Systemic risk, crises, and macroprudential regulation

Xavier Freixas, Luc Laeven, José-Luis Peydró 05 August 2015



‘Macroprudential’ has been one of main buzzwords emerging from the Global Crisis. But it means different things to different people. For some, macroprudential policy is about managing the economic cycle. For others, it is about reining in the financial instability inherent to financial markets and institutions. For some sceptics, it is simply an empty term because the political economy of booms is such that country authorities will always find it hard to smooth them, as booms bring substantial benefits to society while they last.

Calls for a more macroprudential approach to bank regulation can be traced back to the late 1970s on the back of growing concerns associated with the rapid pace of bank lending to developing countries. However, despite numerous financial crises since the 1970s, the term macroprudential was little used prior to the recent Global Crisis and its meaning remained somewhat obscure (Clement 2010).

Confusion about macroprudential policy

Unfortunately, there is much confusion about what constitutes macroprudential policy and little agreement about how to operationalise it. In part, this is because its objective is not clearly defined but also because there is scarce historical experience of the use of macroprudential tools to gauge their effectiveness and calibration. Moreover, the measurement and the theory of financial fragility and systemic risk of the financial system are still in their infancy, and there is little agreement on the scope of financial regulation and the institutional framework for macroprudential policy. What are the strengths and limitations of the current prudential policy framework and how should it change? What are the differences between micro- and macroprudential policy? Should macroprudential policy only target crisis management, or should it also target the booms when excessive risk is created? What is the boundary of financial regulation? How can systemic risk be measured and monitored in real time? What lessons can be drawn from the history of the financial crises for the management of credit and asset price bubbles and bursts? How should macroprudential policy interact with macroeconomic policy? Is there any role for monetary policy in combating systemic risk?

Challenges in implementing macroprudential policy: Evidence from a new book

In a new book on systemic risk and macroprudential regulation (Freixas et al. 2015), we offer a framework to assess and operationalise macroprudential policy, and discuss the challenges in the implementation of macroprudential policy and its limitations. The analysis is based on a growing body of academic and policy-oriented literature, including that based on the lessons from the history of financial crises and on country experiences of macroprudential policies.

Being the first book on the topic, some issues are covered in more detail than others because our knowledge on these issues is still limited and both our views and the state of the literature are still evolving. In particular, there is disagreement about the optimal policy mix and the measurement of systemic risk. And there is large uncertainty about the unintended consequences of macroprudential policy on systemic risk and the constraints imposed by political economy forces.

Before turning to the analysis and conclusions of the book, some preamble on the Crisis that led us to this discussion is in order. The Global Crisis that started in 2007 has reinvigorated a debate on how to regulate banks and other financial institutions to ensure financial stability. Central to this debate has been the recognition that financial regulation has been largely micro-focused on the risk of individual financial institutions rather than focused on the financial system as a whole.

Capital adequacy levels were set on the implicit assumption that by creating buffers to absorb unexpected shocks at individual banks, the system as a whole was safer. Yet, by responding to capital regulations with only their own interest in mind, banks can potentially behave in ways that collectively undermine the system as a whole. For example, banks hit by a negative shock may prefer to deleverage when faced with binding capital constraints, causing a credit crunch and a generalised drop in asset prices, thereby exacerbating the initial negative shock. Importantly, negative spillovers can be substantial, as financial institutions have incentives to take correlated exposures in credit and asset price bubbles, and hence are deeply connected. To control such systemic risk that may jeopardise financial stability with strong negative real effects for the economy, regulation and supervision will need to become more macroprudential, concerning themselves with the stability of the financial system as a whole, and its relation with the economy at large.

Additionally, regulatory failures and political economy constraints in dealing with the build-up of financial imbalances are seen by many as equally, if not more important, underlying causes of the Global Crisis. A discussion of macroprudential policy therefore cannot occur without consideration of political and regulatory motives, especially around the times of financial crises. Some financial regulations were badly designed in the first place, paying undue attention to correlated risks, and financial regulators failed to identify the build-up of correlated risks early on. Significant parts of the financial system were not regulated or regulatory arbitrage was easily allowed. Some of the regulatory failures can be linked to shortcomings in the regulatory framework, notably the lack of discernment of macroprudential regulation and systemic risks. Indeed, in the aftermath of the current crisis, the consensus among policymakers and academics has been that regulators did not pay sufficient attention to the financial fragility of the financial system as a whole — the correlated risks in the financial system arising from perverse incentives — and the necessity to monitor systemic risk by putting in place a macroprudential regulatory framework.

While some of these shortcomings in the regulatory framework have been addressed by recent financial regulatory reform – such as the Basel III regulations, EU directives, and the US financial reform under the Dodd–Frank Act – some fundamental questions remain unaddressed. For example, resolving the ‘too big to fail’ problem and the implementation and interactions of macroprudential policy with monetary policy remain open questions.

The future success of banking regulation will largely depend on the changes made to the current regulatory framework for banks. The new regulations that curtail bank activities or increase capital requirements will force banks to become less leveraged, and therefore less risky. However, at the same time there is a risk that bank activity will shift to less regulated parts of the financial system, including to shadow banking, institutional investors and financial markets. While there are strong benefits to having a more diverse financial system, without additional regulation, risk could become concentrated in unregulated entities and take systemic proportions. As a result, systemic risk could increase even though banks become less risky.

