By John Lipsky

The devastating impact of the global financial crisis created a consensus that pre-crisis financial regulation didn’t take the “big picture” of the system as a whole sufficiently into account and, as a result, supervisors in many markets “missed the forest for the trees.” In other words, they did not take into account the macro-prudential aspects of regulation, which has now become the focus of many authorities.

Consensus regarding the need for macro-prudential regulation is particularly striking—previously this type of regulation had been used relatively little and, at present, there are no agreed standards that can be applied internationally

Thus, each of the countries that have adopted a new structure for the macro-prudential approach following the global crisis – including the United States, the euro area, and the United Kingdom – have created somewhat different forms of organization.  In contrast, traditional micro-prudential regulations – that focus on the status of individual financial institutions and on the conditions prevailing in markets for specific financial instruments – long have been formed through cooperation in international standard-setting bodies. It is not surprising, therefore, that post-crisis reforms in traditional regulation already have made substantial progress, with improved international accords in many sectors being agreed in time for the upcoming summit for the leaders of the Group of Twenty industrialized and emerging market economies (G-20) in Seoul.

Macro-prudential conference in Shanghai

Recognizing the need to reach greater understanding about the potential roads to internationally-consistent and effective macro-prudential regulation—and in an effort to make sure that an appropriately broad range of views are taken into account—earlier this week, the Peoples’ Bank of China hosted an IMF-sponsored conference in Shanghai. The conference brought together central bankers and senior financial officials from Asia and around the world to examine and discuss key issues regarding macro-prudential policies. The conference, titled Macro-Prudential Policies: Asian Perspectives, allowed international participants as well as Fund staff attendees to benefit from the views of key Asian policymakers. And vice versa.

What are the aims?

At the conference, there was wide agreement that the first step in designing macro-prudential policies ought to be a convergence of views regarding the objectives of such policies.

Of course, the most basic objective is straightforward—to prevent a crisis like the one just experienced.

As the recent crisis unfolded, troubles in one institution spread quickly to related institutions as well as across national borders, rapidly and dramatically undermining the complex global web of financial relationships. The crisis thereby demonstrated that examining only the safety and soundness of individual financial institutions was inadequate. Supervisors need to be aware of, and respond to, the build-up in system-wide risks.

Thus, a key challenge is to put in place a regulatory framework that ensures the safety and soundness of the entire financial system, and captures how the economic and financial systems affect each other.

A basic objective of reform is to design and implement policies that will short-circuit cross-institution or cross-market knock-on effects that magnify problems. A second objective is to reduce the likelihood that the system as a whole will experience such knock-on effects. This means seeking to dampen the swings in credit and financial cycles that can produce financial system volatility that can damage both the stability of financial markets and the broader economy.

Means of implementation

A basic practical issue is how macro-prudential policies can be incorporated with the traditional set of policy tools.

One option would be some type of capital surcharge or levy based on the degree of systemic risk created by any specific financial institution. In addition to classic micro-prudential requirements for minimum capital to back individual institutions, the new approach would add a new capital layer that takes into account the systemic importance of an institution. The idea would be to modulate an institution's behavior by making it more costly to pursue those activities that contribute to the build-up of systemic risk.

Other proposals to control systemic risk focus on quantity rather than price-based restrictions, including constraints on size or legal structure or certain activities by financial institutions. In general, however, price-based instruments tend to be more effective because quantity-based instruments may be more subject to gaming and regulatory arbitrage.

Because systemic risks refer not only to institutions but also to markets, new measures should be considered that would make key markets more resilient.

Effective Implementation through Cooperation

Like so many other policy challenges facing modern, globalized markets, a cooperative solution is required. Policymakers need to ensure that macro-prudential policies in differing countries—when designed and implemented—do not contradict or offset each other.

Supervisors also need to focus on cross-border exposures. The effective resolution of large and complex financial institutions that operate in multiple jurisdictions will need to rely on a clearly-designed cross-border framework to reduce moral hazard and support financial stability. On this point, the IMF has proposed a pragmatic approach. We hope a small set of countries that house the most interconnected firms will begin to make progress in this area.

For many countries, an open question remains regarding which agency should design and implement macro-prudential policies – a new global body, a central bank, or the existing micro-prudential regulatory body? In general, participants in the Shanghai conference favored this job being awarded to central banks.

Whatever path is chosen, however, the regulators must be supported by good information gathering, clear mandates and powers, effective tools, and, perhaps most important, cooperation between authorities nationally, and across borders.