International finance and macroeconomics.

• Author: Frankel, Jeffrey A.
• Position: Program Report

In the years since the severe global financial crisis of 2008, (1) macroprudential policies have attracted interest as a potential additional set of tools to complement ordinary monetary policy, a possible means of counteracting financial market excesses and subsequent crashes.

In the six years since my last report, (2) members of the International Finance and Macroeconomics Program have written over 600 working papers. Many have been published subsequently in leading journals. There is not space here to summarize all or most of them. Instead, I will concentrate on recent research on international macroprudential regulation. All of the working papers in the International Finance and Macroeconomics Program can be found on the program's publications page, http://www.nber.org/papersbyprog/IFM.html.

We have long had microprudential regulation of banks and securities markets. But macroprudential thinking begins with the observation that the whole of the financial system is more than the sum of the parts. A micro-prudential regulation might, for example, limit the loan-to-value ratio for individual mortgages or set capital minimums for individual lenders at levels that are figured by taking the probability of housing price fluctuations as exogenous. Thus it is a "partial equilibrium" approach. A macro-prudential approach recognizes that housing prices are endogenous, and that during a credit-fueled housing boom, the probability of a crash is greater and so regulations on individual borrowers and lenders may need to be set more stringently.

Financial regulators need to think about business cycle fluctuations, and macroeconomic policy-makers need to think about financial regulation. It is not just banks and private financial institutions that were led by a micro perspective into thinking that default probabilities were independent across households, and that therefore treated mortgage-backed securities as virtually riskless. Some regulatory agencies also neglected the correlation across borrowers and so underestimated the possibility that many mortgages could fail simultaneously in a housing downturn.

This survey of recent NBER research on international macroprudential policies is divided into four distinct areas: (1) national prudential policies that address macroeconomic issues in the sense of varying over the business cycle; (2) macroprudential regulation that focuses on the composition of debt, for example treating foreign debt as carrying an extra risk beyond that of domestic debt and perhaps restricting mortgage borrowing in foreign currency more than in domestic currency; (3) a precautionary approach to the national balance sheet with regard, in particular, to foreign exchange reserves; and (4) global liquidity conditions and coordination issues. This survey places some emphasis on findings from emerging markets.

1. Cross-country Differences in the Use of Macroprudential Policies

   One root source of capital market imperfections is the need for borrowers to have collateral in order to prove their creditworthiness. (3) A debtor who is up against a collateral constraint may be forced to sell assets ("fire sale"), driving down the market price and thereby putting other borrowers up against their own constraints. Javier Bianchi and Enrique Mendoza show how overborrowing carries a pecuniary externality because private agents do not internalize how the price of assets used for collateral responds to collective borrowing decisions. (4) Their model suggests that financial innovation may have played a role in the financial crisis of 2008-09. (5)

   Many observers warn of the moral hazard dangers of bailing out creditors or lenders in a financial crisis. But if the time-consistent system features government intervention during the deleveraging phase of the cycle, it is appropriate to take this into account beforehand. Restrictions or taxes on overborrowing during the boom phase of the cycle will reduce the likelihood or pay the costs of bailouts during the bust phase. In theory, taxes on debt and dividends that vary with the stage of the cycle can offset the overborrowing externality. (6)

   Wall Street is connected to Main Street. Financial market imperfections can interact with the provisions of standard macro models in which labor markets and goods markets do not always clear. The collateral constraint acts as a financial accelerator, magnifying economic downturns. Monetary policy may not be adequate to combat the recession that results during the deleveraging phase, especially if the nominal interest rate cannot fall enough because of a liquidity trap, more specifically the zero lower bound. (7) In this context, central banks may be able, in place of monetary policy, to use ex ante macroprudential policies such as debt limits and mandatory insurance requirements during the boom phase. These policies can offset the overborrowing externality. (8)

   Financial market shocks can be transmitted to the real economy through the banking sector in particular. (9) Standard bank regulations to reduce risk include (10) capital requirements, a limit on leverage, dividend taxes, liquidity requirements, (11) deposit insurance, (12) stress tests, (13) ongoing supervision of financial institutions, (14) and minimum reserve requirements. Pablo Federico, Carlos Vegh, and Guillermo Vuletin find that developing countries use reserve requirements countercyclically far more than advanced countries do (see Figurei), probably as a substitute for monetary policy which is diverted, for example, by the need to raise interest rates in recessions in order to defend the currency. (15)

   Booms in real estate lending and house prices bubbles, which can originate in loose credit market conditions imported from abroad, materially heighten the risk of financial crises. (16) Some countries have had success using regulations in the housing sector to discourage households from excessive mortgaging. The regulations include maximum ratios of debt service-to-income (DSTI) and loan-to-value (LTV). These become "macroprudential" when they are raised or lowered with the cycle. (17)

2. Macroprudential Regulation in Emerging Markets

   Models of financial market imperfections, overborrowing, crises, and macroprudential regulation were considered appropriate for emerging markets (18) long before the financial crisis of 2008 impelled most economists to contemplate them seriously for advanced countries. Some of the same lessons and models that international economists developed to explain the emerging markets' sudden stops of the 1990s, for example, could be applicable to Europe and the U.S. as well. (19) Korea, in particular, has had some success with macroprudential measures that vary over the cycle. (20)

   * Regulation of Foreign Liabilities

   In open economies, prudential regulation cannot be imposed domestically without regard to the international activities of financial institutions. In some cases, authorities may decide to treat foreign debt as carrying extra risk beyond that of domestic liabilities and may, for example, set higher reserve requirements for banks' foreign-currency deposits than for domestic deposits.

   The tightening of capital requirements or other regulations on domestic banks in one country may cause a "leak" abroad, in the sense that some of the projects that might previously have been funded by domestic...