A new bank regulatory framework

Based on our analysis in this book, the new bank regulatory framework should have the following elements:

  • Be more macroprudential with greater attention to systemic risks, including those emerging from outside the regulated sector;
  • Counter the build-up of financial imbalances and excessive leverage, including through increased capital requirements, especially in good times;
  • Improve the measurement of systemic risk, including improving collection and access to large micro datasets of the financial system;
  • Pay more attention to cross-border spillovers, including those arising from cross-border financial flows, notably short-term foreign debt;
  • Improve bank resolution frameworks and reduce the ‘too big to fail’ problem;
  • Reduce debt finance by households and firms, including by removing subsidies on debt, and improve resolution mechanisms for household, non-financial firms, and sovereign debt;
  • Strengthen supervision, including at the macroprudential level, and be more resistant to political pressures and to regulatory loopholes;
  • Strengthen market discipline and sound corporate governance (especially in highly leveraged institutions such as banks), including through bail-in policies;
  • Develop a more diversified financial system to reduce the negative spillovers from banks’ problems to the real economy;
  • Recognise that monetary and prudential policy cannot be entirely independent; and
  • Avoid excessive costs on the regulated sector from excessive regulation.

But we are left with many unanswered questions regarding how best to build and implement such a regulatory framework in support of financial stability and economic prosperity. The analysis in our book points to the following key lessons from the Crisis and the resulting metamorphosis of the banking regulatory framework that should serve as a guide in the pursuit of these objectives.

How to implement such a regulatory framework

  • First, systemic risk needs to be managed pre-emptively, including through monitoring (and curtailing) rapid (excessive) credit growth, asset bubbles, and other forms of leverage.

Systemic risk generally builds up slowly but well in advance of an eventual crisis. Dealing with the build-up of systemic risk ex ante, for example by curtailing excessive credit growth and building up capital buffers, can not only help prevent a crisis but also help in dealing with the ex post management of a crisis. For example, the build-up of capital buffers will not only help in crisis prevention by forcing banks to internalise risk taking to a greater extent, but will also allow banks to better absorb the shocks from a crisis, especially when markets for new capital are closed.

  • Second, systemic risk is an endogenous concept, complicating policy.

Banks will respond to new regulations by altering their risk profile in ways that can result in unintended consequences. For example, by limiting risk in one part of the financial system, risk may be pushed elsewhere. There is a risk that new regulations, by focusing on one type of risk, could be crafted without consideration of such second-round effects. Additionally regulations may conflict, so macroprudential policies should be coordinated.

  •  Third, the introduction of macroprudential policies alone will be insufficient to limit systemic risk.

The macroprudential policies need to be strictly enforced, which requires that administrators be empowered to act without interference from vested interests. And they need to be supported by sound macroeconomic policies to manage the economic cycle. Additionally, corporate governance reform is needed to limit systemic risk at the source, by requiring bank managers to act in the interests not only of bank shareholders, but also of the bank’s stakeholders at large. An important step in this direction, apart from bail-in mechanisms that will improve market discipline, is that capital requirements be substantially higher in good times when excessive risk is taken. Incentives are crucial, and corporate governance and market discipline are essential, including through capital requirements, compensation structures, and bail-in and resolution procedures.

  • Fourth, given the globalisation of the financial and banking system and the potential international spillovers, macroprudential policy needs to safeguard not only domestic financial systems but also address cross-border externalities.

These effects are a consequence of the process of financial liberalisation that started in the 1970s, and as evidenced by the major financial crises in recent decades, each domestic crisis had an important international dimension.

Concluding remarks

Given these challenges and limits, one has to be realistic about how much macroprudential regulation can accomplish in terms of managing financial imbalances and ensuring financial stability. Much depends on the strength and independence of the macroprudential authority and the risk attitude of the public at large toward boom-bust cycles. Moreover, political economy constraints will continue to plague the resolution of too big to fail institutions during a systemic financial crisis, the creation of new, optimal regulation measures, and also enforcing the new regulations in the booms. Our advice is therefore to focus on the prevention of financial crises through higher capital requirements, to use less (short-term) debt finance in general (including households, not only firms), and to use macroprudential measures to tame the build-up of leverage and credit booms. Financial crises often end up being extremely costly for taxpayers and welfare in general. One cannot afford imprudence and negligence.

Authors' note: The views expressed here are those of the authors and should not be interpreted to reflect those of the ECB or IMF. The book was written while Laeven, who is currently at the ECB, was a staff member of the IMF.


Clement, P (2010), “The term “macroprudential”: origins and evolution”, BIS Quarterly Review, March.

Freixas, X, L Laeven, and J-L Peydró (2015), Systemic Risk, Crises, and Macroprudential Regulation, Boston, MA: MIT Press, June 2015. 



Topics:  Financial regulation and banking Global crisis Macroeconomic policy

Tags:  Macroprudential policy, global crisis, financial regulation, systemic risk, bank regulation, financial crises

Professor, Universitat Pompeu Fabra; CEPR Research Fellow

Director-General of the Directorate General Research, European Central Bank and CEPR Research Fellow

ICREA Professor of Economics at UPF, Barcelona GSE; Research Professor and Research Associate, CREI; and CEPR Research Fellow