Credit Booms & Credit Busts

There is now a growing consensus among policymakers and academics that a key element to improve safeguards against financial instability is to strengthen the “macroprudential” orientation of regulatory and supervisory frameworks.


According to Dr. Claudio Borio, Head of the Monetary and Economic Department, Bank for International Settlements, one could even say that “we are all macroprudentialists now”. And yet, a decade ago, the term was hardly used. What does it mean?

According to Borio, it denotes a systemic or system-wide orientation of regulatory and supervisory frameworks and their link to the macroeconomy. Essentially, the macroprudential approach has two distinguishing features. It focuses on the financial system as a whole, with the objective of limiting the macroeconomic costs of episodes of financial distress. And it treats aggregate risk as dependent on the collective behaviour of financial institutions (in economic jargon, as partly “endogenous”). This contrasts sharply with how individual agents treat it. They regard asset prices, market/credit conditions and economic activity as independent of their decisions, since, taken individually, they are typically too small to affect them.

In turn, the macroprudential approach is best thought of as consisting of two dimensions.

  • How risk is distributed in the financial system at a given point in time – the “cross-sectional dimension”.
  • How aggregate risk evolves over time – the “time dimension”.

Borio discusses the challenges facing regulators, in particular central bankers, as they seek to navigate through an increasingly complex financial system, made even more fraught by the use of highly unconventional policy measures adopted by the global central banking community in the aftermath of the 2008 Great Financial Crisis. As the run-up to the crisis intensified, Borio was one of the few who presciently recognized the financial fragility building in the system, but he even has recognized that it both measuring system-wide risks and calibrating policy tools remain a significant challenge. For example, what size of capital buffers are needed so that they can be credibly run down without markets insisting on much higher ones at times of potential stress? And how far can their build-up and release be based on rules rather than discretion? Does dynamic provisioning even work (the Spanish experience raises questions). Other challenges are of a more institutional and political economy nature. For instance, it is essential to align authorities’ objectives with control over instruments and the know-how to use them. But in many cases, financial markets are fraught with “Knightean” uncertainty. How can the central banker know which controls to deploy when he (she) is flying blindly? Boris discusses these challenges and many other aspects of central banking in this interview.

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