Unifying monetary and macroprudential policy

Julia Giese, Michael McLeay, David Aikman and Sujit Kapadia

Central banks have been using a range of monetary policy and macroprudential tools to maintain monetary and financial stability. But when should monetary versus macroprudential tools be used and how should they be combined? Our recent paper develops a macroeconomic model to answer these questions. We find that two instruments are better than one. Used alone, interest rates can control inflation, but are ineffective for financial stability. Policymakers can do better by also deploying the countercyclical capital buffer, a tool that varies the amount of additional capital banks must set aside. The appropriate combination of tools can vary: both should tighten to counter a joint expansion of credit and activity, but move in opposite directions during an exuberance-driven credit boom.

Financial crises and macroprudential policy

The global financial crisis of 2007–08 highlighted major deficiencies in macrofinancial policy frameworks. With monetary policy focused on stabilising inflation and prudential regulation largely targeted towards the safety of individual banks, major fault lines developed unchecked in the financial system. The development of macroprudential policy frameworks has been one of the major policy responses to the crisis. It is partly thanks to enhanced systemic resilience from macroprudential policy that UK banks were part of the solution rather than part of the problem during the Covid shock.

Many such macroprudential instruments are designed with the waves of optimism and pessimism that characterise financial systems in mind. In particular, there is a strong collective tendency for financial institutions, companies and households to overexpose themselves to risk in the upswing of a credit cycle and to become overly risk-averse in a downswing. In the face of this behaviour, macroprudential instruments such as time-varying capital requirements may help to reduce the risk of financial crises.

The countercyclical capital buffer (CCyB), adopted into the international regulatory framework under Basel III, is an example of a time-varying capital buffer. It enables authorities to adjust banks’ risk-weighted capital ratio as cyclical risks in the system evolve. It is the only macroprudential tool with a concrete, common international implementation framework. And it has already been used in several major countries, including the United Kingdom, France and Germany.

The emergence of the CCyB, and the broader debate around whether monetary policy should ‘lean against the wind’ to tackle systemic risk in the face of credit booms, requires incorporating macroprudential policies into macroeconomic models to guide policy intervention. With this in mind, we exploit earlier work embedding financial crises within a macroeconomic setup by developing a model to assess the CCyB and its interplay with monetary policy.

We use a simple, two-period version of the New Keynesian models typically used for monetary policy analysis. As is normal in these setups, interest rates can be used to stimulate or curtail aggregate spending as needed to ensure output is equal to potential and inflation is at target. In our model, we embed financial stability concerns by allowing for the possibility of a financial crisis occurring in the second time period. We assume that monetary and macroprudential policies can affect the amount of credit in the economy and, through that, GDP and inflation. Our empirical results, which we use to calibrate the model, imply that both policies can also influence probability of financial crises and that crises are more likely during a credit boom, or when capital ratios are low. This creates the potential for trade-offs between monetary and financial stability.

Monetary and financial trade-offs

In the model, the policymaker targets financial stability considerations alongside traditional inflation and output goals. We find that economic outcomes substantially improve when the policymaker can deploy the CCyB to respond to changing financial stability risks rather than relying solely on interest rates. When a policymaker only has one tool available, there is a significant trade-off between financial and monetary stability. This is illustrated in the grey dashed line in Chart 1. The vertical axis shows the quadratic welfare loss from inflation away from target and output away from its potential today (Period 1). The horizontal axis shows the financial instability losses from having a financial crisis tomorrow (Period 2). The trade-off implies that interest rates should not increase much as financial stability risks rise ie there is only a very small amount of ‘leaning against the wind’, because reducing the crisis probability with interest rates alone would require inflation too far from its target. With a second policy option, the CCyB, policymakers can be more active in enhancing financial system resilience against future tail risks. This is because increasing the CCyB can both directly increase the resilience of the banking system and help to limit the extent of the credit boom. And monetary policy can also be loosened if raising the CCyB has an adverse effect on GDP and inflation. Monetary policy cannot perfectly offset the effects of the CCyB, however, as deploying the CCyB also affects the cost of lending, which adversely affects the short-term supply potential of the economy. There is therefore still a trade-off, but this is much reduced, shown by the solid blue line in Chart 1.

