential policies complement microprudential regulations and traditional macroeconomic tools of monetary and fiscal policies. Emerging market countries have more experience with these tools because of the higher volatility in their economies. Both advanced and emerging market countries have a lot to learn from the experience of countries that have used these policies.

Most of the previous studies on this topic have looked at an aggregate or a subsector level. The authors extend the research by examining the impact of macroprudential policies at the level of individual banks. They consider a large sample of banks across economies that differ in development, relative openness, and stage of economic cycles.

They find that, in general, macroprudential policies are quite effective in reducing banking system vulnerabilities during boom times. Specifically, a number of policies, such as caps on debt-to-income and loan-to-value ratios, limits on foreign currency lending, dynamic provisioning, and restrictions on profit redistribution, are quite effective in containing the buildup of leverage. Other than limits on credit growth and restrictions on profit redistribution, all policies help contain asset growth during boom times. Policies that place limits on foreign currency lending or require dynamic provisioning are effective in limiting the growth of noncore to core liabilities. The demand-oriented measures aimed at the real estate markets are also effective. In addition, the effectiveness of many macroprudential policies increases when financial vulnerabilities increase. But few macroprudential policies help stop the speed of decline in bank variables during downturns. These policies are best used as ex ante tools.

Macroprudential policies have some inherent costs, including a possible limiting effect on financial sector development. They need to be properly calibrated for the characteristics of a country, its financial system, and its current economic cycle to prevent distortions and even a perverse effect.

How Did the Authors Conduct This Research?

The authors evaluate the effectiveness of macroprudential policies in mitigating vulnerability in the banking system by studying the effect of these policies on the panel data of balance sheets of banks in 48 countries. They ascertain the impact of nine macroprudential policies on three bank variables using generalized method of moments panel regressions.

The three bank variables are leverage, assets, and noncore to core liabilities in US dollar terms and are adjusted for accounting policy differences. The data are from Bankscope and include the top 100 banks during 2000–2010 in 48 countries in both emerging and developed markets. The resulting sample has 18,000 observations of 2,820 banks, of which 1,650 are in 24 developed countries and 1,170 are in 24 emerging markets.

The nine macroprudential policies covered are the ones that have actually been used. They include loan-to-value caps, debt-to-income caps, credit growth caps, foreign currency lending limits, reserve requirements, dynamic loan loss provisioning, countercyclical capital requirements, profit distribution restrictions, and other policies.

To ensure robustness, the authors attempt to provide for time-varying country controls, country characteristics, endogenity, and interaction in macroprudential policies and other policy tools in the regression analysis.

Abstractor’s Viewpoint

The large sample of banks in the countries that are studied makes this work useful. But, as the authors also acknowledge, financial system vulnerabilities are potentially beyond just the banking system. There could be externalities that may increase risks for the financial system as a whole by transferring risks to parts that are regulated differently. This transference of risk has been seen at different times in various markets, including during the recent global financial crisis. These risks could possibly be studied after more comprehensive time-series data become available for various countries.

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