## _sdn1305

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---

### Executive Summary: core findings
- Microprudential policy focuses on the health of individual financial institutions; macroprudential policy addresses risks to the financial system as a whole.
- These policies usually complement and reinforce each other: the health of individual institutions is a necessary, though not sufficient, condition for system-wide stability, while a stable system contributes to the health of individual institutions.
- Conflicts can occur because of overlapping policy mandates and the way policies are applied.
- Clarifying respective mandates, functions, and toolkits can help maximize synergies and limit negative consequences of policy interaction.
- Helpful measures include:
  - setting primary and secondary policy objectives to clarify responsibilities;
  - establishing separate but complementary policy functions (supervision and enforcement for microprudential authorities; identification of systemic risks and vetting of regulations for macroprudential authorities);
  - clearly assigning powers to reduce tensions.
- Tensions are more likely at certain stages of the credit cycle, notably during the downturn phase and at crucial turning points.
- Information sharing, joint analysis of risks, and general dialogue between microprudential and macroprudential authorities can reduce differences of opinion.
- Encouraging the buildup of shock-absorbing buffers in good times and having effective resolution mechanisms to allow unviable institutions to die safely reduce tensions during downturns.
- A credible joint communication strategy by microprudential and macroprudential authorities can minimize market misperceptions and bolster investor confidence during turbulent periods.
- Institutional mechanisms to enhance cooperation should reflect country-specific circumstances; if mandates are split across entities, a coordination committee is important; some jurisdictions may award both mandates to a single authority; and where conflicts remain, mechanisms should exist to decide which policy prevails.
- The paper provides general and preliminary guidance; solutions will be shaped by country-specific circumstances and require flexibility because of continuing uncertainty about policy impacts and evolving understanding of systemic risk.

### I. Introduction: framing and scope
- Microprudential supervision contributes to system resilience by focusing on risks and resilience of individual institutions; it is a necessary condition for a sound financial system but not sufficient because of complexity and "fallacy of composition" effects.
- Macroprudential policy complements microprudential supervision by addressing system-wide risks, calming booms, softening busts, and mitigating systemic risks from concentration and interconnectedness.
- The analysis identifies complementarities, potential conflicts, and mechanisms for aligning the two policies.
- Considerable uncertainties about policy impacts complicate assessment of interactions; analysis and understanding of systemic risk and instruments are still developing.
- Scope limitations:
  - Concentrates on banking and policies conducted within an individual country; banking supervision treated as representative for other microprudential policies.
  - Does not address cross-border policy application complexities.
  - Does not address crisis management, resolution frameworks, or structural measures (e.g., ring-fencing), though authorities responsible for micro- and macroprudential policies should be closely involved in their design and implementation.

### II. Mandates, synergies, and tensions
- Policy mandates:
  - Basel Core Principles: the “ultimate objective” of supervision (microprudential policy) is to promote the “safety and soundness of banks and the banking system.”
  - In some jurisdictions banking supervisors have explicit responsibility for financial stability; central banks often hold implicit or explicit financial stability mandates.
  - Microprudential policies typically examine responses of an individual bank to exogenous risks and usually do not incorporate endogenous risk and interconnectedness.
  - Macroprudential ultimate objective: to avoid output and wealth losses in the long run by limiting the buildup of system-wide financial risk (IMF, 2011a).
  - Macroprudential policy addresses negative externalities and acts counter to the natural decline in measured risks during booms and rise in measured risks during downturns; it also aims to mitigate risks from sector concentration and interconnectedness.
  - Macroprudential policy has both a time dimension and a cross-sectional (structural) dimension.
  - Macroprudential authority focuses on herd behavior and shifts in overall risk appetite.
- Areas of overlap and sources of tension:
  - Objectives:
    - When supervision objectives include both individual soundness and system safety, confusion can arise over responsibility for systemic risk and necessary actions.
  - Risk perimeter:
    - Microprudential supervisors must consider external environment risks (e.g., Pillar 2), which overlap with macroprudential concerns.
  - Institutional perimeter:
    - In concentrated systems, actions on individual firms can have systemic consequences; systemic policies significantly affect the few firms comprising the system.

### Key conceptual points and uncertainties
- Fallacy of composition: what is true for an individual bank need not hold for the banking system as a whole.
- Systemic externalities include:
  - strategic complementarities leading to excessive or correlated risk-taking during upswings;
  - fire sales causing asset price declines and balance sheet impairment during contractions;
  - interconnectedness propagating shocks from systemic institutions or through networks.
- Considerable uncertainty remains about:
  - the effect along the cycle of microprudential requirement changes on aggregate lending;
  - identification of systemic risk;
  - effectiveness of measures aimed at containing systemic risk.
- Implication: policy design and institutional arrangements should be flexible and allow active feedback due to evolving understanding.

### Policy design and reducing tensions
- Clarify mandates by setting primary and secondary objectives to clarify responsibilities between microprudential and macroprudential authorities.
- Assign separate but complementary policy functions:
  - Microprudential: supervision and enforcement.
  - Macroprudential: identification of systemic risks and vetting financial regulations from a systemic risk perspective.
- Clearly assign powers to reduce potential tensions in application.
- Encourage buildup of shock-absorbing buffers during good times (countercyclical elements).
- Ensure effective resolution mechanisms enabling unviable institutions to exit safely.
- Improve cooperation through information sharing, joint risk analysis, and regular dialogue to reduce differences of opinion.
- Develop credible joint communication strategies to avoid market misperceptions and to support investor confidence during turbulent periods.

