Macroprudential Policy: Preventing Systemic Risk and Ensuring Financial Stability

Taryk Bennani, Laurent Clerc, Virginie Coudert, Marine Dujardin and Julien Idier

Couverture du livre : « Politique macroprudentielle : Prévenir le risque systémique et assurer la stabilité Financière »

Ensuring financial stability is essential to the smooth functioning of the economy. In order to avoid crises, appropriate measures need to be taken at an early stage in the interests of prevention. The aim is to mitigate risks and to strengthen the resilience of the financial system when it is still possible to do so. This is the whole purpose of macroprudential policy. "Whereas microprudential supervision seeks to ensure the soundness of institutions taken individually, macroprudential policy aims to prevent systemic risk by targeting the financial system as a whole."

In this book, we take up the research topics of the Financial Stability Directorate and draw on the experience gathered over the past two years in the context of the establishment of macroprudential authorities in France and at European level. We bring all of this together in an educational volume entitled "Politique macroprudentielle : Prévenir le risque systémique et assurer la stabilité Financière", which is aimed at a wide audience of students and professional economists. According to Jean Tirole (Nobel Prize in Economics), who wrote the preface, "This book highlights the procyclicality of our economies and the interaction between the financial sphere and the real economy. It contains a detailed exposition of the prudential reforms and the analytical elements that underpin the rationale for these reforms. It is also very educational."

In the first four chapters, we show how market failures, financial risks, the build-up of imbalances over the course of the financial cycle and financial crises make it necessary to put macroprudential regulations in place.

Chapter 1 is devoted to an analysis of market failures, in particular the phenomena of contagion and information asymmetries.

The systemic dimension of the 2008 financial crisis and its major ramifications opened the way for far‑reaching reforms of the financial system, including the Basel III accord, which, for the first time, introduces a macroprudential component into banking regulation. The framework of macroprudential policy can be summed up in four points: (i) its aim, which is to safeguard financial stability by preventing and mitigating systemic risk; (ii) its scope, which is the financial system taken as a whole; (iii) its instruments, which include concrete measures such as additional capital requirements and lending standards; and (iv) its governance, which comprises a well-identified macroprudential authority with an appropriate mandate and binding instruments.

Chapter 2 identifies the main systemic risks and financial vulnerabilities

As pointed out in our book, "The extremely broad scope of systemic risk calls for oversight of the whole of the financial system, but also for identification of the transmission channels from the financial sector to the real economy." We provide a stylised description of the balance sheets of different financial and non‑financial players: banks, insurance companies, mutual funds, households and firms. All of these sectors are exposed directly or indirectly to financial shocks through contagion effects. This analysis helps the reader gain a better understanding of the interactions between the financial sphere and the real economy.

Chapter 3 describes the incentives for risk-taking during the "boom" phase of the cycle, particularly for banks

The financial cycle can be defined as the alternating periods of "boom" and financial crises ("bust"). "The upward phase of the cycle leads to a build-up of debt in the economy, which generates a steady rise in credit and market risk." Chapter 3 sets out the incentives for risk-taking during the "boom" phase, especially for banks – due to the "too big to fail" problem – and for asset managers, due to their mode of remuneration. Lower risk aversion goes hand-in-hand with rising asset prices and growing debt. A whole range of factors combine to amplify the financial cycle and make the downturn even more costly for the economy.

Chapter 4 looks at the different types of financial crisis

This chapter looks at the different types of financial crisis – exchange rate, balance of payments, sovereign debt and systemic banking crises – showing that they have a common feature of generally going through a phase in which imbalances build up. The 2008 crisis is no exception to this rule. The financial accelerator mechanism, together with direct and indirect contagion effects, amplifies the intensity of financial crises and their repercussions on the real economy. The resulting economic costs are extremely high, which fully justifies putting preventive measures in place.

While preventing crises is important, the choice remains of the instruments to be used and the appropriate macroprudential framework to be put in place. The following five chapters are devoted to these questions.

