A Macroprudential Approach to Financial Regulation

Abstract

Many observers have argued that the regulatory framework in place prior to the global financial crisis was deficient because it was largely "microprudential" in nature. A microprudential approach is one in which regulation is partial equilibrium in its conception and aimed at preventing the costly failure of individual financial institutions. By contrast, a "macroprudential" approach recognizes the importance of general equilibrium effects, and seeks to safeguard the financial system as a whole. In the aftermath of the crisis, there seems to be agreement among both academics and policymakers that financial regulation needs to move in a macroprudential direction. In this paper, we offer a detailed vision for how a macroprudential regime might be designed. Our prescriptions follow from a specific theory of how modern financial crises unfold and why both an unregulated financial system, as well as one based on capital rules that only apply to traditional banks, is likely to be fragile. We begin by identifying the key market failures at work: why individual financial firms, acting in their own interests, deviate from what a social planner would have them do. Next, we discuss a number of concrete steps to remedy these market failures. We conclude the paper by comparing our proposals to recent regulatory reforms in the United States and to proposed global banking reforms.

Financial Stability in the Aftermath of the 'Great Recession'

“…A number of writers have argued that the regulatory framework was problematic because of that deficiency (see, for example, Hansen et al, 2011, and a number of additional references therein). A macroprudential approach is therefore of enormous importance.…”

“…It is a 'systemwide oversight' approach, and as such it 'would broaden the mandate of regulators and supervisors to encompass consideration of potential systemic risks and weaknesses as well' (Bernanke, 2008). In terms of the macroprudential tools, Hansen et al (2011) discuss six sets of such tools: time-varying capital requirements; higher-quality capital; corrective action targeted at capital as opposed to capital ratios; contingent capital; the regulation of debt maturity; and the regulation of the shadow banking system. They offer empirical evidence to conclude that macroprudential regulation is of paramount importance.…”

Adjusting denominators of capital ratios: Evidence from Japanese banks

“…The dynamic adjustment of regulatory capital is a topic of significant research interest to academics. In addition, it is an important issue to financial regulators worldwide (Hanson et al (2011)). 1 In particular, since Basel III proposed the new time-varying regulation, it is important to evaluate the speed of capital ratio adjustment and construct a method to measure it from a policy perspective.…”

Managing systemic risk in The Netherlands

“…Nonetheless, it is possible that although banks look healthy at the individual level, they may still present threats to the stability of the system, through interbank exposures. Therefore, there is an argument for banking regulations to be designed from a systemic perspective in order to improve the stability of the financial system (Crockett, 2000, Borio, 2003and Hanson, Kashyap, and Stein, 2010). We investigate one possible regulatory framework, macroprudential capital requirements, which requires each bank to hold a buffer of capital that is consistent to the bank's contribution to the total risk of the system (Adrian andBrunnermeier, 2008 andAcharya, Pedersen, Philippon, andRichardson, 2010).…”