Macroprudential policies aim to protect financial stability and prevent disruptions in credit and other vital services. The risk of financial instability increases when institutions have high levels of leverage, rely heavily on short-term funding sources, and are interconnected with each other. When this occurs, there is an increased risk that institutions in one country will experience distress and spread to other institutions.
Macroprudential policies are generally implemented by financial regulatory authorities. They should be aimed at maintaining price stability and financial stability and should respond more strongly to output variations than to fluctuations in demand. Ultimately, this would increase financial and macroeconomic stability. However, policy coordination is often necessary to ensure that macroprudential policies are effective.
Often, macroprudential policies are intended to limit the risks of foreign exchange mismatches and excessive capital outflows. Moreover, these policies may prevent the onset of an economic crisis by limiting large capital outflows from the economy. In other words, they prevent an economic crisis from turning into a financial crisis. These policies can also help avoid a vicious cycle in which large capital outflows result in liquidity pressures in the banking and corporate sectors.
Another way macroprudential policies help prevent the systemic risks associated with individual banks is by enhancing the capital of banks. Banks must be able to raise sufficient capital to support their operations and maintain their credit quality. However, this can be a challenging process. The BIS measures the effectiveness of these policies by monitoring the level of credit growth and the size of the banks’ capital and liquidity buffers.
In order to support financial stability, macroprudential policies should also be coupled with fiscal policy. This is especially true when the interest rate has fallen below zero and the scope of monetary policy is limited. Further, the combination of macroprudential policies can reduce the risk of short-term defaults.
Although research on the impact of macroprudential policies has been limited, it shows that they can be effective in curbing credit growth and enhancing resilience. The use of macroprudential policies has increased in both advanced and emerging market economies. The chart below shows the use of these policies in different countries.
Macroprudential instruments have a strong impact on financial stability and the financial cycle. The appropriate use of these instruments should be closely coordinated with monetary policy. For example, the policy should ensure that banks have adequate capital and liquid reserves to protect against economic downturns. This is an important factor in ensuring macroeconomic stability.