• Friday, June 21, 2024
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The dynamic interplay between monetary and macroprudential policy

Brief reflections on the economy and monetary policy

One of the fascinating aspects of writing about banking regulation is the remarkable realisation that conventions are undergoing a remarkable transformation right before our very eyes. This realisation often ignites a sense of surprise, prompting a natural inclination to explore deeper into the subject.

As I penned this piece, I found myself precisely experiencing the emotions I described earlier. I am immensely grateful to the editor for providing me with this platform to share my thoughts. However, let’s set aside these sentiments for now and shift our focus to the subject at hand.

Let me start by saying that banking conversations are consistently centred around the ongoing debate regarding the use of monetary policy to control inflation and the confidence placed in employing macroprudential tools to mitigate excessive risks. These topics remain at the forefront of discussions in the sector and continue to captivate the attention of industry experts and stakeholders alike.

The background to my article today stems from the series of significant banking failures that occurred in Europe during the spring of 2023, involving prominent regional banks such as Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank. In this endeavour, my objective is to highlight the merits of understanding key concepts and how they can effectively address the risks posed to financial stability.

To achieve this objective, I will begin by outlining the fundamental principles of “macro-pru” (a common term used to refer to macroprudential policy) that serve as the foundation for effective macroprudential policymaking. I will then briefly set out some crucial aspects of fostering effective collaboration between monetary and macroprudential policies.

And I will conclude by providing insights into the practical implementation of macroprudential approaches and the specific recommendations associated with them. Through that, I hope to set out some strategies necessary for successful macroprudential policymaking.

Interactions between monetary and macroprudential policies

The most basic and straightforward question that arises is: What do these concepts mean and imply?

Monetary policy primarily revolves around the actions taken by central banks to regulate the money supply, interest rates, and credit conditions in an economy. Its core objective is to achieve price stability and promote sustainable economic growth. Central banks use various tools, such as adjusting interest rates, open market operations, and reserve requirements, to influence borrowing costs, control inflation, and stimulate or moderate economic activity.

On the other hand, macroprudential policies, by definition, refer to financial policies that are specifically formulated to safeguard the stability of the financial system. The primary objective of these policies is to prevent substantial disruptions to vital financial services, which play a critical role in fostering stable economic growth. Their purpose is to proactively identify and address risks within the financial system, thereby minimising the likelihood of systemic crises and ensuring the smooth functioning of key financial institutions and services.

While monetary policy primarily targets price stability and economic growth, macroprudential policy concentrates on financial system stability and mitigating systemic risks. They work in tandem, with monetary policy providing a broader economic framework and macroprudential policy focusing on the stability and resilience of the financial system. Cooperation and coordination between these policies are crucial to ensure a balanced and robust financial environment.

Take the case of Nigeria. Our banking history to date, serves as a vivid reminder that the country has experienced a series of banking failures and volatility in its financial markets. These challenges have been present not too long ago, underscoring the importance of understanding the past to navigate the present and shape a more stable and resilient financial future.

As a response to these challenges, Nigeria implemented policy reforms that have significantly impacted the banking industry. Measures such as the consolidation of the banking sector, the establishment of an expanded discount window, and the creation of the Asset Management Company (AMCON) were key components of the central bank’s approach.

These policy reforms were instrumental in ensuring a sustained period of positive performance thus far, aiming to mitigate the risk of economic disruptions in the aftermath of the global financial crisis. The implementation of these measures demonstrates a proactive stance towards safeguarding the stability of the Nigerian economy and its financial sector.

However, I am firmly of the opinion that there is still much work to be done in this aspect. This leads us to question how we can further diminish the likelihood of systemic crises, enhance the smooth functioning of vital financial institutions, and achieve the dual objectives of price stability and sustainable economic growth.

Furthermore, it serves as a compelling reminder that despite the apparent resolution of issues in the financial sector, as indicated by robust recoveries, we must not make the mistake of assuming that systematic macroeconomic crises in banking and finance will not resurface automatically. Therefore, it is imperative that we take proactive measures to explore supplementary strategies and measures that can reinforce the resilience of the financial system and effectively address potential vulnerabilities.

In light of this perspective, it is crucial to acknowledge that although monetary policy is a valuable tool, its effects can be somewhat imprecise, often involving interest rate adjustments. hese measures may inadvertently lead to undesirable consequences such as increased unemployment and the potential risk of deflation. In contrast to micro-prudential regulation, which focuses on ensuring the safety of individual banks, what is truly essential are macroprudential policies that incorporate targeted rules to mitigate potential instabilities within the financial system.

In simpler terms, macroprudential policies aim to address risks arising from the interactions between individual institutions, the financial system and the real economy.

So, what does it look like in practice?

The significance of macro-prudential policies

From the outset, it has been evident that there is an intrinsic relationship between monetary and macroprudential policy actions, and both policies are of equal relevance and necessity. Yet, there is no doubt that macroprudential policy is committed to adopting a comprehensive approach to identifying and managing potential risks and regulations that can significantly affect the financial system.

This recognition underscores the unquestionable economic importance of macroprudential policies and their pivotal role in safeguarding the sector. Moreover, it appears likely to me that macroprudential stimulus may be required at some point to proactively prevent risks within the sector from escalating into more pernicious outcomes.

To provide a concise illustration, consider the interactions between borrowers and individual institutions. Often, these interactions demonstrate a tendency to prioritise personal incentives and benefits, overlooking the broader social implications of their choices.

