The experience of recent years has reinforced the view that the financial system tends to amplify shocks over the cycle, leading to excessive lending in boom times and sharp contractions when economic conditions deteriorate. Common explanations for this are based on the fact that the players in the financial system are typically subject to constraints that tend to exacerbate shocks, such as borrowing constraints that fluctuate with asset prices, risk-sensitive capital requirements or remuneration schemes based on relative performance.

Based on the experience of violent crises in the past years, there has been a significant interest in designing macroprudential policies that limit fluctuations in the financial system:

  • The new Basel Accord incorporates capital buffers that are built up in good times and can be run down when economic conditions deteriorate;
  • The liquidity coverage ratio of Basel III ‒ which aims at safeguarding banks against short-term outflows ‒ contains a countercyclical element to the extent that such liquidity buffers are released in bad times; and
  • On the accounting side, there is a discussion about whether mark-to-market accounting ‒ which has the potential to amplify the impact of asset price changes ‒ should be suspended when prices are depressed.

There is also a growing debate about whether monetary policy should ‘lean against the wind’ with respect to the financial cycle, that is, whether the central bank should raise interest rates when the economy experiences excessive credit expansion and asset price inflation, but lower interest rates in times of significant contraction in lending or general stress in the financial system.

However, it is also well known that the financial system tends to react to new policies in surprising – and often undesirable – ways. In a new policy paper we highlight three potential areas of concerns regarding the implementation of the new macroprudential policies.

Firstly, intervention in one dimension of systemic risk might create new risks in other dimensions. In particular, as we have shown in an earlier paper, countercyclical policies designed to lower procyclicality in the financial sector have the potential to increase cross-sectional risk, leading to eg herding in investment activities, the use of common funding sources, interconnectedness through interbank linkages, or even convergence of risk management practices and trading strategies.

Secondly, new macroprudential regulation suffers from a time inconsistency problem, similar to the one arising for monetary policy. Ex-ante, regulators have an interest to be tough in order to limit risk-taking in the financial system. However, ex-post regulators are likely to bail out financial institutions in order to safeguard the stability of the financial system.

This issue arises because Basel III introduces a significant amount discretion in regulation. For example, Basel III contains guidelines for when countercyclical buffers should be invoked, but the ultimate decision is left to the regulators. To be sure, there are good reasons for this. In contrast to monetary cycles, it is more difficult to quantify credit cycles. It is hence important to leave significant room to regulators as to when to implement countercyclical policies. The concern is however, that pressure from the financial industry and politicians will make it difficult for regulators to impose additional capital requirements when excesses start to materialize.

Finally, the new accords do not take into account sufficiently the endogenous nature of booms and busts. Buffers are implemented when an excessive boom (by some measure) materializes, while buffers can be released if there is a sufficiently severe downturn. Cycles, however, develop over time. The response to a shock can initially be small but may be amplified later on. More importantly, cycles are to a large extent endogenous ‒ they are not simply driven by a series of fundamental shocks. In particular, the literature on the nexus between finance and macroeconomics has emphasized that there are various feedback and amplification mechanisms that can lead to the endogenous build-up of a boom. Ignoring these effects will reduce the effectiveness of macroprudential regulation.

Balint Horvath is Lecturer in Finance at the University of Bristol. Wolf Wagner is Professor of Finance at the Rotterdam School of Management and a fellow of the CEPR.