Macropru is new. Although many countries have now used macroprudential tools, there is no well-established guidebook to help policymakers develop their reaction functions. The principles behind macroprudential strategy are still being explored, with recent speeches by Alex Brazier, Vitor Constancio, and a review by the IMF,FSB & BIS. This post illustrates how the balancing act at the heart of the macroprudential debate can be formalized – it is a call to arms for further research, rather than the definitive guide.
The overarching objective of macroprudential policy is to create a financial system that fosters rather than disrupts the growth path of the economy. That applies both to stressed situations and during calmer times. The result is a balancing act, weighing up the benefits of building greater resilience against the cost of any sand in the wheels of credit provision. This post presents a simple model of that trade-off through the lens of the countercyclical capital buffer (CCyB). The CCyB is a macroprudential tool which enables policymakers to vary banks’ required capital buffers through time, as risks from the financial cycle ebb and flow. We explore what might influence how it is used.
Economic shocks are unavoidable, but undue amplification of those shocks through the financial system can be avoided. The risk of amplification is likely to get bigger as indebtedness grows and smaller when banks are more resilient – for example, because of a higher CCyB. Guided by crisis mitigation alone, ever more capital and ever lower credit might seem desirable. But productive finance also supports economic activity, so restricting it too much is costly.
The result is a balancing act between resilience and sustainable credit, which can be summarized in an ad hoc loss function.