The Use and Effectiveness of Macroprudential Policies: New Evidence

Introduction

The global financial crisis of 2007-2009 served as a brutal lesson in economic management. It revealed a critical blind spot in traditional policy frameworks: a near-exclusive focus on taming inflation and smoothing business cycles through monetary policy (i.e., adjusting interest rates), while largely neglecting the build-up of systemic risk within the financial system itself. In the aftermath, a new paradigm emerged, shifting the focus from the stability of individual institutions—the realm of microprudential regulation—to the stability of the financial system as a whole. This new approach is known as macroprudential policy.

This document summarizes "The Use and Effectiveness of Macroprudential Policies: New Evidence," which has accumulated over the past decade on the use and effectiveness of these macroprudential tools. It charts the journey from theoretical concept to practical implementation, assessing what works, what doesn’t, and the complex challenges that lie ahead.

The Philosophical Shift: From Micro to Macro

To understand the new evidence, one must first grasp the fundamental shift in thinking. Microprudential policy is like a doctor ensuring each individual soldier in an army is healthy and has strong armour. It looks at individual banks, mandating capital buffers, and conducting stress tests on a firm-by-firm basis. This is crucial, but it misses the forest for the trees. An army of perfectly healthy soldiers can still be defeated if they are all deployed in the same vulnerable formation or are prone to panicking and retreating at the same time.

Macroprudential policies are the general look at the entire battlefield. It is concerned with the interconnectedness of institutions, their common exposures to certain risks (like a housing market bubble), and the procyclicality of the financial system—the dangerous tendency for financial institutions to lend too much during booms and too little during busts, thereby amplifying the economic cycle. Its primary goal is to lean against the wind of the financial cycle, building resilience during the good times so the system can withstand shocks during the bad times without collapsing and crippling the real economy.

The Toolkit: What Are Macroprudential Policies?

Macroprudential policies are not a single instrument but a diverse toolkit, often categorized by the type of risk they aim to mitigate.

1. Policies Targeting Borrower Resilience (The Demand Side): These aim to prevent households and firms from taking on excessive debt that they cannot service when conditions change.

   • Loan-to-Value (LTV) Ratios: Caps on the size of a mortgage relative to the value of the property.

   • Debt-to-Income (DTI) Ratios: Caps on the size of a loan relative to the borrower's income.

   • Debt Service-to-Income (DSTI) Ratios: Limits on mortgage repayments as a share of income.

2. Policies Targeting Lender Resilience (The Supply Side): These force financial institutions to build buffers that can be drawn down in times of stress.

   • Countercyclical Capital Buffer (CCyB): Requires banks to hold extra capital during periods of excessive credit growth.

   • Systemic Risk Buffers (SyRB): Additional capital charges for systemically important institutions.

   • Leverage Ratios: A non-risk-based cap on a bank's total assets relative to its capital.

   • Sectoral Capital Requirements: Higher risk weights for exposures to specific sectors, like real estate.

3. Policies Targeting Liquidity and Interconnectedness:

   • Liquidity Coverage Ratio (LCR) & Net Stable Funding Ratio (NSFR): While born from Basel III microprudential rules, they have a strong macroprudential dimension by ensuring banks have enough liquid assets to survive a short-term funding crisis.

   • Limits on Interbank Exposures: To prevent contagion if one large institution fails.

New Evidence on Use: A Global Proliferation

The first major finding from new evidence is the sheer scale of adoption. Before the crisis, only a handful of advanced economies, notably those in Asia who had learned from their own crises in the late 1990s, actively used these tools. Today, the story is different. The IMF's Integrated Macroprudential Policy (iMaPP) database meticulously tracks this expansion, showing that the use of macroprudential instruments has become a global norm, employed by over 130 countries.

The pattern of use, however, is not uniform. Emerging market economies (EMEs) have been the most prolific and innovative users. For many EMEs, this was a necessity. Facing volatile capital flows and rapid financial deepening, they could not rely solely on interest rate policy, which, if raised to cool credit growth, might attract even more destabilizing "hot money" from abroad. For them, macroprudential tools offered a more targeted way to manage financial stability risks without compromising other economic objectives.

Advanced economies were initially slower to adopt, often due to more complex governance structures and political resistance. However, following the crisis, countries like the UK established powerful new bodies like the Financial Policy Committee (FPC) within the Bank of England, with a explicit macroprudential mandate. The European Union also developed a framework for national macroprudential authorities. The evidence shows a clear trend: the toolkit is now a standard part of the policymaker's arsenal across the globe.

New Evidence on Effectiveness: The Mixed Verdict

This is where the research becomes most nuanced. The broad, overarching question "Are macroprudential policies effective?" is too simplistic. The new evidence compels us to ask a more refined set of questions: Effective at what? Under what conditions? And with what side effects?

1. Effectiveness in Curbing Credit and House Price Growth: The bulk of the evidence suggests that macroprudential tools, particularly those targeting the housing sector, are moderately effective in the short to medium term.

