Thursday, April 16, 2009

On macro-prudential regulation

Vox carries an informative article explaining the concept of macro-prudential regulation, with its focus on "system-wide orientation of regulatory and supervisory frameworks and their link to the macroeconomy". Claudio Borio defines two characteristics of such regulation - (a) it focuses on the financial system as a whole, with the objective of limiting the macroeconomic costs of episodes of financial distress; (b) it treats aggregate risk as dependent on the collective behaviour of financial institutions (or "endogenous"), in contrast to how individual agents treat it (exogenous).

He writes that the macroprudential approach consists of two dimensions - "cross-sectional dimension" (distribution of risk in the financial system at a given point of time) and "time dimension (evolution of aggregate risk over time). He writes,

"The key issue in the cross-sectional dimension is how to deal with common (correlated) exposures across financial institutions. These arise either because institutions are directly exposed to the same or similar asset classes or because of indirect exposures associated with linkages among them (e.g. counterparty relationships). Common exposures are critical because they explain why institutions can fail together... macroprudential regulator would focus on the joint failure of institutions, which determines the loss for the financial system as a whole. The main policy question is how to design the prudential framework to limit the risk of losses on a significant portion of the overall financial system and hence its 'tail risk'.

The key issue in the time dimension is how system-wide risk can be amplified by interactions within the financial system as well as between the financial system and the real economy. This is what pro-cyclicality is all about. Feedback effects – the endogenous nature of aggregate risk – are of the essence. During expansions, declining risk perceptions, rising risk tolerance, weakening financing constraints, rising leverage, higher market liquidity, booming asset prices, and growing expenditures mutually reinforce each other, potentially leading to the overextension of balance sheets. The reverse process operates more rapidly, as financial strains emerge, amplifying financial distress. As a result, actions that are rational and compelling for individual economic agents may result in undesirable aggregate outcomes, destabilising the whole system. The main policy question is how to dampen the inherent pro-cyclicality of the financial system."

And on the way ahead with regulation in these two aforementioned dimensions, he writes,

"In the cross-sectional dimension, the guiding principle for the calibration of prudential tools is to tailor them to the individual institutions’ contribution to system-wide risk. Ideally, this would be done in a top-down way. One would start from a measure of system-wide tail risk, calculate the contribution of each institution to it and then adjust the tools (capital requirements, insurance premia, etc.) accordingly. This would imply having tighter standards for institutions whose contribution is larger, contrasting sharply with the microprudential approach, which would have common standards for all regulated institutions. In turn, that contribution will depend on features that are either specific to the institution itself (e.g., its size and probability of failure) or relevant for the system as a whole (its direct and indirect common exposures with other institutions).

In the time dimension, the guiding principle is to calibrate policy tools so as to encourage the build-up of buffers in good times so that they can be drawn down as strains materialise. By allowing the system to absorb the shock better, this would help to limit the costs of incipient financial distress. Moreover, the build-up of the buffers, to the extent that it acted as a kind of dragging anchor or 'soft' speed limit, could also help to restrain the build-up of risk-taking during the expansion phase. As a result, it would also limit the risk of financial distress in the first place."

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