“Take nothing on its looks; take everything on evidence. There’s no better rule.

”
– Charles Dickens, Great Expectations

Macroprudential frameworks: (too) great expectations?

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By Claudio Borio

Contribution to the 25th anniversary edition of Central Banking Journal

Introduction

If there is one lesson from the Great Financial Crisis that has been embedded in policy, it is the need to
put in place macroprudential frameworks. Following the crisis, the term “macroprudential” went from
virtual obscurity – the idiom of a few cognoscenti – to rock-star status almost overnight, with the
international community’s full endorsement (G20 (2009), FSB-IMF-BIS (2011a)). This was source of some
satisfaction at the Bank for International Settlements (BIS), which had been advocating the need for such
an approach for years (Clement (2010)).
The lesson is welcome and important. There is no doubt that macroprudential frameworks must
be part of the solution to the perennial quest for the so far elusive goal of lasting financial stability.
Adopting a more systemic orientation in prudential arrangements is essential.
But intellectual pendulums have a habit of swinging too far. There is a risk of entertaining
unrealistic expectations about what macroprudential schemes can do on their own. If these expectations
become entrenched in policy, there is even an outside risk that, so far from being part of the solution,
macroprudential frameworks could, paradoxically, become part of the problem. Complacency is always
not too far around the corner. If the quest for financial stability has proved so elusive, it must be for a
reason.
Put differently, macroprudential policy must be part of the answer but it cannot be the whole
answer. Other policies also need to play their part, not least monetary and fiscal policy. And making the
most of macroprudential frameworks calls for a mix of ambition and humility – ambition to make
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systematic use of the available tools; humility in recognising their limitations.
This short article develops this basic point by considering various aspects of macroprudential
frameworks: objectives, strategy, tools and governance, both nationally and internationally. But before
delving into these aspects, it is worth recalling what macroprudential frameworks are about.

1
Head of the Monetary and Economic Department, Bank for International Settlements.
2
For a further elaboration, see Borio (2011) and, on the contours of macroprudential policy, Caruana (2010a).

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The systemic dimension takes centre stage

Macroprudential frameworks have been the response to prudential regulatory and supervisory
arrangements too heavily focused on individual institutions. By tending to target institutions on a
standalone basis, such “microprudential” approaches had two drawbacks. First, they set the same
standards regardless of the impact of an institution’s failure on the financial system. It is as if the same
speed limit applied to both trucks and cars. Second, they set the same standards regardless of the
financial system’s condition. It is as if the same speed limit applied irrespective of traffic conditions. In
effect, the microprudential approach assumes that the sources of risk – asset prices, credit conditions
and the macroeconomy – are independent of what financial institutions collectively do, ie they are what
economists call “exogenous”.
The macroprudential approach addresses the two drawbacks head-on by focusing on the
system as a whole rather than on individual institutions – on the wood rather than the trees (Crockett
(2000), Borio (2003)). The approach calibrates standards with respect to both the systemic footprint of
individual institutions (the so-called “cross-sectional dimension”) and the evolution of system-wide risk
(the so-called “time dimension”). In so doing, it also addresses what has come to be known as the
“procyclicality” of the financial system – those self-reinforcing processes that amplify financial booms
and busts and are at the root of financial crises.
Post-crisis, policy has addressed both dimensions. Basel III illustrates this quite well. Capital
surcharges for systemically important banks (SIBs) and the countercyclical capital buffer target,
respectively, the cross-sectional and the time dimension (BCBS (2012a,b and 2010a,b)). But Basel III is
just the core of a much broader response. Examples range from efforts to put in place orderly resolution
schemes for SIBs, or centralise the clearing of derivatives, to the adoption of a whole set of instruments
to deal with the build-up of disruptive financial booms, including minimum loan-to-value (LTV) and
debt-to-income (DTI) ratios, to name just two.
Addressing the cross-sectional dimension raises thorny issues. For instance, the pace at which
central clearing has gained ground has proved disappointing. At the same time, there are legitimate
concerns about the risk of concentrating too much risk in central clearing counterparties (CCPs). As a
result, a lot of work has been done to develop adequate recovery and resolution procedures for these
key players (CPSS (2012)). Likewise, despite all the efforts under way, putting in place adequate
resolution procedures for SIBs is still very much work in progress and faces huge challenges. 3 And tricky
questions arise about how best to deal with non-bank financial institutions, including the shadow
banking system (Caruana (2014)).
Even so, the time dimension is probably more controversial. It is here that macroprudential
policy inevitably intersects with macroeconomic policy. The debate about their relationship is in full
swing. Given space limitations, therefore, what follows focuses on this dimension.

What objective?

