Angus Foulis and Jon Bridges
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 formalised – 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 summarised in an ad hoc loss function:
where
The greater resilience induced by setting a higher CCyB is likely to come at the cost of lower levels of credit, presenting a potential trade-off for the policymaker. For a thorough analysis of how changes in capital requirements affect bank behaviour see Bahaj and Malherbe 2016. In this post, we consider a very simple ad hoc transmission mechanism for the CCyB:
where
This completes our toy model. Raising the CCyB now has two effects. First, it boosts resilience directly, reducing expected tail losses. Second, it indirectly reduces tail losses, by dampening credit risks. But the trade-off is that raising the CCyB too far could leave credit too far below its equilibrium path (
Static Case
When the policymaker only sets the CCyB for one period, the macroprudential balancing act can be illustrated in a diagram. The blue curves in Figure 1 depict the preferences of the policymaker, with each “indifference” curve showing the combinations of
In this illustrative framework, the policymaker would optimally choose the CCyB so that their preference to substitute between
Despite the stylised setting, this conveys some useful generic principles for macroprudential strategy. First, some insurance should be bought against tail events. Second, policy should be countercyclical – where there are positive shocks (
To illustrate the importance of the transmission mechanism, consider a case where the CCyB has little impact on credit conditions. This is captured by a lower level of ω, which in Figure 1 has the impact of rotating the red line clockwise. In response to this reduced cost of resilience, the CCyB would be raised in this framework, resulting in a new equilibrium
Similarly, the CCyB would be raised in this framework when there is a positive shock to credit
This simple CCyB reaction function also responds to the severity of tail outcomes, for example given a change in the effectiveness of resolution regimes. A greater exogenous tail severity would be captured in a higher
Dynamic Case
In practice, the setting of the CCyB is dynamic and costs and benefits must be balanced through time. We need to go beyond comparative statics. To capture this, an extension is considered which minimises the sum of expected future losses, with discount factor
In the dynamic setting
Finally, the model can also be extended to help explore whether macroprudential policy should respond in anticipation of future risks. Suppose at time there is news that the exogenous tail event severity
The parameter
We are a long way from a definitive model of the macroprudential balancing act and judgement will always be a key accompaniment in the real world. But a simple framework like the one presented in this post can uncover key questions for future research. For example, it highlights the importance of understanding whether bank lending is affected predominantly by the required level of capital per se or by changes in capital requirements. The model also throws up more general questions, like what is the right measure of financial conditions “B” and what is its equilibrium path
Angus Foulis and Jon Bridges both work in the Bank’s Macroprudential Strategy and Support Division.
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