### Box 1. Pillar 2 of the Basel Capital Framework — overview and implications
- Pillar 2 requires an assessment by the firm and supervisor of capital adequacy of an individual institution to ensure capital is commensurate with risks.
- The assessment is both quantitative and qualitative and is not limited to risks under Pillar 1.
- Pillar 2 is often considered the quintessential microprudential tool.
- Three aspects of overlap with macroprudential policy in the Pillar 2 approach:
  - (i) the risks considered under Pillar 2 include systemic elements;
  - (ii) the primary tool of Pillar 2 is the creation of a capital buffer;
  - (iii) the level of the buffer may be adjusted depending upon the point of the cycle.
- Concerns or risks authorities may address include concentration, reliance on volatile wholesale funding, extent of leverage, exposure to currency funding, or implicit state guarantees.
- Distinct tool objectives:
  - Microprudential policy adjusts capital based on individual institutions’ risks.
  - Macroprudential policy adjusts overall levels of capital based on the financial cycle and systemic relevance.
- Overlapping instruments imply largely identical transmission channels and can create tensions when deployed for different purposes; cumulative or counteracting joint effects need consideration.
- Other instruments usable by both policies include:
  - direct limits on credit buildup;
  - loan-to-value (LTV) ratios;
  - debt-to-income (DTI) standards;
  - required reserves;
  - levies.
- Macroprudential policy can extend to the shadow banking sector; the perimeter and instruments may need adjustment over time in reaction to financial innovation or regulations.
- Interactions:
  - Buffers built for system resilience contribute to firm soundness.
  - Macroprudential authorities can detect threats from other public policy areas and alert relevant authorities.
  - Tensions across the cycle:
    - Macroprudential policy leans against the financial cycle.
    - Microprudential instruments (e.g., risk-based capital adequacy requirements) can be procyclical.
    - Tensions arise from deleveraging pressures when microprudential standards are raised post-shock and from releasing capital buffers in downturns which can harm weaker institutions.
  - Note: excess capital levels are not always indicative of strength; capital ratios can be volatile so release of a buffer may appear acceptable even if it endangers institutions.

### III. Optimizing synergies and reducing scope for tension
A. Mandates
- Separate, explicit, and well-documented mandates should define objectives, roles, instruments, and responsibilities.
- Mandates should include mechanisms for transparency, accountability, and protection of independence as required.
- Mandates should cover instruments needed by both policies and be reviewed regularly.
- Complementary mandates are advisable: allow macroprudential objectives (systemic stability) to be a secondary objective for microprudential policy, and vice versa.

B. Functions
- Clear functions facilitate coordination and consultation; open communication, information sharing, and transparency are essential.
- Key collaborative functional areas:
  - Systemic risk assessment:
    - Both authorities need a view on systemic risk, including interactions with the broader economy.
    - Different perspectives and analytical techniques strengthen assessment.
    - Reaching a common view based on shared information reduces incentives for disagreement; macroprudential view should incorporate bottom-up observations from supervision.
  - Policy development:
    - Shared insights and mutual scrutiny improve policy quality and reduce unintended consequences.
    - Macroprudential authority should scrutinize wider factors affecting systemic stability, including other public policies.
    - Under Basel III, enhanced risk sensitivity is balanced with measures to dampen procyclicality, such as the leverage ratio and countercyclical capital buffers.
  - Supervision:
    - Microprudential authority leads relationships with individual firms; supervision is the primary source of firm-level information.
    - All relevant data should be shared between authorities subject to adequate protocols.
    - Supervision should monitor financial innovations as potential systemic risk sources.

C. Toolkits
- Two jurisdictional approaches in advanced countries:
  - (1) allocation of all tools to the microprudential authority, with macroprudential input; and
  - (2) legal allocation of instruments to separate authorities.
- Neither approach eliminates disagreements; mechanisms must exist for requests/recommendations or for conceptual/empirical guidance when toolkits are separated.

### Aligning the policies across the financial cycle
- Upswing and Peak:
  - Both perspectives encourage buildup of capital and liquidity buffers when leverage increases and underwriting standards relax.
  - Microprudential: scrutinizes individual credit standards and provisioning; intervenes via Pillar 2.
  - Macroprudential: monitors indicators that trigger countercyclical capital buffers or tools like LTV ratios.
  - Divergence can occur near the peak: microprudential indicators may look positive while systemic indicators warn (the “paradox of financial instability”).
  - Trade-offs between using capital versus provisioning (issues on credible buffer reduction in downturn; provisioning interacts with accounting standard setters).
- Downturn:
  - Microprudential focus: ensure stability of individual firms—restrict dividends, raise capital requirements, deleverage, emphasize valuation and provisioning.
  - Macroprudential focus: stabilize the broader system—avoid excessive deleveraging, may seek to release built capital buffers.
  - Tension: how far and how quickly buffers can fall without jeopardizing institutions.
  - Consider both formal minimum buffers and additional amounts banks actually hold, which vary over the cycle and can be influenced by Pillar 2.
  - Risks of regulatory forbearance: supervisors may delay loss recognition; incentives for forbearance increase with pressures to release buffers.
  - Liquidity measures: relaxing liquidity measures may be less susceptible to market misinterpretation than changes in published capital buffers; central bank contingent lines can mitigate macroprudential concerns.
- Mitigating forbearance and managing buffer release:
  - Greater automaticity (e.g., dynamic provisioning) can mitigate forbearance; examples include Spain, Bolivia, Colombia, Peru, Uruguay.
  - Insufficient confidence in indicators limits use of fully automatic approaches; supervisory judgment remains necessary to avoid undercapitalization.
  - Measured buffer release should depend on:
    - a common assessment of systemic risk;
    - rigorous and regular diagnostic stress tests on individual firms (example: U.S. Comprehensive Capital Analysis and Review).
  - Possible targeted approaches:
    - exempt vulnerable institutions from general capital release;
    - apply relief only to certain forms of new lending;
    - formulate objectives in amounts of capital rather than capital ratios (experiences mixed);
    - encourage shedding noncore business lines to alleviate capital strains.
  - Communication: credible joint communication strategy is essential; intention and rationale for releasing buffers should be public ex ante; focus on buffer sizes and resilience rather than specific supervisory ratios.
- Recovery and return to an upswing:
  - Authorities typically agree on restoring resilience, though timing and intensity may differ.
  - Consistent, coordinated risk assessment fosters alignment.
- Turning points:
  - Identifying turning points is difficult; existing indicators are not failsafe.
  - Reliable information assists in resolving conflicts when macroprudential policymakers lean to release buffers and microprudential supervisors lean to raise them.

