A quick guide to macroprudential policies
24 May 2017
What does macroprudential mean?
The prefix macro indicates that the policies or actions relate to the whole or significant parts of the financial system rather than individual financial institutions. Supervisory or regulatory policies for individual financial institutions, by contrast, are known as microprudential policies.
Prudence is another word for caution involving forethought, and prudential policies relate to actions that promote sound practices and limit risk-taking. So macroprudential policies should help ensure that everyone takes a cautious approach to risks that could become systemic, that is, risks related to the whole financial sphere.
What are macroprudential policies and why do we have them?
Macroprudential authorities monitor the financial system and identify risks and vulnerabilities. Policies addressing such risks and vulnerabilities can be put in place and limit them from building up further and spreading across the financial system.
In other words, the policies can be put in place to prevent risks from affecting the financial system more broadly, or becoming systemic.
If systemic risk were to materialise, the provision of necessary financial products and services by the financial system could be impaired, even to a point where economic growth and people’s well-being was significantly affected.
These effects were seen in the financial crisis which began in 2007, with recessions affecting a number of countries in Europe and many banks needing to be shored up.
So, in essence macroprudential policies are there to promote financial stability. If we have a stable and sound financial system we are better placed to withstand shocks and avoid the worst effects of financial crises.
Examples of risks that could lead to systemic risk
- The building-up of asset price bubbles. When the prices of assets, such as houses, increase far beyond their intrinsic value, the risk of a sudden fall in those prices creates dangers
- Excessive risk-taking by banks
- Excessive corporate or household debt
What action do the authorities take based on these policies?
The authorities (often, central banks) can take a range of actions designed to directly address the risk.
For example, financial institutions (typically, banks) may be required to set aside extra capital – to deal with unforeseen events and shocks – and these capital buffers may vary over time and be greater for some types of institution.
This might especially be the case for institutions that are systemically important, i.e. their failure would cause a significant ripple effect across the financial system.
Alternatively, macroprudential policies may place restrictions on financial institutions’ activities by, for example, setting mortgage lending conditions.
For example, a limit could be placed on the amount house-buyers can borrow compared with the cost of a house or their income. These caps can be used to cool a housing market with rapidly increasing house prices and associated mortgage debts.
Who are the macroprudential authorities in the EU?
- The European Central Bank
- The European Systemic Risk Board
- The national designated authorities – typically central banks or financial supervisory authorities – of the 28 Member States.
At a glance: what is the financial system?
A web of interactions
The financial system features a complex web of dependencies and interactions between different actors.
Banks and insurance companies
Banks and insurance companies act as intermediaries by directing funds from those willing to lend or invest to those who want to borrow.
Financial markets such as bond and money markets also directly bring together lenders and borrowers.
Meanwhile, payment and securities settlement systems, the plumbing of financial markets, ensure the safe flow of money and financial assets.