IMF endorses, AFR slams, macroprudential


The kool aid is flowing today in Pyrmont:

A new paper by the International Monetary Fund is likely to raise further doubts that Australia should impose stricter debt limits on banks and borrowers, because such tools have been found to be ineffective in preventing a crash in asset prices.

And here’s what the actual paper concluded:

Recent theoretical advances and policy thinking support a role for macro-prudential policies in safe-guarding financial stability. Such policies can reduce the buildup of vulnerabilities and can help mitigate the impact of adverse cycles by encouraging a greater buildup of buffers. Our analysis confirms that countries stand to benefit from greater use of macro-prudential policies to reduce the risk arising in their banking systems. Using a large panel data set of individual bank balance sheets, we find that some macro-prudential policies reduce the growth in assets. We find in particular caps on borrower and financial institutions’ assets and liabilities–based measures to be effective, while buffer-based policies seems to have little impact on asset growth. Overall, there is little evidence that the effectiveness of these tools varies by the intensity of the cycle.

When we differentiate the effectiveness of policies in reducing vulnerabilities by phase of the financial cycle, we confirm that many help reduce risks during upswings. In contraction phases, however, most tools seem to be less effective in maintaining financial intermediation. This is to be expected since many policies are more suited to reducing the buildup of vulnerabilities, while only some are more geared towards building up buffers. However, even tools which help build buffers in good times generally do not help to provide cushions that alleviate crunches during downswings. As such, macro-prudential tools may be less promising to mitigate adverse events.

There are large differences across countries in the usage of macro-prudential policies, with emerging markets and closed capital account countries using these policies relatively more than advanced countries and open capital account countries. We find some evidence that some policies are somewhat more effective at curbing risks in advanced countries and others in emerging markets. Notably, borrower-based measures seem to work better in advanced countries. This ought not to surprise, given that real estate boom and bust cycles are more important in determining their overall financial cycles. There is also some evidence that a package of macro-prudential policies works better in emerging markets, perhaps as their financial systems are less liberalized, allowing a combination of policies to be used. We also conjecture that there could be both complementary and substitution relationships between macro-prudential policies and capital flow management tools, with the latter used more in emerging markets.

As documented, emerging markets have been at the forefront of using macro-prudential policies. In light of recent events one may, however, question whether emerging markets are more exposed to risks and more in need of these policies. In principle, all types of countries can experience the externalities and market failures that macro-prudential policies try to address. In practice nevertheless, the choice of what policies (if any) to use will have to be country- and circumstance-specific, as some of our findings suggest. While in some respects, systemic risks concerns are becoming similar across countries, emerging markets likely need to use a different and broader set of policies, including, besides the traditional monetary, fiscal, and micro-prudential policies, macro-prudential and capital flow management tools. At the same time, their general pragmatic approaches to date can benefit from further research on what are the most effective and efficient approaches given specific conditions (see also Acharya, 2013, and Shin, 2013, on how to adapt policies, especially to emerging markets and developing countries).

Our work comes with caveats and related suggestions for future research. Residual selection, endogeneity and omitted variables problems can still drive our results. Propensity scoring could be used to control to some degree for country selection issues. Techniques such as matching banks from different macro-prudential policy regimes could address another type of selection problem. Another way to control for bank characteristics would be to study how subsidiaries of the same foreign bank behave in countries with different macro-prudential policies. While this would reduce the number of observations significantly, as few global banks have operations in many countries, it would control for otherwise difficult to capture bank-specific aspects, such as the quality of its risk management.

A major issue is how to account for circumventions and risk transfers to other, possibly less regulated parts of the financial system. Our regression results indicate that (some) macro-prudential policies are more effective in reducing vulnerabilities in banks. It could, however, be that these policies are also more easily avoided by channeling financing through less regulated parts of the financial system (note that this applies less to those macro-prudential policies aimed directly at borrowers as those are less likely to be avoided). As such, using macro-prudential policies need not be associated with less overall systemic risks or reduced financial cycles.

One way to investigate this possibility is to use more aggregate financial measures, as has been done in some studies using overall credit development. This has its own (econometric) caveats, however, including greater concerns for endogeneity. Another way is to investigate how complementary, market‐based measures, such as asset prices (including credit spreads) and systemic risk rankings (e.g., those based on Marginal Expected Shortfall Measures, as developed in Acharya et al., 2010, or CoVaR, as developed in Adrian and Brunnermeier, 2011) respond to various macro-prudential policies. By being less institutions’ specific and possibly more comprehensive, such measures may suffer less from issues of circumvention. These and other extensions are left for future research, in part as many of these measures and underlying data are not (yet) available for a large sample of countries and a long time period.

Finally, while our results suggest that macro-prudential policies can be important elements of the toolkit aimed at overall systemic risk mitigation especially for countries exposed to international shocks, the adoption of such policies may also entail some costs. In particular, in as much as macro-prudential policies affect resource allocations, they may affect economic activity and growth and/or possibly limit (efficient) financial sector development. This is likely to be a fruitful area of research as well.

The whole point of MP is to affect allocation of capital so this is a bit daft at the end. Even so, the paper is a firmly positive endorsement of MP and should help allay doubts about the use of such tools in an advanced economy vulnerable to external shocks, contrary to the AFR’s strangely editorialised copy.

Of course that’s all academic anyway given the rise of Pasconomics. Full IMF paper here.

Houses and Holes
Latest posts by Houses and Holes (see all)


    • Strange Economics

      RBA says – macroprudential if the “housing bubble starts to get out of control”.
      So we have an in-control bubble. These are the good bubbles.
      Hmmm RBA admitted its a bubble then!.

      Still Bubble ? What bubble? to quote CBA, etc.
      In-control bubbles Benefitting big banks, future bank employees from the RBA, investment house and negative gearing politicians
      (e.g. Joe Hockeys wife renting at $270/night to Joe Hockey in a non-arms length transaction – and from an ATO view? )

      And RBA wants people to invest in some risky new business? (which the banks won’t business loan for ? ). Why would you bother when housing is a govt guaranteed no-risk protected and leveraged bubble. (in control so not going to pop).

  1. .. in as much as macro-prudential policies affect resource allocations, they may affect economic activity and growth and/or possibly limit (efficient) financial sector development.

    And the entire basis of the objection to such tools is precisely for this reason. At a political level, the risk from curtailing economic growth from lower credit growth is too much to bear. At the level of individual banks trying to maintain return on equity, why would they give a s**t about systematic risk when they are fully aware that the political equation will mostly always fall in their favour.

  2. arctic explorer

    The language in the report has so many caveats that it’s hard to see how the null hypothesis (that macroprudential has no effect) has been disproven. Even ignoring their caveats, LTV is about the only MP tool that is statistically significant in reducing asset growth – but while statistically significant the reduction is pretty small.

    On this basis one would have to say the jury is still out on whether it’s worth using MP tools – especially given that the costs of MP haven’t been articulated and could well be significantly larger than its benefits.