Justifying macroprudential policy

Here is a good post on VoxEU, that aim to give a strong conceptual framework for justifying macroprudential policies:

The purpose of macroprudential policy is to reduce ‘systemic risk’ …

It is common to distinguish two key aspects of systemic risk. One is the “time-series dimension”: the procyclicality of the financial system, that manifests in excess risk-taking in booms and excess deleveraging in busts. Another is the ‘cross-sectional dimension’: the risk of contagion due to simultaneous weakness or failure of financial institutions. Accordingly, macroprudential policy it thought of as a set of tools that help reduce these two forms of risk (Borio 2009; Bank of England 2011).

Yet thinking about macroprudential policy by looking solely at these two dimensions of risk is unsatisfactory. First, this view, per se, does not provide a justification for regulatory intervention. For example, is it really desirable to avoid any form of cyclicality and have a zero risk of contagion in the financial system? Second, it is not a priori clear what can macroprudential policy achieve that traditional micro-prudential regulation cannot.

In a recent IMF study (DeNicolò et al. 2012), we aim to tackle these questions. We start by articulating that, as for any form of regulatory intervention, the objective of macroprudential regulation must be to address market failures.

Following the crisis we have heard many commentators demand something should be done.  Those with more of an economics bent could see the value of macroprudential policies, however regulation shouldn’t be based solely on the intuitive feel of economists and analysts – instead we should use the descriptive economic framework to help us understand what issues may exist in the financial industry, and then ask whether policy can help to improve outcomes.

Whether the externalities they have identified are fair is another question, one day I will read the paper and have a think – although I probably won’t post on this.  However, actually looking at regulation through a regulatory framework instead of screaming about large movements in arbitrary aggregates is the appropriate way to think about direct regulation in the financial industry (along with a recognition that we provide these firms implicit insurance) – a point of view that has been missing from some writing about the introduction of any such measures.