Chapter 5 presents the operational tools utilised to detect risks

This chapter presents the operational tools utilised to detect risks based on the advanced indicators traditionally scrutinised by macroprudential authorities. We show how certain visual techniques, such as "heat maps", make it possible to summarise the great variety of risks to which financial systems are subject. We however warn against any mechanical overuse of these statistical analyses, which ultimately are merely decision-making tools. Indeed, the financial system changes quickly and undergoes constant transformations in the face of which any statistical or historical analysis quickly reaches its limits.

Chapter 6 sets out the macroprudential instruments

"An instrument is called macroprudential when it aims specifically to prevent or mitigate systemic risk." This chapter sets out the macroprudential instruments available, such as additional capital requirements, liquidity ratios, lending constraints and debt ceilings. Some instruments are harmonised at international level, such as the countercyclical capital buffer that came out of Basel III and the buffers for institutions of global systemic importance; others are designed only at national level and may vary between countries.

Chapter 7 describes the main methods and analytical tools related to macroprudential policy

Just as monetary policy has evolved dedicated macroeconomic models and analytical frameworks, we are currently seeing major analytical developments in macroprudential policy. Chapter 7 sets out the main methods and activation and calibration tools of macroprudential instruments. At the moment, in many countries formal analyses of leading crisis indicators are widely used to assess the probability of a future financial crisis. The calibration follows a number of stages: the drawing-up of scenarios, assessment of the measures' costs and benefits, and use of stress tests and analyses of contagion and feedback to the real economy. Stress tests are also among the tools utilised by macroprudential analysis: they have been developed over the past few years to complement the solely microprudential approaches that demonstrated their inadequacy in preventing the 2008 crisis.

Chapter 8 examines the interactions and potential conflicts of objectives between macroprudential and other economic policies

Macroprudential policy has a cross-cutting dimension. In chapter 8, we analyse its interactions and potential conflicts of objectives with other economic policies: (i) microprudential policy; (ii) monetary policy; and (iii) fiscal policy, with which macroprudential policy has a number of similarities due to the quasi-fiscal nature of some measures and its countercyclical approach. Indeed, "the development of macroprudential policies in the post-crisis period has taken place in a context in which the ability to use fiscal policy to stimulate economic activity has been very greatly constrained by the need to curb public deficits."

The last chapter provides a description of the different modes of institutional organisation for macroprudential policy

The last chapter provides a detailed description of the different modes of institutional organisation for macroprudential policy. The issues of the remit and power of macroprudential authorities are analysed here. The frameworks adopted in practice for macroprudential governance are presented by means of the following three examples: France, Europe and internationally. In this respect, it is important to stress that the more measures are coordinated internationally, the more effective macroprudential policy is, on account of its cross-border effects.

This is the first book devoted to macroprudential policy in France. We believe that this policy should constitute a distinct component in the training of economists, especially since the interactions between the financial sphere and the real economy will only keep on growing.

Portraits des auteurs

The authors:

• Taryk Bennani: an engineer by training, a graduate of the École Supérieure des Sciences Économiques et Commerciales (ESSEC) and Stanford University, and a specialist in issues of financial stability, Taryk Bennani is the head of the Macroprudential Policy Division at the Banque de France.
• Laurent Clerc has been the Director of Financial Stability at the Banque de France since May 2010. His research has been published in international peer-reviewed journals such as the Journal of International Economics, the Journal of Banking and Finance and the International Journal of Central Banking
• Virginie Coudert is a scientific advisor in the Financial Stability Directorate. She has a PhD in economics from Paris 1 University Panthéon-Sorbonne, and specialises in the monetary and financial fields.
• Marine Dujardin is an advisor in the Banque de France Governor's Private Office, having been an economist in the Macroprudential Policy Division. She is a graduate of the École normale supérieure de Cachan and of Sciences Po Paris.
• Julien Idier is currently co-head of the division dedicated to Macroprudential Policy in the DGSO. He has a PhD in economics from Paris 1 University Panthéon-Sorbonne.