Rediscovering the
macroeconomic roots of
financial stability policy:
journey, challenges and a way
forward
Professor: Ester Faia
Students: Syed Ali Zaidi, Hayk Aleksanyan
Content
Research Question
Introduction
Financial Stability Policy before crisis
Prudential and monetary policy (pre-crisis)
Prudential and monetary policy (post-crisis)
A way forward/outstanding challenges
Macroprudential and monetary policy frameworks
Critical analysis
Conclusion
Bibliography
Research Question
What are the main challenges of the
policy shift and what other measure
should be taken to ensure the financial
stability?
What are the main challenges of the
policy shift after the financial crisis to
control systemic risk and what other
measure should be taken to ensure the
financial stability?
Introduction
The reason of the financial crisis:
Microeconomic explanation for the crisis
Failure of individual institutions rather than financial system
as a whole
Macroeconomic reasons mostly matter (Jagannathan et al al.
(2009)), (Obstfeld and Rogoff (2009)), (Reinhart and Rogoff
(2011))
Post-crisis response:
Strengthening systematic (macroprudential) orientation of
regulatory and supervisory frameworks
Financial Stability Policy before
crisis
Prudential
regulatory and
supervisory
arrangements
focused on the
stability of
individual
institutions
(microprudential
orientation)
Monetary policy
arrangements
focused on
achieving price
stability over
relatively short
periods (around 2
years)
Financial Stability Policy before crisis
Prudential policy
Main points:
the whole financial system is sound if and only if each
institution is sound (Borio (2003a)).
Bottom-up
Treats the risk exogenous with respect to the behavior
of individual institutions
Prudential balance sheet restrictions focus on solvency
rather than liquidity
Financial Stability Policy before crisis
Monetary policy
Was distancing itself from banking and financial stability
concerns
Inflation targeting (rather short horizons)
Focuses on interest rates
However, Central banks didnt loose interest in financial
stability
Financial crisis
Bust of a major financial cycle, caused by the systems
vulnerabilities and imbalances
Low and stable inflation cannot ensure financial and
macroeconomic stability
Microprudential framework could not prevent the crisis
Mainly focus on macroprudential
regulations
Financial Stability Policy after crisis
Prudential policy
Monitoring and limiting of the risk of financial distress
on the real economy as a core policy
Risks are considered to be partially endogenous
Ensures the stability of the whole financial system not
the separate institutions
Top down approach
Financial Stability Policy after crisis
Prudential policy
Time dimension
How aggregate risk in the financial system evolves over
time
The source of financial distress is the procyclicality of
the financial system
Policy principle to deal with the distress:
Build up buffer in good times and apply them during
bad times to stabilize the system
Financial Stability Policy after crisis
Prudential policy
Cross-sectional dimension
How risk is allocated within the financial system at a
point in time
The source of financial distress is the common
exposures and interlinkages that result joint failure of
financial institutions
Policy principle to deal with the distress:
Calibrate prudential tools with respect to contribution of
each of institution to systematic risk to ensure that each
Financial Stability Policy after crisis
Monetary policy
No consensus exist to adjust monetary policy
frameworks
The role of monetary policy in building up the crisis is
still not clear
How far monetary policy regimes should be adjusted
against the build up of risks is also a challenging
question currently
Monetary policy is asked to contribute to control
systemic risks in the financial sector ( Faia & Angeloni
2009)
Monetary policy influences the degree of riskiness of the
financial sector ( Faia & Angeloni 2009)
Financial Stability Policy after crisis
Monetary policy
TWO VIEWS
Monetary policy should continue to focus on price
stability
Implementing only a macroprudential framework can
help but it is not sufficient
ROLE OF MONETARY POLICY
There is no agreement on role of monetary policy be it
interest rate or balance sheet policy
There has been no new rethink of the analytical
framework underlying policy.
A WAY FORWARD/ OUTSTANDING CHALLENGES
Macroprudential Frameworks
The crisis has created opportunity to put in place full-fledged
macro prudential frameworks
It has raised number of challenges that includes:
The criterion of success;
How best to measure systemic risk and the associated data
requirements;
How close instruments should track systemic risk;
The range of instruments to be used;
The balance between rules and discretion;
Governance arrangements
Macroprudential Frameworks
The criteria of success should be realistic
Through proper frameworks frequency and severity can be
reduced
Distinction between the time and cross-sectional dimensions of
measurement of systemic risk should be made
Macroprudential
Framework
Failure to anticipate the recent financial crisis was not mainly
because of inadequate data
There is a need to improve very long-term series to help calibrate
leading indicators of financial distress.
Still a major gap concerning commercial property prices
Requirement for readily available consolidated balance sheets of
banks global operations
It would be a mistake to expect prudential tools to track systemic
risk closely.
the Basel Committees use of the credit-to-GDP ratio
Macroprudential Frameworks
The range of prudential instruments should be as wide as possible.