• Borrower-Based Tools (LTV, DTI) are the Stars: A strong consensus has emerged that caps on LTV and DTI ratios are among the most effective tools. Numerous cross-country studies find that tightening these measures is associated with a statistically significant reduction in household credit growth and house price appreciation. They work by directly limiting the most vulnerable types of borrowing—high-leverage, speculative purchases—thereby cooling the market from the demand side. For example, evidence from countries like Canada, South Korea, and Israel shows that successive tightenings of LTV and DTI caps helped temper roaring housing markets.

• Capital-Based Tools are More Nuanced: The evidence on the CCyB and other capital buffers is more mixed. Their primary purpose is to build resilience for a future downturn, not necessarily to sharply brake credit growth in the present. While they do have a moderating effect on lending, it appears to be smaller and slower-acting than that of borrower-based tools. Their great value is revealed during a crisis, as they provide a pre-positioned capital cushion that can be released to support lending, as seen in the COVID-19 pandemic response.

2. Effectiveness in Enhancing Resilience: This is a harder outcome to measure, as it involves proving something didn't happen. We cannot easily run a counterfactual world where these policies weren't in place. However, the new evidence is encouraging. Studies using stress-test models show that banks in jurisdictions with active macroprudential policies, and higher capital buffers in particular, are projected to be much more resilient to severe economic shocks. The building of these buffers during the long post-crisis expansion meant that banks entered the pandemic-induced recession of 2020 in a far stronger position than they entered the 2008 crisis, which was critical in avoiding a credit crunch.

3. The Leakage Problem and Cross-Border Spillovers: Perhaps one of the most significant findings from recent research is the issue of "leakage" or "substitution." When a policy is applied to a specific sector (e.g., regulated banks), risk can simply migrate to less-regulated parts of the financial system—the so-called "shadow banking" sector. For instance, if LTV caps make it harder to get a mortgage from a bank, a non-bank lender might step in to fill the gap, bypassing the policy's intent.

Similarly, macroprudential policies can have significant cross-border spillovers. A tightening of policy in one country might lead to a surge in cross-border lending from foreign banks not subject to the same rules, or drive capital into neighbouring countries, inflating financial risks there. This evidence highlights that a purely national approach to macroprudential policy is insufficient in a globally integrated financial system, pointing to the need for greater international coordination.

The Critical Role of Governance and Communication

New evidence strongly underscores that the how of implementation is just as important as the what. Macroprudential policy is inherently political. Measures like LTV caps are highly visible and can be unpopular, perceived as denying the "dream of homeownership." This creates a significant time-inconsistency problem: it is politically difficult to "take away the punchbowl" when the party is in full swing.

Therefore, the institutional setup is critical. The evidence favours delegating macroprudential authority to independent, technically-competent institutions—typically the central bank or a committee within it. This shields decision-making from short-term political pressures. Furthermore, effective communication is paramount. The authority must clearly explain its financial stability mandate, the risks it sees building, and why a specific policy action is necessary. This builds public and political legitimacy, making it easier to act pre-emptively.

The Interaction with Other Policies: A Delicate Dance

Macroprudential policies do not operate in a vacuum. Its effectiveness is deeply intertwined with monetary and fiscal policy.

• Interaction with Monetary Policy: This is a complex and sometimes contentious relationship. In an ideal world, they work in harmony: monetary policy focuses on price stability and the output gap, while macroprudential policy focuses on financial stability. However, conflicts can arise. For example, if a central bank is keeping interest rates low to stimulate a weak economy, it might simultaneously be fuelling a housing bubble, forcing the macroprudential authority to tighten its tools aggressively. New evidence suggests that while macroprudential policy can "buy space" for monetary policy, it cannot fully substitute for it. The two must be carefully coordinated.

• Interaction with Fiscal Policy: Tax policies, such as mortgage interest deductibility, can powerfully stimulate housing demand, directly working against the goals of LTV or DTI caps. A coherent approach requires aligning housing-related tax policies with financial stability objectives.

Conclusion: An Evolving and Indispensable Framework

The accumulation of new evidence over the past decade leads to several firm conclusions.

First, macroprudential policies are here to stay. It has successfully established itself as a necessary third pillar of economic policy, alongside monetary and fiscal policy.

Second, its effectiveness is context-dependent and tool-specific. Borrower-based instruments like LTV and DTI caps are potent for cooling overheating housing markets. Capital-based tools like the CCyB are essential for building systemic resilience but are blunter instruments for fine-tuning credit cycles.

Third, the framework is not a panacea. It faces significant challenges, including regulatory leakage to the shadow banking sector, difficult-to-manage cross-border spillovers, and the constant risk of political interference.

Looking ahead, the macroprudential agenda is still evolving. Future challenges include developing tools for the non-bank financial sector, which has grown enormously and now represents a major potential vulnerability. Incorporating new risks, such as those related to climate change, into financial stability assessments and the macroprudential toolkit is another frontier.

In summary, the new evidence paints a picture of a policy framework that has moved decisively from theory to practice. It has proven to be a valuable and largely effective set of instruments for safeguarding financial stability. While it is complex to implement and requires careful calibration and strong governance, the lesson of the global financial crisis is clear: the cost of not having a macroprudential framework is unacceptably high. The journey of learning and adaptation is far from over, but the direction of travel is firmly set towards a more resilient, and therefore more stable, global financial system.