What should be the objective of macroprudential policy in the time dimension? Two possibilities should
be distinguished. The first is to increase the resilience of the financial system; the second is to constrain

3
For a useful narrative of the efforts under way, see FSB (2013).

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financial booms. These objectives are sometimes referred to, respectively, as protecting the banks from
the financial cycle and protecting the financial cycle from the banks (or taming the financial cycle).
The second objective is much more ambitious than the first. In order to increase the financial
system’s resilience, it is sufficient to build up adequate buffers in good times for the system to withstand
a bust. In effect, all macroprudential tools do precisely that – provided, of course, they are vigorously
deployed. By contrast, when it comes to constraining financial booms, the build-up of the buffers should
also succeed in reining in the growth of credit and asset prices as well as risk-taking.
My reading of the growing empirical evidence is that the effectiveness of macroprudential
measures in achieving this more demanding objective is limited, especially for the typical range of
variation in the instruments. To be sure, some tools do work better than others. For instance, DTI ratios
and, to a lesser extent perhaps, LTV ratios are comparatively more effective than increases in loan
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provisions or capital requirements. Indeed, the recent activation of the Basel III countercyclical capital
buffer in Switzerland seems to have had little impact on pricing and credit extension. It is no coincidence
that the explicit objective of this buffer, as clarified in the Basel III framework, is to increase resilience, not
to restrain the boom: restraining the boom is regarded simply as a desirable side benefit if it
materialises. The limited effectiveness of the tools should not be that surprising. Similar constraints were
extensively tried in the 1970s, albeit under different names (eg hire-purchase restrictions). And the
results were not that different.
The main reason is regulatory arbitrage. Money, like water, has a nagging habit of finding the
point of least resistance. This suggests that macroprudential policy cannot bear the whole burden – a
point to which I return below.
The risk of unrealistic expectations applies not just to the boom, but also to the bust. And here
the risk is, if anything, even greater.
A common view is that the objective of macroprudential policy during a bust should be to
boost credit growth. This is seen as the mirror image of the objective of restraining it during the boom. It
is a small step from here to feeling disappointed when the tool proves unfit for purpose.
This, however, is the wrong objective, for it fails to recognise the fundamental asymmetry
between booms and busts. The right and more realistic objective is to prevent unnecessary constraints
on the supply of credit. The legacy of the boom is too much debt. This debt overhang has to be
reabsorbed if the basis for a lasting, self-sustained and sound recovery is to be established. In the
meantime, the demand for credit is necessarily weak: people want to pay back what they borrowed on
the basis of overly optimistic expectations about the future. There is, in fact, growing evidence for this
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effect, which is also why post-bust recoveries are credit-less. To expect credit to grow strongly during
the bust is both unrealistic and counterproductive.
How can one remove unnecessary constraints on credit supply? One precondition is to ensure
that buffers are high enough to start with, so that markets do not become the limiting factor, at least for
long. This is not easy, since markets become very demanding as financial strains emerge. In addition, it is
worth thinking of ways to maximise the size of the buffer once the bust occurs. One option is to more
actively use restrictions on dividend payments. If the restrictions are applied to the sector as a whole,
rather than to specific institutions, the risk of unwelcome procyclical effects would be mitigated, as this

4
For some recent cross-country empirical evidence, see Lim et al (2011), Claessens et al (2013) and Kuttner and Shim (2013).
5
On the importance of deleveraging following crises and credit-less recoveries, see Bech et al (2013), Takáts and Upper (2012)
and Calvo et al (2006).

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would eliminate any stigma (the so-called “signalling effect”). No stigma can apply if everyone is in the
same boat and the decision is taken by supervisors, not banks themselves.

What tools and strategy?

This analysis also has implications for the range of tools and their deployment strategy.
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It suggests that a few well targeted tools may be superior to a vast array. The risk of a vast
array is that policymakers may soon find themselves extending the range of measures and inadvertently
drift into credit allocation. And the temptation to resort to capital controls to underpin macroprudential
instruments could at some point become quite strong, even where a more vigorous use of standard
macroprudential tools could be superior. This puts a premium on well-designed governance
arrangements: the authorities need to have control over the proper set of instruments and be mandated
to use them to limit systemic risk rather than to pursue more ambitious goals. For instance, it is not
surprising that, in countries where macroprudential frameworks are not yet in place, some central banks
have relied on monetary tools as an alternative (eg reserve requirements). Nor is it surprising that
reliance on a broad set of tools, including capital controls, has gone hand in hand with the pursuit of
more ambitious goals, such as managing the business cycle, for which macroprudential frameworks were
not originally intended.
The analysis also suggests that, to the extent that they are feasible, rule-based arrangements
can help. They can limit the risk of regulatory drift. And, when the party gets going, they can stiffen
policymakers’ resolve to take the famous punchbowl away. Very much as in fiscal policy, automatic
stabilisers are especially useful. For instance, very conservative LTVs or DTIs or even leverage ratios can
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limit the need for discretionary action, varying the calibration of the tools with economic conditions. To
be sure, there are clear limits to how effective automatic stabilisers can be, especially since financial
imbalances come in various shapes and sizes. Even so, if arrangements across the world are considered,
the impression is that the balance between rules and discretion is probably too heavily tilted towards
discretion.
The increasing popularity of macro stress tests illustrates some of these potential risks. As
discussed in detail elsewhere (Borio et al (2012)), such tests can be very useful tools for crisis
management and resolution, helping to repair balance sheets once a crisis has erupted. They are also
extremely helpful in bridging the hugely different perspectives of macroeconomists, prudential
supervisors, risk managers and bank managements, thereby fostering a badly needed common culture.
But, as early warning devices to identify vulnerabilities in tranquil times, they have so far proved woefully
deficient. Their effectiveness is undermined by limitations of the modelling technology, not least the
ability to capture sudden changes in behaviour, and by the context, not least the “this-time-is-different”
syndrome. No macro stress test, in fact, identified the serious vulnerabilities that ushered in the financial
crisis. While improvements have been made, there is a risk of putting too much faith in the tool’s
remedial properties.