### Areas of strong fallacies of composition
- Interconnectedness and common exposures:
  - Macroprudential policy identifies concentrations, common exposures, linkages, and interdependencies causing contagion; may recommend adjustments in microprudential supervision.
  - Interests of both policies align in addressing systemic concerns; greater macroprudential credibility increases market responsiveness.
- Treatment of collateral:
  - Collateral-based credit risk mitigation can increase systemic risk under stress via feedback loops and forced selling.
  - Macroprudential role: identify contagion potential and recommend raising minimum margin requirements in the upswing.
  - Potential friction greater in downturn when supervisors may resist lowering minimum margins; higher initial margins can reduce tension.
- Liquidity requirements:
  - Microprudential supervisors may require higher liquidity buffers under stress, prompting banks to sell less liquid assets and risk fire sales.
  - Macroprudential authority should be involved in such decisions; central bank liquidity provision can alleviate macroprudential risks.
  - Post-Liquidity Coverage Ratio view: liquidity buffers should be accessible and used in stress provided there is a credible plan to rebuild them.

### Organizational mechanisms and governance arrangements
- General principles:
  - Close coordination promotes aligned policy action while preserving primary objectives.
  - Arrangements should ensure clarity of responsibility and timely action; transparency by the macroprudential authority is essential.
- Institutional design options:
  - Cross-representation of authorities in decision-making bodies facilitates cooperation and information sharing when mandates are separate.
  - Coordinating committee structures are useful when mandates are assigned to multiple agencies.
  - Assigning both mandates to one institution internalizes tensions and ensures a single voice; may reduce transparency unless complemented by communication mechanisms.
  - Examples of central banks holding both mandates cited: Brazil, Bulgaria, Czech Republic, Malaysia, Singapore, Thailand.
  - Recommendations with “comply or explain” requirement: public recommendations can apply pressure to act; disclosure of noncompliance reasons shares responsibility.
- Policy hierarchy:
  - Some jurisdictions adopt a formal hierarchy allowing one authority to override the other; others do not.
  - A macroprudential override may be justified by the high cost of financial instability; a microprudential override may reflect supervisors’ closer knowledge of institutions.
  - Constraints:
    - overrides must not compromise minimum prudential standards;
    - overrides can affect independence of the overridden authority.
  - Overrides can be comprehensive or constrained, automatic or flexible, or conditional on criteria.
- Communication policy:
  - Embedding communication in a previously articulated policy framework conditions market expectations and avoids misinterpretation.
  - Microprudential and macroprudential authorities should coordinate communications so authorities “speak with one voice”; public recommendations need not signal disagreement.

### ANNEX III. Basic elements of microprudential and macroprudential toolkits
- Microprudential policy toolkit requires, at a minimum:
  - a set of risk-based quantitative instruments to establish capital and liquidity requirements for individual institutions;
  - effective supervisory powers over institutions (e.g., licensing, governance, risk management, sanctions, and powers to take corrective actions).
- Macroprudential policy toolkit requires, at a minimum:
  - prudential instruments constructed to have an impact on procyclicality (e.g., countercyclical capital buffers) or on contribution to systemic risk (e.g., Systemically Important Financial Institution surcharges);
  - instruments to address buildup of systemic risk in specific market segments (such as loan-to-value ratios) and instruments aimed at constraining general or specific leverage in nonfinancial sectors (such as debt-to-income ratios);
  - tools to address systemic liquidity concerns.
- Use of nonprudential instruments and recommendations:
  - Macroprudential authority can potentially use nonprudential tools reassigned from other public policies, such as some types of financial transaction taxes/levies, reserve requirements, or capital controls.
  - Macroprudential authority should have the right to issue formal recommendations to activate tools outside its direct control.
  - Use of such instruments may reduce “competition” over prudential instruments and help in addressing liquidity risk.
- Coordination on additional instruments and limits:
  - For instruments both policies may want to use permanently or occasionally, mechanisms are needed to reach an understanding on their use, respecting pre-agreed principles.
  - Example limit: measures to address concentration or foreign exchange risk might remain microprudential up to certain limits (e.g., a maximum exposure of 25 percent of an institution’s capital).
- ANNEX IV — Financial cycle stylized policy reactions (summary):
  - Boom:
    - Conditions: Strong credit and asset price growth, higher risks (but seems contained), high returns, over-optimism, weakening underwriting standards, expansive leveraging.
    - Microprudential: no need to intervene generally; intervention in underwriting standards desirable.
    - Macroprudential: correct excessive imbalances; build countercyclical capital and liquidity buffers.
  - Bust type-I (no crisis):
    - Conditions: Slowdown in credit growth, stable or falling asset prices, lower returns, no confidence lost.
    - Microprudential: preserve stability; stabilize or increase capital and liquidity ratios; restrict dividends selectively.
    - Macroprudential: avoid serious deleveraging; release countercyclical buffers.
  - Bust type-II (crisis):
    - Conditions: Deleveraging, substantial asset price falls, substantial financial losses, loss of confidence.
    - Microprudential: regain confidence in institutions; increase capital and liquidity ratios; extensive scrutiny; possible forbearance.
    - Macroprudential: regain confidence in the system; avoid deleveraging; decrease or increase buffers depending on source of lack of confidence.
  - Recovery:
    - Conditions: cautious re-leveraging, moderate credit and asset price growth.
    - Microprudential: maintain or rebuild capital and liquidity ratios; no need to intervene.