Chart 1: Monetary and financial stability trade-offs with 10% annual real credit growth

How policymakers need to adjust these two tools will depend on the specific shocks hitting the economy. In a credit boom driven by over-optimistic exuberance in the financial system, the policies should be moved in opposite directions, with monetary policy loosening when the CCyB tightens to cushion the adverse effects on output (Chart 2, left-hand bars). But it may sometimes be sensible to adjust the instruments in the same direction. For example, when a credit boom goes hand-in-hand with higher demand in the economy, both macroprudential and monetary policies should be tightened (Chart 2, middle bars). Such a scenario may reflect an environment of heightened ‘animal spirits’ manifesting themselves in both the credit and business cycle as, for example, occurred during the late 1980s Lawson boom in the United Kingdom. By contrast, when faced with a reduction in the availability of credit, which leads to tighter credit conditions and lower output and inflation, our model suggests that policymakers should cut both the CCyB and interest rates (Chart 2, right-hand bars). But in setting the CCyB in this scenario, the policymaker faces a difficult tension between supporting current output while not jeopardising the future resilience of the financial system – this arguably corresponds to the challenge faced by policymakers in the immediate aftermath of the global financial crisis.

Chart 2: Optimal responses to different shocks and shock combinations

The model also provides a sense of how much the CCyB might need to be varied over a typical financial cycle, shown in the dark blue line in Chart 3. For example, if credit growth reaches about 12.5% per year – as it did in the UK prior to the global financial crisis – a CCyB of 5% is warranted. And, in a full simulation of the model, the standard deviation of the CCyB is around 2.2 percentage points. This contrasts with a CCyB ceiling of 2.5% in some jurisdictions.

Extensions to the model

For policy to best achieve its goals, both tools must be available and effective. With this in mind, we extend the model in various ways to explore the appropriate design of policy under different potential challenges which policymakers may face.

First, we show that if monetary policy becomes constrained by the effective (zero) lower bound to interest rates, the trade-off faced by policymakers is worse because monetary policy is unable to cushion any negative macroeconomic consequences from tightening the CCyB. As a result, the CCyB should be activated later and less aggressively than is otherwise the case (red dashed line in Chart 3), though this effect may be offset if it is additionally assumed that the costs of financial crises are greater when interest rates are constrained at the effective lower bound. The appropriate setting of the CCyB then depends on how big the costs of financial crises are, with two possibilities, based on estimates by other authors, shown in the green and light blue lines in Chart 3.

Chart 3: Optimal CCyB setting at different rates of credit growth

Second, we explore what happens if tight macroprudential policy applied to banks causes credit growth to migrate to a market-based finance sector which is not subject to the CCyB. This limits the effectiveness of the CCyB relative to monetary policy which ‘gets in all the cracks’ and affects all sectors equally, and so the CCyB should be used less actively in the face of a credit boom.


Taken together, our results highlight that deploying the CCyB improves outcomes significantly relative to when monetary policy is the only tool. This reinforces the rationale for having expanded central-bank toolkits including this policy lever. Our framework also provides a useful quantitative guide for assessing how monetary and macroprudential policies should be set in a unified manner under different economic scenarios. A strength of our modelling framework is that it provides a flexible structure to explore other key issues relating to macroprudential policy design. For example, the model could be extended to highlight the benefits of international co-ordination, or to consider the role of other macroprudential tools.

Julia Giese works in the Bank’s International Surveillance Division, Michael McLeay works in the Bank’s Monetary and Financial Conditions Division, David Aikman is a Professor of Finance and Director of the Qatar Centre for Global Banking and Finance at King’s College London, and Sujit Kapadia is Head of the Market-Based Finance Division at the European Central Bank. Sujit primarily worked on the associated research paper while at the Bank of England.

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