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For a discussion of possible tools, see, for instance, CGFS (2012).
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Another possibility is to rely more on simple and transparent indicators that have proved reliable in the past, such as the
credit-to-GDP gap, used as reference guide for the countercyclical capital buffer. For a discussion of a range of candidate
indicators and the role of this variable in particular, see Drehmann et al (2011) and Drehmann and Tsatsaronis (2014).

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What governance?

Everyone would agree that good governance calls for a seamless alignment of instruments with the
know-how and willingness to use them based on clear mandates. Efforts to put fully fledged
macroprudential frameworks in place have sought to do precisely that, guided in part by the work of
international organisations under the G20’s aegis (FSB-IMF-BIS (2011a,b)).
Three governance issues merit special attention: the extent of insulation from political cycles,
the tension between microprudential and macroprudential perspectives, and international coordination.
A degree of insulation from political cycles is even more important in macroprudential than in
monetary policy. As noted, the essence of good macroprudential policy is to take the punchbowl away
just as the party gets going. And this is even harder than in the case of monetary policy. The lag between
measures and outcomes is longer: as extensively documented, the financial cycle, which is relevant for
financial stability, is much longer than the business cycle, which is seen as relevant for inflation
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(Drehmann et al (2012)). While some well-established constituencies are ranged against inflation, hardly
any exist to combat the dizzying but illusory feeling of getting richer during a boom. And some of the
policy instruments have more obvious distributional consequences, which strengthens political economy
resistance to their activation. All this heightens the risk of an inaction bias. To be sure, this risk is
necessarily country-specific, varying with intellectual and institutional traditions. But it can be increased
by a prominent involvement of the Treasury in decision-making. Looking across countries, however,
Treasures often have a leading role in the setting of macroprudential measures.
Tensions may also arise, and have already arisen, between the macroprudential and
microprudential perspectives. Authorities in charge of the safety and soundness of individual institutions
may at times find it harder to draw the link between macroeconomic developments and the fortunes of
institutions: for historical reasons and given the importance of operational responsibilities, legal and
accounting backgrounds dominate. Therefore, the authorities may naturally put less weight on the
dangers of financial booms as long as financial institutions appear well capitalised. This, too, can
heighten the risk of an inaction bias. For instance, in Switzerland, the supervisory authority (FINMA)
openly opposed the central bank’s proposal to activate the countercyclical buffer. And similar differences
of view have emerged in Sweden. This suggests that assigning a core role to central banks should be a
priority.
The need for international coordination in the governance of instruments has not received the
attention it deserves. A lack of coordination can make arrangements especially vulnerable to cross-
border arbitrage. In fact, one of the most underestimated achievements of Basel III’s countercyclical
capital buffer is that it addresses this question head-on (Borio et al (2011)). The relevant exposure
measure is a weighted average of an institution’s exposure to different jurisdictions. And specific
reciprocity clauses tackle the inaction bias. It is the host authority that activates the buffer with respect to
the exposure to its jurisdiction while the home authority can always do more but never less. This is
particularly helpful whenever the exposures are large and hence systemic with respect to the host
country but small and hence of little significance in relation to the lending institution’s portfolio – a
common state of affairs given the size of internationally active banks. Such reciprocity clauses could be a
model for a broader set of macroprudential tools. Disappointingly, however, so far an extension of their
scope has not been on the policy agenda.

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On this, see also Aikman et al (2010) and Claessens et al (2011).

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Conclusion

Macroprudential frameworks are a very welcome response to the Great Financial Crisis: a stronger
systemic orientation is essential to help secure financial stability. They are, however, very much still work
in progress. There is scope for improving the range of tools available, the balance between rules and
discretion, and governance arrangements, both nationally and internationally.
The key to success is to blend ambition with humility – ambition to put in place frameworks
that are capable of constraining financial booms and to use the tools vigorously; humility to recognise
the limitations in what the frameworks can achieve on their own. The experience so far indicates that it
would be imprudent to rely exclusively on these frameworks, or even prudential regulation and
supervision more generally, when seeking to tame the financial booms and busts that have caused such
huge economic costs. Financial cycles are simply too powerful. As discussed in more detail elsewhere,
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other policies, not least monetary and fiscal, should also play a role. Macroprudential frameworks must
be part of the answer, but they cannot be the whole answer.

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