### Conclusions and guiding principles
- No single border between microprudential and macroprudential policies fits all countries and circumstances; flexibility is required.
- Guiding principles to assist country choices:
  - clarify respective mandates and roles;
  - clearly allocate instruments between authorities;
  - promote open dialogue, shared information and analysis, and mutual understanding;
  - coordinate communications so authorities “speak with one voice.”
- Tensions are most likely at credit cycle turning points and during downturns; good practices to mitigate tensions include:
  - ensuring sound and resilient capital levels at cycle peaks;
  - joint stress tests involving both authorities for common resilience assessments;
  - considering objectives in amounts of capital rather than capital ratios (experiences mixed);
  - microprudential supervisor participation in macroprudential formulation and consideration of systemic risk when setting Pillar 2 requirements;
  - having a sound resolution framework to remove weak institutions without causing contagion.
- Structural or hierarchical measures to address persistent differences may include cross-representation, assignment of both mandates to one institution, or “comply or explain” recommendation powers; introducing a hierarchy can avoid impasses but entails costs in independence.

*Source: _sdn1305 - Executive Summary, Box 1, Annex III, and related sections.*

### Executive Summary ......................................................................................................

### _sdn1305 - Executive Summary

### Executive Summary: core findings
- Microprudential policy focuses on the health of individual financial institutions; macroprudential policy addresses risks to the financial system as a whole.
- These policies usually complement and reinforce each other: the health of individual institutions is a necessary, though not sufficient, condition for system-wide stability, while a stable system contributes to the health of individual institutions.
- Conflicts can occur because of overlapping policy mandates and the way policies are applied.
- Clarifying respective mandates, functions, and toolkits can help maximize synergies and limit negative consequences of policy interaction.
- Helpful measures include setting primary and secondary policy objectives to clarify responsibilities; establishing separate but complementary policy functions (supervision and enforcement for microprudential authorities; identification of systemic risks and vetting of regulations for macroprudential authorities); and clearly assigning powers to reduce tensions.
- Tensions are more likely at certain stages of the credit cycle, notably during the downturn phase and at crucial turning points.
- Information sharing, joint analysis of risks, and general dialogue between microprudential and macroprudential authorities can reduce differences of opinion.
- Encouraging the buildup of shock-absorbing buffers in good times and having effective resolution mechanisms to allow unviable institutions to die safely reduce tensions during downturns.
- A credible joint communication strategy by microprudential and macroprudential authorities can minimize market misperceptions and bolster investor confidence during turbulent periods.
- Institutional mechanisms to enhance cooperation should reflect country-specific circumstances: if mandates are split across entities, a coordination committee is important; some jurisdictions may award both mandates to a single authority; and where conflicts remain, mechanisms should exist to decide which policy prevails.
- The paper provides general and preliminary guidance; solutions will be shaped by country-specific circumstances and require flexibility because of continuing uncertainty about policy impacts and evolving understanding of systemic risk.

### I. Introduction: framing and scope
- Microprudential supervision contributes to system resilience by focusing on risks and resilience of individual institutions; it is a necessary condition for a sound financial system but not sufficient because of complexity and "fallacy of composition" effects.
- Macroprudential policy complements microprudential supervision by addressing system-wide risks, calming booms, softening busts, and mitigating systemic risks from concentration and interconnectedness.
- The paper analyzes interactions between microprudential and macroprudential policies to identify complementarities, potential conflicts, and mechanisms for aligning the two policies.
- Considerable uncertainties about policy impacts complicate assessment of interactions; analysis and understanding of systemic risk and instruments are still developing.
- Caution, flexibility, and arrangements that promote active feedback among authorities are recommended.
- Scope limitations:
  - Concentrates on banking and policies conducted within an individual country; banking supervision treated as representative for other microprudential policies.
  - Does not address cross-border policy application complexities.
  - Does not address crisis management, resolution frameworks, or structural measures (e.g., ring-fencing), though authorities responsible for micro- and macroprudential policies should be closely involved in their design and implementation.

### II. Microprudential and Macroprudential Policies: mandates, synergies, and tensions
- Policy mandates:
  - Basel Core Principles: the “ultimate objective” of supervision (microprudential policy) is to promote the “safety and soundness of banks and the banking system.”6
  - In some jurisdictions banking supervisors have explicit responsibility for financial stability; central banks often hold implicit or explicit financial stability mandates.
  - Microprudential policies typically examine responses of an individual bank to exogenous risks and usually do not incorporate endogenous risk and interconnectedness.
  - Macroprudential ultimate objective: to avoid output and wealth losses in the long run by limiting the buildup of system-wide financial risk (IMF, 2011a).7
  - Macroprudential policy addresses negative externalities and acts counter to the natural decline in measured risks during booms and rise in measured risks during downturns; it also aims to mitigate risks from sector concentration and interconnectedness.8
  - Macroprudential policy has both a time dimension and a cross-sectional (structural) dimension.
  - Macroprudential authority focuses on herd behavior and shifts in overall risk appetite.9
- Areas of overlap and sources of tension:
  - Objectives:
    - Where banking supervision objectives include equally the soundness of individual institutions and the safety of the banking system, confusion can arise over who is ultimately responsible for addressing emerging systemic risk and which actions are needed to preserve financial stability.
  - Risk perimeter:
    - Microprudential supervisors, when acting on individual banks, must take into account risks from the external environment (e.g., Pillar 2 of the Basel capital framework10), which are also key elements of the macroprudential function.
  - Institutional perimeter:
    - In highly concentrated systems, actions aimed at individual firms can have systemic consequences; policy actions to address systemic risks would significantly affect the few firms that comprise the system.

