Macroprudential Policy

Macroprudential policy is the use of prudential tools, mainly rules on bank capital, lending standards and liquidity, to limit systemic risk: the risk that problems spread across the financial system and damage the wider economy. Its best-known tools include the countercyclical capital buffer, limits on loan-to-value (LTV) and debt-to-income (DTI) ratios for mortgages, and extra capital charges for the largest banks. It is usually run by a central bank or a dedicated committee.

It sits between two older policy areas. Microprudential supervision checks whether each bank is safe on its own; macroprudential policy asks whether the system as a whole is building up risk, such as a credit boom or herd behaviour, that no single bank's books would reveal. It is also distinct from monetary policy, which uses interest rates to steer inflation, although the two interact. The idea is decades old but became mainstream after the 2008 financial crisis.

Think about fire safety in a town. One job is inspecting each house for faulty wiring. A different job is watching the whole town: are houses being built too close together, is the summer unusually dry, are the hydrants full? A town where every house passes inspection can still burn down if the fire spreads from roof to roof.

Macroprudential policy is that second job for the financial system. When borrowing is booming and house prices are racing ahead, it asks banks to set aside extra capital and asks buyers to put down bigger deposits, much like filling the hydrants before a dry season. When trouble comes, those reserves can be released so that banks keep lending instead of all pulling back at once.

Records of the Bank for International Settlements (BIS) show the term in use at a June 1979 meeting of the Cooke Committee, the forerunner of the Basel Committee on Banking Supervision. It appeared in published BIS reports in the 1980s, regained attention after the Asian financial crisis of 1997–98, and moved to the centre of policy after 2008, when it became clear that banks that each looked sound had together created a system-wide crisis around sub-prime mortgages and short-term funding.

The response built new institutions. The G20 set up the Financial Stability Board in April 2009 to coordinate reforms. The Dodd-Frank Act of 2010 created the Financial Stability Oversight Council in the United States, the European Systemic Risk Board was established in 2010, and the Bank of England's Financial Policy Committee became a statutory body in 2013.

• Countercyclical capital buffer. Under Basel III, authorities can require banks to hold extra common equity, generally up to 2.5% of risk-weighted assets, when credit grows too fast, and release it in a downturn. The gap between the credit-to-GDP ratio and its long-run trend is a common guide. The UK rate has been 2% since July 2023.
• Systemic surcharges. Global systemically important banks hold additional regulatory capital because their failure would do outsized harm.
• Borrower-based limits. Caps on LTV, DTI and debt-service-to-income ratios restrict how much households can borrow against a home or relative to their income.
• Liquidity and funding rules. Requirements such as the liquidity coverage ratio limit reliance on short-term wholesale funding that can vanish in a panic, protecting market liquidity.
• Foreign-currency limits. Caps on banks' open currency positions or foreign borrowing, which may also count as capital flow management measures.

The loan-to-value ratio compares the size of a mortgage with the value of the property that secures it:

The loan amount is the sum borrowed, and the property value is usually the lower of the purchase price and the bank's valuation. If a regulator caps LTV at 80% and a home costs $400,000, the largest permitted loan is $0.80 \times 400{,}000 = 320{,}000$, so the buyer needs a deposit of $80,000. If prices later fall 15% to $340,000, the borrower still has $340{,}000 - 320{,}000 = 20{,}000$ of equity, whereas a buyer who borrowed 95% would owe more than the home is worth. Tightening the cap in a boom slows credit growth and leaves a buffer against price falls.

For small open economies, macroprudential tools can make up for limited room on interest rates. Under the impossible trinity, a country with a pegged currency and open capital markets has little monetary policy independence, so it may rely on LTV limits or capital buffers to cool a credit boom fuelled by foreign money. Tools aimed at foreign-currency lending also reduce currency mismatch in the banking system.

The approach has limits. Tighter rules on banks can push lending into shadow banking, where they do not apply. Measuring systemic risk in real time is hard, buffers set too late do little, and tightening lending in a boom is often politically unpopular.

• Financial Stability Board
• European Systemic Risk Board
• Bank of England: The countercyclical capital buffer