[1] But only in the early 2000s—after two decades of recurrent financial crises in industrial and, most often, emerging market countries[2]—did the macroprudential approach to the regulatory and supervisory framework become increasingly promoted, especially by authorities of the Bank for International Settlements.
The main argument is that in its role of lender of last resort and provider of deposit insurance, the government alters the incentives of banks to undertake risks.
As argued by Greenwald and Stiglitz (1986),[6] when there are distortions in the economy (such as incomplete markets or imperfect information),[7] policy intervention can make everyone better off in a Pareto efficiency sense.
An International Monetary Fund policy study argues that risk externalities between financial institutions and from them to the real economy are market failures that justify macroprudential regulation.
[9] In the mood swings paradigm, animal spirits (Keynes) critically influence the behavior of financial institutions' managers, causing excess of optimism in good times and sudden risk retrenchment on the way down.
Additionally, other sophisticated financial tools and models have been developed to assess the interconnectedness across intermediaries (such as CoVaR),[11] and each institution's contribution to systemic risk (identified as "Marginal Expected Shortfall" in Acharya et al., 2011).
Most of these instruments are aimed to prevent the procyclicality of the financial system on the asset and liability sides, such as: The following tools serve the same purpose, but additional specific functions have been attributed to them, as noted below: To prevent the accumulation of excessive short-term debt: In addition, different types of contingent capital instruments (e.g., "contingent convertibles" and "capital insurance") have been proposed to facilitate bank's recapitalization in a crisis event.).
Popov and Smets (2012)[22] thus recommend that macroprudential tools be employed more forcefully during costly booms driven by overborrowing, targeting the sources of externalities but preserving the positive contribution of financial markets to growth.
In analyzing the costs of higher capital requirements implied by a macroprudential approach, Hanson et al. (2011)[23] report that the long-run effects on loan rates for borrowers should be quantitatively small.
Jeanne and Korinek (2011),[25] for instance, show that in a model with externalities of crises that occur under financial liberalization, well-designed macroprudential regulation both reduces crisis risk and increases long-run growth as it mitigates the cycles of boom and bust.
This is well reflected by the organizational structure of institutions such as the Financial Stability Oversight Council and European Systemic Risk Board, where central bankers have a decisive participation.
The question of whether monetary policy should directly counter financial imbalances remains more controversial, although it has indeed been proposed as a tentative supplementary tool for addressing asset price bubbles.