### Key conceptual points and uncertainties
- Fallacy of composition: what is true for an individual bank need not hold for the banking system as a whole; micro-level reasoning may produce erroneous macro-level conclusions.
- Systemic externalities identified include:
  - Strategic complementarities leading to excessive or correlated risk-taking during upswings.
  - Fire sales causing asset price declines and balance sheet impairment during contractions.
  - Interconnectedness propagating shocks from systemic institutions or through networks.8
- Considerable uncertainty remains about:
  - The effect along the cycle of microprudential requirement changes on aggregate lending.
  - Identification of systemic risk.
  - Effectiveness of measures aimed at containing systemic risk.
- Implication: policy design and institutional arrangements should be flexible and allow active feedback due to evolving understanding.

### Policy design, interactions, and reducing tensions (summary of approaches)
- Clarify mandates by setting primary and secondary objectives to clarify responsibilities between microprudential and macroprudential authorities.
- Assign separate but complementary policy functions:
  - Microprudential: supervision and enforcement.
  - Macroprudential: identification of systemic risks and vetting financial regulations from a systemic risk perspective.
- Clearly assign powers to reduce potential tensions in application.
- Encourage buildup of shock-absorbing buffers during good times (countercyclical elements).
- Ensure effective resolution mechanisms enabling unviable institutions to exit safely.
- Improve cooperation through information sharing, joint risk analysis, and regular dialogue to reduce differences of opinion.
- Develop credible joint communication strategies to avoid market misperceptions and to support investor confidence during turbulent periods.

### Institutional mechanisms and governance (overview)
- Institutional design should reflect country-specific circumstances.
- Options include:
  - Separate entities holding different mandates with a required coordination committee to ensure policy alignment.
  - A single authority holding both mandates to consolidate accountability and decision-making.
- Where conflicts persist, mechanisms must exist to determine policy precedence.
- Policy hierarchy, governance arrangements, and communication policies are important components of effective cooperation (detailed chapters follow in the main text).

### Conclusions
- The paper offers general and preliminary guidance to promote effective cooperation between microprudential and macroprudential policies in pursuit of financial stability.
- Solutions will be shaped by country-specific circumstances and require flexibility, given continuing uncertainty about policy impacts and an evolving understanding of systemic risk.

*Source: _sdn1305 - Executive Summary*

### Box 1. Pillar 2 of the Basel Capital Framework

### Box 1. Pillar 2 of the Basel Capital Framework

### Pillar 2 overview
- Pillar 2 requires an assessment by the firm and also by the supervisor of the capital adequacy of an individual institution to ensure that the capital it holds is commensurate with the risks to which it is exposed.
- The assessment is both quantitative and qualitative, and is not limited to an assessment of risks that are taken into account under the general minimum Pillar 1 requirement.
- Pillar 2 is often considered the quintessential microprudential tool.
- Three aspects of overlap with macroprudential policy in the Pillar 2 approach:
  - (i) the risks considered under Pillar 2 include systemic elements;
  - (ii) the primary tool of Pillar 2 is the creation of a capital buffer;
  - (iii) the level of the buffer may be adjusted depending upon the point of the cycle.
- Concerns and risks that either authority may wish to address include concentration of the banking system, reliance by banks on volatile wholesale funding, extent of leverage within banks, exposure to currency funding, or implicit state guarantees. Any of these risks could impair the viability of banks and imply that the calibration of the Basel minimum standard (Pillar 1) may be too low from both the perspective of an individual bank and potentially on a system-wide basis.
- Example: Stefan Ingves, Governor of the Swedish Riksbank and Chair of the Basel Committee, has repeatedly indicated that systemic banks in Sweden should have higher capital than the Basel III required minimum level (see Risk Magazine, November 2011).

### B. Toolkits
- Both microprudential and macroprudential authorities use prudential policy instruments and tools applied at the level of the individual firm, such as buffers (whether capital or liquidity) and balance sheet restrictions.
- Distinct objectives:
  - Microprudential policy adjusts capital based on individual institutions’ risks.
  - Macroprudential policy adjusts overall levels of capital based on the financial cycle and systemic relevance to guard against systemic risk buildup.
- Both policies depend on capital and liquidity tools deployed at the level of the individual institution; prudential standards act as safety standards providing a backstop of resilience to both the firm and the system.
- Overlapping instruments imply largely identical transmission channels and can create tensions when instruments are used for different purposes; cumulative or counteracting joint effects need consideration.
- Other instruments usable by both policies:
  - direct limits on credit buildup;
  - loan-to-value (LTV) ratios;
  - debt-to-income (DTI) standards;
  - required reserves;
  - levies.
- These tools may not be under direct control of either prudential supervisor or macroprudential authority, raising coordination issues with other policy objectives (e.g., housing policy); prudential authorities can influence their use via recommendations or opinions.
- Macroprudential policy can also involve regulation of markets more generally and extend to entities in the shadow banking sector; the perimeter of macroprudential policy and its active instruments may need to adjust over time in reaction to financial innovation or regulations.

