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Symposium 2011

Proposal - Macroprudential policy must be coordinated between countries in order to avoid inaction

The Challenge

The global financial crisis has revealed how systemic risk in the banking system can lead to huge economic downturns. Many of the problems leading to the crisis have been discussed and many suspects h ...

The global financial crisis has revealed how systemic risk in the banking system can lead to huge economic downturns. Many of the problems leading to the crisis have been discussed and many suspects have been identified (including investment banks, central banks, rating agencies, regulators and the economics profession).

I argue that in the absence of strong regional or international coordination of national macroprudential policies, the combination of these policies will be dangerously weak in preventing the future global financial crises.

There are two main reasons for my prediction. First, there is a well known problem of "taking the punch bowl away in the middle of the party", which makes the containment of financial excesses politically difficult at a national level. Second, there is an additional "first-mover disadvantage problem", which aggravates the "punch bowl problem" in an integrated financial market.

The first-mover disadvantage problem is caused by an inability of national policymakers to internalise the positive cross-border externalities that a successful national macroprudential policy entails. In a world of integrated financial markets, a reduction of financial risk in an individual country contributes to financial stability in other countries. Conversely, a national inaction entails negative externalities, as financial crises are more likely to spread to other countries in the absence of decisive national policy measures.

To grasp the nature of the first-mover disadvantage problem, consider the decision-making problem of a national macroprudential authority in a strong upturn of an international financial cycle, during which asset prices grow at the fast pace, leverage increases excessively and the pricing of risk declines at the same time in many countries. A country which is tightening its macroprudential policy – say, a countercyclical capital buffer or a loan-to-value (LTV) ratio requirements for domestic lending – in isolation would internalise only some of the financial stability benefits of this tightening while bearing all the perceived costs in terms of reduced competitiveness of the national financial industry.

This may lead to a first-mover disadvantage problem: no country is willing to be the first to tighten its national macroprudential policy unless it knows that other countries are committed to doing the same. This, at worst, may lead to a bad equilibrium, in which global macroprudential policies become overly passive.


What can we do to avoid this bad equilibrium? I have four suggestions

First, to decrease the political pressure not to take action, we should try to develop the rules-based macroprudential policy instruments (like rules on loan loss provisions or tax-based macroprudential tools) as much as possible.

Second, national policymakers need robust enough mandates, independence and legitimacy to make their macroprudential policy decisions, which are almost always highly unpopular.

Third, to reduce the first-mover disadvantage problem, we need strong international coordination of macroprudential policies. In the EU, the European Systemic Risk Board should take that coordinating role.

Fourth, to avoid cross-border regulatory arbitrage, we should promote full international reciprocity of national macroprudential regulations . That is, national macroprudential regulations (eg. the countercyclical capital buffer) should apply in the same way to all credit exposures located in that jurisdiction irrespective of whether these exposures are held by domestic or foreign financial institutions.

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