An apt example can be observed when borrowers pursue sizable mortgages based on expectations of rising property prices, while lenders, motivated by the prospect of higher profits, readily grant such loans. However, this dynamic can result in repayment challenges and, in the event of a potential economic downturn, create ripple effects that negatively affect the entire economy.

To address such situations, macroprudential tools assume a pivotal role in aligning the interests of individuals and institutions with broader societal costs and benefits. As I will discuss later, these rules aim to prevent customers from overextending themselves financially and ensure that financial institutions engage in responsible lending practices. By doing so, macroprudential rules contribute to the promotion of a resilient financial system capable of withstanding shocks and safeguarding against detrimental outcomes.

To clarify, while it is technically possible to utilise monetary policy in addressing system-wide financial risks, as mentioned earlier, macroprudential tools offer a more effective approach as the initial line of defence, aiming to mitigate the impact on the broader economy.

Recent events – the failure of several banks in the US and in Switzerland, raised important questions about the importance of macroprudential measures. As such, it would be beneficial to outline a few macroprudential tools and their potential applications. Please note that the following list is not exhaustive, as there are numerous policy measures often implemented by regulatory authorities to manage systemic risks and foster financial stability.

Given space limitations, I will provide a concise overview of a few fundamental examples of macroprudential tools, which may appear obscure but hold significant importance.

First, capital buffers are a remarkable instrument available to regulators, providing a robust defence against financial instability. These buffers oblige financial institutions, like banks, to maintain capital levels surpassing the minimum regulatory standards. Such a measure empowers banks to establish a personalised safety net of capital, ensuring they have a sturdy cushion to rely on when confronted with challenging economic conditions. In essence, capital buffers act as a shield, fortifying banks against potential losses and providing them with the resilience needed to weather turbulent times.

We can trace the origins of stricter capital requirements back to the aftermath of the global financial crisis in 2008. In response to the meltdown, regulatory authorities introduced measures like the Basel III framework, aimed at enhancing the resilience of banks and mitigating future risks. These regulations have proved instrumental in fortifying the banking sector and improving its ability to weather economic storms.

To curb the risk of excessive borrowing and prevent asset bubbles, let me come on to the mix of employing Loan-to-Value (LTV) and Debt-to-Income (DTI) limits. These limits establish caps on the maximum loan-to-value ratio or debt-to-income ratio that borrowers can obtain. For example, when the real estate market experiences rapid price appreciation, authorities may tighten LTV limits. By doing so, they prevent borrowers from taking on mortgage debt that exceeds the value of the property, reducing the risk of a housing bubble.

In conjunction with capital buffers and borrowing limits, the significance of liquidity requirements in preserving financial stability cannot be overstated. From my perspective, these requirements hold great promise. They effectively mandate that financial institutions maintain an ample supply of liquid assets to navigate periods of funding stress and market volatility.

Banks are obligated to possess a specific level of liquid assets, such as cash or high-quality government securities, which enable them to fulfil their short-term obligations, even in the face of turbulent conditions. Adhering to these requirements diminishes the risk of liquidity crises, thus contributing to the overall stability of the financial system.

There is a prevailing notion that it is better to prepare for uncertainty rather than wait for uncertainty to catch up with you. Stress testing is another indispensable tool in the macroprudential toolkit. I use the word ‘indispensable’ deliberately. Today, we have regulators subjecting banks to simulated stress events, such as economic recessions or market shocks, to assess their resilience.

And this is perfectly reasonable and pragmatic. The ability to evaluate banks’ ability to withstand adverse scenarios, enables regulators to identify vulnerabilities and take necessary actions. For instance, they may require banks to raise additional capital or adjust risk management practices, thus reinforcing the resilience of the financial system. This is an important lesson as the central bank must do what is necessary to ensure financial stability.

Finally, let me turn to the prospect of systemic risks. Looking back at all that has happened in recent years, the global economy has been hit by a series of external shocks. Certain banks, known as systemically important banks, pose a potential threat to the overall financial system due to their size, interconnectedness, or importance. The concept of systemic risk holds significant importance as it revolves around the fear that the failure of a major bank, which holds substantial deposits, could trigger a widespread loss of confidence, potentially resulting in a bank run. This is something that regulators would not like to see. Therefore, it comes as no surprise that authorities are diligently considering measures to mitigate the likelihood of such scenarios.

Read also: Monetary policy: Bismarck Rewane calls for institutional reform

To mitigate such risks, regulators impose systemic risk buffers. This is a good thing in many ways as systemic risk buffers require systemically important banks to hold additional capital as a safeguard against potential risks stemming from their systemic importance. And in my view, more likely than not, this measure aims to reduce the risk of disorderly failures and the contagion effects that could spread throughout the financial system.

Let me finish with a few words. I find that incorporating a targeted macroprudential tool offers greater benefits compared to relying exclusively on monetary policy to tackle risks to domestic financial stability. Similarly, I strongly advocate for the use of efficient and effective international macroprudential tools to effectively tackle risks to financial stability. It is evident that there is substantial room for improvement in monitoring, designing, and implementing global macroprudential tools, which I believe can effectively mitigate the potential emergence of significant negative spillover effects.

Omeihe is the Chair of African Studies at the British Academy of Management and serves as a Senior Economic Advisor at Marcel. He holds the position of Associate Professor at the University of the West of Scotland.