### C. Interactions
- The health of individual financial institutions is necessary but insufficient for financial stability; buffers built for system resilience contribute to the soundness of individual institutions.
- Macroprudential authorities seek to detect threats to financial system stability stemming from other public policy areas and can alert relevant authorities to contain systemic risk; successful macroprudential policy creates a more stable environment for microprudential supervisors.
- Potential for complementarities, tensions, or policy confusion given closely linked objectives and overlapping toolkits:
  - authorities may disagree on consequences or timing of actions.
- Dynamic tension across the cycle:
  - Macroprudential policy aims to lean against the financial cycle and strengthen system resilience.
  - Microprudential instruments (e.g., risk-based capital adequacy requirements) can be procyclical; the microprudential supervisor focuses on minimum capital for individual institution resilience at any point in time.
  - Macroprudential authority is better placed to assess unhealthy credit build-ups and system-wide interactions.
  - Tensions can arise, e.g., deleveraging pressures when microprudential standards are raised post-shock; conversely, releasing capital buffers in downturns to prevent deleveraging can harm weaker institutions and complicate microprudential supervision.
- Note: In the case of weaker firms, excess capital levels are not always indicative of strength as capital ratios are often much more volatile, so release of a buffer may appear to be acceptable even though it might put the institution at risk.

### III. OPTIMIZING SYNERGIES AND REDUCING THE SCOPE FOR TENSION
- The overlaps between microprudential and macroprudential mandates create both flexibility and ambiguity; clarifying mandates, functions, and toolkits helps exploit synergies and limit negative consequences of fuzzy borders.

A. Mandates
- Separate, explicit, and well-documented mandates can define objectives, roles, available instruments, and responsibilities of institutions (authorities).
- Mandates should provide mechanisms for transparency, accountability, and protection of independence as required.
- Mandates should cover instruments needed by both policies and respective responsibilities and be reviewed regularly given evolving systemic risk.
- It is advisable to design complementary mandates to further ex ante coordination; mandates can recognize prime policy objectives and allow macroprudential objectives (systemic stability) to be a secondary objective for microprudential policy, and vice versa.

B. Functions
- Clear understanding of functions facilitates coordination and consultation between authorities; open communication, information sharing, and transparency are essential.
- Arrangements may be more or less formalized, but frequency of contact, senior-level engagement, and open exchanges are prerequisites.
- Key functional areas where collaboration is critical:
  - Systemic risk assessment:
    - Both authorities need a view on systemic risk to assess implications for supervised institutions and general vulnerabilities in the financial system, including interactions with the broader economy.
    - Different perspectives and analytical techniques can strengthen assessment.
    - Reaching a common view based on shared information reduces incentives for disagreements and uncoordinated action; the macroprudential view should incorporate bottom-up observations from microprudential supervision and feed into firms' assessments.
  - Policy development:
    - Shared insights and mutual scrutiny of regulation and policy development improve policy quality and reduce unintended consequences.
    - The macroprudential authority should extend scrutiny to a wider circle to capture factors affecting systemic stability, including those from other public policies.
    - Examples include debates on procyclical elements of microprudential regulation and the fallacy of composition; under Basel III, enhanced risk sensitivity is balanced with measures to dampen procyclicality, such as the leverage ratio and countercyclical capital buffers.
    - The outcome at the macro level depends on institutional characteristics, interactions in financial markets (e.g., correlation risk), network structure, and behavior of other financial institutions; negative feedback loops (e.g., falling asset values and rising margin calls) can turn prudent firm-level measures into systemic distress.
  - Supervision:
    - Microprudential authority performs the supervisory function and leads relationships with individual firms; supervision is the primary source of information on firms, but macroprudential authorities may have relevant market intelligence.
    - All relevant data should be shared between authorities subject to adequate protocols.
    - Supervision should monitor financial innovations developed by firms as potential sources of systemic risk.

C. Toolkits
- Jurisdictional approaches to the overlap differ; two approaches used in advanced countries:
  - (1) allocation of all tools to the microprudential authority, with macroprudential input; and
  - (2) legal allocation of instruments to separate authorities.
- Neither approach eliminates potential disagreements; decisions remain on which tools should be used and when to meet both objectives.
- If all tools are assigned to the microprudential authority, mechanisms must exist for the macroprudential authority to request or recommend activation or recalibration of instruments.
- If toolkits are separated, a conceptual or empirical basis is needed to guide their choice.

*Source: _sdn1305 - Box 1. Pillar 2 of the Basel Capital Framework*

### Annex III). To date, the empirical evidence is limited, but one option might be to assign the

### ALIGNING THE POLICIES

### Financial Cycle
- During Upswing and Peak of the Credit Cycle:
  - Both microprudential and macroprudential perspectives encourage buildup of capital and liquidity buffers when individual institutions increase leverage and relax underwriting standards.
  - Microprudential authority: scrutinizes individual firms’ credit standards and provisioning; intervenes through Pillar 2 mechanisms.
  - Macroprudential authority: monitors—and acts on—indicators that trigger countercyclical capital buffers or other tools affecting credit granting such as LTV ratios.
  - Differences may be limited in early upswing but can diverge approaching the peak—microprudential indicators may appear very positive while systemic risk indicators warn urgently (the “paradox of financial instability”).
  - Use of capital versus provisioning:
    - Capital use raises issues on how to credibly reduce buffers in downturn.
    - Provisioning use raises interactions with accounting standard setters.

