The Conceptual Foundations of Macroprudential Policy: A Roadmap

• Author: Alain Ize,Augusto de la Torre
• Date: 01 December 2016
• Published date: 01 December 2016
• DOI: http://doi.org/10.1111/infi.12096

The Conceptual Foundations of

Macroprudential Policy:

A Roadmap

Augusto de la Torre and Alain Ize

World Bank.

Abstract

The global financial crisis unleashed a flurry of academic literature and

regulations addressing macroprudential issues. However, reflecting weak

links between research and policy as well as varying risk environments

(across countries and over time), pol icy remains exposed to pitfalls,

including overreacting, underreacting and applying the wrong or untimely

medicine. To help policy makers navigate through the maze, this paper

proposes a broad typology of financial frictions that classifies the root

causes of socially pernicious financial dynamics under four ‘paradigms’,

with distinct grounds, implications and aims for macroprudential policy:

(i) offsetting the moral hazard implications of bailouts; (ii) protecting un-

sophisticated market participants from abusive practices; (iii) inducing

market players to internalize the systemic consequences of their individual

actions; and (iv) tempering destructive mood swings. As policies to curb one

source of systemic risk can exacerbate others, the macroprudential policy

challenge is to strike a sensible balance among complicated trade-offs.

This paper is a condens ed version of de la Torre and Ize (2013). T he authors are grateful for

comments from Tito Cordella, Anton Korinek, Carlos Montoro, Lev Ratnovski, C arlos Vegh and two

anonymous reviewers. Maga li Pinat provided excelle nt research assistance. Augusto de la Torre and

Alain Ize work for the World Bank as, respectively, chief economi st for Latin America an d the

Caribbean and senior consult ant. The views and opinions i n this paper are the authors’and do not

necessarily reflect thos e of the World Bank, its executive directors, or the countri es they represent.

International Finance 19:3, 2016: pp. 333–352

DOI: 10.1111/infi.12096

© 2016 John Wiley & Sons Ltd

I. Introduction

Despite significant advances in research and a flurry of regulations following the

global financial crisis, ma croprudential polic y continues to be stifled by the lack of

an encompassi ng conceptual f ramework speci fying w hy, when and how polic y

intervention is required from a so cial-welfare perspec tive.

1

This problem is sig nifi-

cantly aggravated by the fa ct that systemic risks a rise from diverse sources whereas

risk environments differ wid ely across countries and can c hange sharply over time.

As a result, policy makers face multiple pi tfalls –including overreacting, under-

reacting or applyin g the wrong or untim ely medicine –which are exacerbated to t he

extent that the same sy mptom may reflect distinct underlying causes and policies to

address one source of risk may bolster oth ers.

To help guide policy makers through this maze w hile maintaining a se nsible

balance between policy tensions and trade-offs, this paper provides a roadmap of

the conceptual foundat ions of macroprudential pol icy. This roadmap is based on a

simple yet general fra mework that interacts col lective action f ailures with learnin g

frictions. The former occur w hen agents do not internal ize the systemic impac t of

their individual b ehaviours, the latter when players are not fully rat ional or the risk

environment in which t hey operate is too complex or evolves too rapidly for them to

fully comprehend. Four ‘paradigms’(or interpret ative analytic al lenses) em erge that

beget different and larg ely independent groun ds, implications a nd aims for macro-

prudential policy. First, absent colle ctive action fai lures or learning fric tions, the

main focus of macroprude ntial regulation is to of fset the moral ha zard implications

of bailouts. Second, whe re learning frict ions are at the forefront, macroprudentia l

policy also se eks to protect the unsoph isticated from abus ive practices. Th ird, where

collective acti on failures occupy centre stage, mac roprudential oversight has also to

induce market players to internali ze the systemic conseque nces of their act ions.

Finally, where both learning fr ictions and coll ective action fai lures are present and

interact, macroprud ential policy is entrusted with the add itional burden of temper-

ing destruct ive mood swings.

To better anchor the analysis, we refer to and or ganize the recent literat ure on

systemic risk in light of th e four mentioned p aradigms, p articularly with refe rence

to macro modelling with financial fri ctions. In add ition, as a preambl e to key issues

underlying our m acroprudential fram ework, we review t wo alternative rational es of

the pre-Lehman microprud ential regulatory archi tecture, one based on boun ded

rationality and the ot her on the moral hazard implicat ions of the financial safety

1

See Brunnermeier et al. (201 2) for a comprehensive survey on the macroeconomic impact of financial

frictions. Bank of Eng land (2009) and Gal ati and Moessner (2012) provide policy overviews. Hanson

et al. (2011) connect t heory and policy. Kashyap et al. (2014a ) propose a framework for macro-

prudential regulation based on the various fun ctions of financi al systems, rather than on a typolog y

of financial friction s as we do here. We believe the two approaches to be complementary.

334 Augusto de la Tor re and Alain Ize

© 2016 John Wiley & Sons Ltd