Steps have relied on
Capital standards,
Loan-to-value ratios
Adjustments to accounting standards
Still there are lack of standards with respect to liquidity
Currently the standards have been calibrated exclusively with
respect to the
risk profile of individual institutions
Addressing systemic risk should rely on as many instruments as
possible, based on their effectiveness
Rules, if well structured, can act as automatic stabilizers and can be
especially effective containing political pressures
Monetary Policy Frameworks
It is imprudent to rely exclusively on a macroprudential framework
The influence of monetary policy on credit conditions, asset prices and
yields is strong
There is growing evidence that monetary policy can also affect risktaking (altunbas et al (2009)
A monetary policy strategy that is constraining the upswing in the
financial cycle but easing aggressively in its aftermath, can have
dangerous outcomes
Monetary policy cannot be arbitraged away as easily as regulatory
restrictions
The bust of outsize financial cycles may be quite costly in terms of
output even if banks are robust enough to withstand it.
Monetary Policy Frameworks
What is needed is a way to allow monetary policy to tighten
even if near-term inflation is under control
It requires lengthening of the policy horizon
Monetary Policy can become counter effective if the easing
is taken too far after averting the implosion of the financial
system
As the easing continues, it raises the risk of perpetuating the
very conditions that make eventual exit harder
Monetary Policy Frameworks
There are increased efforts on behalf of economics
professionals to understand systemic risk
Moving forward, the greatest payoff can come from
drawing the lessons of the crisis
The crisis is generated slowly during stable conditions,
where things remain unchecked
There is a need to treat our monetary economies more
seriously
Monetary Policy Frameworks
Working with better representations of monetary economies should help cast
further light on the aggregate and sectoral distortions
The priority here is to better document the financial cycle and its relationship with
the business cycle.
Financial cycles can have a much longer duration than business cycles
Much more needs to be done to establish the relationship between different
monetary and financial regimes affect the relationship between financial and
business cycles
CRITICAL ANALYSIS
The IMFs Macroprudential Policy Tools and Frameworks report 2011 cites following progress
for Macroprudential framework
First, the identification of systemic risk is a nascent field. Further fundamental and applied
research is needed, to better inform the collection and analysis
Second, newly introduced tools will need to be tried out in different circumstances and their
performance evaluated against expectations
Finally, many jurisdictions still lack specific institutional arrangements for the conduct of
macroprudential policy
Institutional arrangements for macroprudential policymaking should be conducive to effective
mitigation of systemic risk.
CRITICAL ANALYSIS
The IMFs Macroprudential Policy Tools and Frameworks
cites progress along following lines
(i) advances in the identification and monitoring of
systemic financial risk;
(ii) the designation of instruments for
macroprudential purposes;
(iii) building institutional and governance
arrangements in the domestic and regional context
CRITICAL ANALYSIS
Improving data and information to support macroprudential policymaking ( IMF Progess report to G20 -2011)
While a broad range of policy instruments is potentially available to address macroprudential risks, those most
commonly used or proposed include ( IMF Progress report)
Tools to address threats to financial stability arising from excessive credit expansion and asset price booms,
Tools to address key amplification mechanisms of systemic risk linked to leverage (e.g.,
Capital tools) and maturity mismatches
Tools to mitigate structural vulnerabilities in the system and limit systemic spillovers in
times of stress,
New macroprudential instruments includes the Basel III framework that includes a maximum leverage ratio, a
capital conservation buffer and a countercyclical capital buffer
Concerning the cross-sectional dimension of systemic risk, framework to manage risk imposed by SIFIs has
been recommended by FSB
Strengthening financial infrastructure, is also important to ensure international consistency
CRITICAL ANALYSIS
Other Economic professionals have suggested and observed that
Possibility of useful interactions between the conduct of monetary policy and that of
systemic prudential regulation. ( Faia & angeloni 2009)
After years of distance, monetary policy and prudential regulation though still unmarried
are moving in together ( Faia & Angeloni 2009)
The financial crisis has made it clear that the interactions between the financial sector
and the aggregate economy imply that monetary policy and financial stability policy are
closely intertwined ( Mishkin 2011)
Introducing bank inter-linkages and heterogeneity in macro models is of the most urgent
challenge in this line of research
CONCLUSION
Major reassessment of policies towards financial stability after crisis.
Shift of focus from a micro- to a macro-prudential orientation
Consideration of monetary policy exclusively focused on short-term price stability is
increasingly been questioned
Proceeding along this road raises a number of analytical challenges
The overriding one would be to reconsider the prevailing paradigm embedded in
macroeconomics
There is need for rediscovery of the monetary nature of our economies
It calls for a better understanding of the relationship between business cycles and the
longer financial cycles that reinforce them.
Bibliography
Jagannathan, Ravi, Mudit Kapoor and Ernst Schaumburg (2009), Why Are We in a
Recession? The Financial Crisis is the Symptom Not the Disease! NBER Working Paper No.
15404.
Nathan, Sussman and Yishay Yafeh (2011), Prudential Policy, Macroeconomic Stability and
Comovement: The Financial Crisis in Historical Perspective
Obstfeld, Maurice and Kenneth Rogoff (2009), Global Imbalances and the Financial Crisis:
Products of Common Causes, CEPR Discussion Paper No. 7606.
Reinhart, Camen, and Kenneth Rogoff (2011), A Decade of Debt, CEPR Discussion Paper
No. 8310.
IMFs Macroprudential Policy Tools and Frameworks Progress Report to G20 (October 2011)
Ignazio Angeloni and Ester Faia 2009 - A Tale of Two Policies: Prudential Regulation and
Monetary Policy with Fragile Banks
Viral V. Acharya 2009 A theory of systemic risk and design of prudential bank regulation
Mishkin 2011 - Monetary policy strategy: lessons from the crisis