- During the Downturn:
  - Microprudential focus: ensure stability of individual firms; options include restricting dividends (capital conservation buffer), raising capital requirements, deleveraging via asset sales, or emphasizing valuation and provisioning.
  - Macroprudential focus: stabilize broader system; avoid excessive deleveraging and collective contraction in lending; may seek to release previously built capital buffers to mitigate systemic contraction.
  - Tension: assessing whether, how far, and how quickly buffers can be allowed to fall without jeopardizing institution stability.
  - Important to consider both formal minimum buffers and additional amounts banks actually hold, which vary over the cycle and can be influenced by supervisory action (Pillar 2).
  - Risks of regulatory forbearance: supervisors may be slow to insist firms recognize losses; incentives for forbearance increase with pressures to release capital buffers.
  - Liquidity measures: relaxing liquidity measures may be less susceptible to market misinterpretation than formal changes in published capital buffers; central bank contingent lines can mitigate macroprudential concerns.

- Mitigating Forbearance and Managing Buffer Release:
  - Greater automaticity (e.g., dynamic provisioning) can mitigate forbearance; dynamic provisioning examples cited: Spain, Bolivia, Colombia, Peru, Uruguay.
  - Insufficient confidence in indicators limits wide use of fully automatic approaches; supervisory judgment remains necessary to avoid undercapitalization.
  - Measured release of capital buffers should depend on:
    - A common assessment of systemic risk.
    - Rigorous and regular diagnostic stress tests on individual firms (example: U.S. Comprehensive Capital Analysis and Review).
  - Possible targeted approaches:
    - Exempt more vulnerable institutions from general capital release.
    - Apply relief only to certain forms of new lending.
    - Formulate objectives in amounts of capital rather than capital ratios (experiences mixed).
    - Encourage shedding of noncore business lines to alleviate capital strains.
  - Communication: credible and joint communication strategy is essential; intention and rationale for releasing buffers should be made public ex ante; focus communication on buffer sizes and resilience rather than on meeting specific supervisory ratios.

- Recovery and Return to an Upswing:
  - Microprudential and macroprudential authorities typically agree on restoring resilience, though timing and intensity may differ.
  - Consistent, coordinated risk assessment and approach fosters alignment of policy actions.

- Turning Points in the Cycle:
  - Identifying cycle turning points is difficult; indicators exist but are not failsafe (IMF, 2011c referenced).
  - Reliable information assists resolving conflicts where macroprudential policymakers lean to release buffers and microprudential supervisors lean to raise them.

### Areas of Strong Fallacies of Composition
- Interconnectedness and Common Exposures:
  - Macroprudential policy identifies risk concentrations, common exposures, linkages, and interdependencies causing contagion and spillovers; may recommend adjustments in microprudential supervision.
  - Interests of both policies are generally aligned in addressing systemic concerns; greater macroprudential credibility increases market responsiveness.

- Treatment of Collateral:
  - Collateral-based credit risk mitigation can increase systemic risk under stress via feedback loops and forced selling.
  - Macroprudential role: identify contagion potential and recommend raising minimum margin requirements in the upswing.
  - Potential friction greater in downturn when microprudential supervisors may resist lowering minimum margins; higher initial minimum margins can reduce tension.

- Liquidity Requirements:
  - Microprudential supervisors may require higher liquidity buffers under stress, prompting banks to sell less liquid assets and risk fire sales.
  - Macroprudential authority should raise such concerns and be involved in decisions; central bank liquidity provision can alleviate macroprudential risks.
  - Post-Liquidity Coverage Ratio agreement view: liquidity buffers should be accessible and used in stress provided there is a credible plan to rebuild them.

### Organizational Mechanisms and Governance Arrangements
- General principles:
  - Close coordination between microprudential and macroprudential authorities promotes aligned policy action while preserving primary objectives.
  - Arrangements should ensure clarity of responsibility and timely action; transparency by the macroprudential authority is essential.

- Institutional Design (examples of architectures):
  - Cross-representation of authorities in decision-making bodies:
    - Applicable when mandates are assigned to separate authorities; facilitates cooperation and information sharing.
    - Macroprudential authority should be involved in microprudential conduct but not in supervisory decisions concerning individual institutions.
  - Coordinating committee structures:
    - Useful when mandates are assigned to multiple agencies; facilitates discussion and mutual cooperation even without formal powers.
  - Assigning both mandates to one institution:
    - Internalizes tensions and ensures a single voice; may reduce transparency unless additional communication mechanisms (speeches, minutes, policy papers) are used.
    - Local circumstances (degree of concentration, legal framework, institutional capacity) inform the choice.
    - Examples of central banks holding both mandates cited: Brazil, Bulgaria, Czech Republic, Malaysia, Singapore, Thailand.
  - Recommendations with “comply or explain” requirement:
    - Public recommendations can apply pressure to act; if reasons for noncompliance are disclosed, responsibility for systemic risk becomes shared.
    - Transparency helps overcome inaction biases; examples of authorities with such powers: United Kingdom, United States, European Systemic Risk Board.

- Policy Hierarchy:
  - Some jurisdictions adopt a formal hierarchy allowing one authority to override the other; others do not.
  - A macroprudential override may be justified by the high cost of financial instability; a microprudential override may reflect supervisors’ closer knowledge of individual institutions.
  - Constraints when considering a macroprudential override:
    - Minimum prudential standards: overrides must not compromise minimum standards applied by microprudential supervisors; routine setting aside of standards is inappropriate.
    - Independence: overrides could affect the independence of the overridden authority; assessment depends on local context and compatibility with supervisors’ discretion over individual banks.
  - Overrides can be comprehensive or constrained, automatic or flexible, or conditional on criteria being met.

