A financial trader in Seoul, South Korea: both emerging and advanced economies use policies to reduce risk to the financial system as whole (photo: Park Jin Hee/Xinhua Press/Corbis)
FINANCIAL POLICY
To help countries design and implement these policies, known as macroprudential policy, the International Monetary Fund has developed a new framework to guide countries as they choose approaches best suited to their needs.
“This framework is the culmination of a multi-year policy development effort,” said José Viñals, Financial Counsellor to the IMF’s Managing Director. “It is a milestone for the IMF and its member countries because it will help them develop essential crisis-prevention tools.”
The policies can include measures such as loan-to-value ratios to stop excessive mortgage borrowing, or additional capital to increase banks’ resilience to economic shocks.
Countries can use the policies to help rein-in excessive lending when the economy is heating up, and then relax the policies in response to adverse shocks. Low interest rates in some advanced economies may lead to more risk taking by financial institutions and capital flows into emerging markets, and macroprudential policies can help address the resulting risks.
The IMF said effective macroprudential policy requires the ability to assess risks to the financial system as a whole, assemble and deploy the right tools to reduce such risk, adjust the scope of financial regulations, and close data and information gaps.
The new policy also requires strong institutions to manage the policies, including a dedicated macroprudential authority – a single institution or a policy committee – with a clearly defined mandate. Although countries’ arrangements may vary, the IMF analysis suggests that central banks should play a key role in conducting macroprudential policy.
Detect and contain risks before they turn into a crisis
The crisis has exposed the costs of financial instability at the national and global levels. Detecting and containing the build-up of such risks requires dedicated macroprudential policies in both advanced and emerging economies.
While establishing a well-functioning macroprudential policy remains a work in progress, there is growing international experience in this area. The new analysis from the IMF brings together—and distills— valuable lessons for policymakers.
Don’t leave home without a roadmap
Countries should clearly define the goals and scope of macroprudential policy at the national level. Macroprudential policy should aim to contain vulnerabilities in a country’s financial system. And it should not be overburdened with objectives for which it may be unsuited.
For example, by limiting the excessive use of borrowed funds, or leverage, macroprudential policy increases the system’s resilience to sharp asset price declines and other economic shocks. Such use of macroprudential policy may, at times, also have a welcome side effect in cooling aggregate demand, but these side-effects should not become the main objective.
Monetary and fiscal policies have a role to play
To achieve the goal of a stable financial system, monetary and fiscal polices must complement macroprudential policies, and policymakers should support them with strong supervision and enforcement.
Effective macroprudential policy can also help these other policies achieve their respective goals. For instance, if countries apply macroprudential policy tools, such as capital buffers, and limits on loan-to-value ratios, then the macroprudential authority will be better able to contain potential undesired side-effects of monetary policy on financial stability.
This can help alleviate conflicts in the pursuit of monetary policy by reducing the need for monetary policy to “lean against” adverse financial developments. Likewise, those who oversee and supervise individual financial institutions are more likely to achieve their objectives in an environment where macroprudential policy reduces the risk of a crisis.
The right tools for the job
While the new framework establishes principles in several key areas, more work remains to make macroprudential policy fully operational. For instance, policymakers should improve the collection of data and information. Lack of data can hinder an assessment of the severity of an identified risk, thereby creating uncertainty about the need for a macroprudential response.
Similarly, policymakers may not have access to an appropriately broad set of macroprudential tools. A range of tools, including broad-based capital buffers, more targeted “sectoral” tools such as loan-to-value limits, and liquidity-based tools may be necessary for the effective conduct of macroprudential policy.
Moreover, strong institutional and governance frameworks are essential for the effective conduct of macroprudential policy. They can benefit from a clearly articulated objective, an appropriate strength of powers, and clear accountability.
For instance, the macroprudential authority should have the power to recommend action by other policymakers. The latter would be required to either comply with the recommendation, or to publicly explain why no action was taken. The central bank needs to play an important role, and it is often in the lead both in the assessment of risks and the formulation of the appropriate policy response, even if political economy and traditions drive the precise arrangements in a given country.
The global dimension and role of the IMF
Cross-border implications of macroprudential policies call for international coordination. Multilateral issues can arise from a lack of forceful macroprudential action in one country that can increase the likelihood of crises, creating a negative impact on other countries.
National policies to contain risks from a rapid build-up of domestic credit can also lead to an increase in the provision of cross-border credit, thus compromising the effectiveness of actions taken at the national level. These issues can be addressed through a combination of international standards, regional cooperation, and surveillance that encourages the appropriate policy action.
The IMF can play a key role, in collaboration with standard setters and country officials, to help ensure the effective use of macroprudential policy.
Over the next few years, the IMF will use the new framework to step up its dialogue with national officials on macroprudential policies, including through its bilateral surveillance, financial sector assessment programs and technical assistance. The goals are to encourage strong institutional underpinnings for macroprudential policy, help analyze evolving risks, and advise on policy responses that appropriately reflect country-specific circumstances. By pursuing these goals, the IMF and its member countries can help ensure lasting domestic and global financial stability.