- Communication Policy:
  - Embedding communication strategy in a previously articulated policy framework conditions market expectations and avoids misinterpretation.
  - Microprudential and macroprudential authorities should act as part of a jointly coordinated strategy; public recommendations can be part of coherent communication and need not signal disagreement.

### Conclusions
- No single border between microprudential and macroprudential policies fits all countries and circumstances; flexibility in arrangements is required.
- Guiding principles to assist country choices:
  - Clarify respective mandates and roles.
  - Clearly allocate instruments between authorities.
  - Promote open dialogue, shared information and analysis, and mutual understanding.
  - Coordinate communications so authorities “speak with one voice.”
- Tensions are most likely at credit cycle turning points and during downturns; good practices to mitigate tensions include:
  - Ensuring sound and resilient capital levels at cycle peaks.
  - Joint stress tests involving both authorities for common resilience assessments.
  - Considering objectives in amounts of capital rather than capital ratios (experiences mixed).
  - Microprudential supervisor participation in macroprudential formulation and consideration of systemic risk assessments when setting Pillar 2 requirements.
  - Having a sound resolution framework to remove weak institutions without causing contagion.
- Structural or hierarchical measures to address persistent differences may include cross-representation, assignment of both mandates to one institution, or “comply or explain” recommendation powers; introducing a hierarchy can avoid impasses but entails costs in independence.

*Source: IMF staff discussion on aligning microprudential and macroprudential policies (document content provided).*

### ANNEX III.  BASIC ELEMENTS OF MICROPRUDENTIAL AND MACROPRUDENTIAL TOOLKITS

### ANNEX III.  BASIC ELEMENTS OF MICROPRUDENTIAL AND MACROPRUDENTIAL TOOLKITS

### Microprudential policy toolkit
- Requires, at a minimum:
  - A set of risk-based quantitative instruments to establish capital and liquidity requirements for individual institutions;
  - Effective supervisory powers over institutions (e.g., licensing, governance, risk management, sanctions, and powers to take corrective actions).

### Macroprudential policy toolkit
- Authority requires, at a minimum:
  - Prudential instruments constructed to have an impact on the procyclicality of the financial system (e.g., countercyclical capital buffers) or on the contribution of a financial institution to systemic risk (e.g., Systemically Important Financial Institution surcharges);
  - Prudential instruments to address a buildup of systemic risk in specific segments of the market (such as loan-to-value ratios) and instruments aimed at constraining general or specific leverage in nonfinancial sectors (such as debt-to-income ratios);
  - Tools to address systemic liquidity concerns.

### Use of nonprudential instruments and recommendations
- The macroprudential authority, potentially, can use nonprudential tools that influence the incidence of systemic risk and which could be reassigned to macroprudential policy from other public policies, such as:
  - some types of financial transaction taxes/levies,
  - reserve requirements,
  - or capital controls.
- The macroprudential authority should also have the right to issue formal recommendations to activate tools outside its direct control.
- The use of such instruments may reduce the “competition” over some of the (prudential) instruments, which can be especially helpful in the context of addressing liquidity risk by both policies.

### Coordination on additional instruments and limits
- Outside the minimum sets of tools, there is a range of instruments that both policies may want to use permanently or occasionally; in such cases there is need for a mechanism to reach an understanding on their use, respecting pre-agreed principles.
- Measures to address concentration risk or to limit foreign exchange risk might fall into this category, where up to certain limits (e.g., a maximum exposure of 25 percent of an institution’s capital) they would remain a microprudential standard, grounded in the need to avoid excessive risk within any individual institution.

### ANNEX IV — Financial cycle and stylized policy reactions (summary)
- Boom
  - Conditions: Strong credit and asset price growth, higher risks (but seems contained), high returns, over-optimism, and weakening underwriting standards. Expansive leveraging.
  - Microprudential objective and actions:
    - No need to intervene (banks are highly profitable and can replenish capital and liquidity if needed).
    - Intervention in underwriting standards to probe the more marginal and “frothy” deals would be very desirable.
  - Macroprudential objective and actions:
    - Address causes of systemic risk, correcting excessive imbalances and/or strengthen financial system resilience.
    - Build up strong countercyclical capital and liquidity buffers.
- Bust type-I (resulting in no crisis)
  - Conditions: Slowdown in credit growth, stable or falling asset prices, lower returns, no confidence lost.
  - Microprudential objective and actions:
    - Preserve stability of financial institutions.
    - Stabilize (or increase selectively) capital and liquidity ratios; some restrictions on dividends, more scrutiny.
  - Macroprudential objective and actions:
    - Avoid serious deleveraging.
    - Release countercyclical capital and liquidity buffers built.
- Bust type-II (resulting in crisis)
  - Conditions: Deleveraging, substantial fall in asset prices due to fire sales, substantial financial losses, confidence lost.
  - Microprudential objective and actions:
    - Regain confidence in institutions.
    - Increase capital and liquidity ratios because the minimum was wrong compared to risk, extensive scrutiny, and possible forbearance.
  - Macroprudential objective and actions:
    - Regain confidence in financial system and avoid deleveraging.
    - Decrease capital and liquidity buffers—if they are deemed enough—or increase them if they are the source of lack of confidence.
- Recovery
  - Conditions: Cautious re-leveraging, moderate credit and asset price growth.
  - Microprudential objective and actions:
    - Maintain capital and liquidity ratios rebuild during crisis or increase if needed.
    - No need to intervene.

*Source: _sdn1305 - ANNEX III.  BASIC ELEMENTS OF MICROPRUDENTIAL AND MACROPRUDENTIAL TOOLKITS (IMF).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2013/_sdn1305.pdf_