The evolution and effectiveness of macroprudential policy

Abstract

This thesis investigates the evolution of macroprudential policy, its objectives and effects on the financial sector with emphasis on the differences between advanced countries and emerging market economies. Firstly, we examine the effectiveness of macroprudential policy in reducing the build-up of financial imbalances in the wider economy. We focus on the aggregate credit-to-GDP gap, which besides being recommended to trigger the Basel III countercyclical buffer, is also widely seen as a key indicator of financial imbalances and a predictor of financial crises. This approach has not been done elsewhere. We find a number of tools to be effective including loan-to-value and debt-to-income ratio regulations, notably when the credit gap is positive. Secondly, we extend the research to look at the cross-border spill over effects of macroprudential policies, which can help in the understanding of the interconnectedness of financial markets via international banks’ claims (lending activities). We consider this of particular relevance for understanding the concept of financial stability given the rapid spread of the 2007-2008 financial crisis to international markets. Our approach is unique because the panel vector autoregressive approach has not been used so far to investigate potential macroprudential instruments spill over effects between countries. Our results show some macroprudential measures spillovers, notably in emerging market economies, but the impact is negligible in term of affecting a country’s financial stability or the build-up of financial imbalances. Thirdly, we study the costs that are incurred when macroprudential policy are employed in the financial sector as well as the relationship with monetary policy. We contend that although the aim of macroprudential policy is to prevent or limit financial instability across the broad financial system, the currently suggested macroprudential regulations target the banking sector narrowly. This can be seen as an added cost to banks which in turn can affect banks’ profitability and hence their ability to lend and potential economic growth. There are very few micro data studies of macroprudential policy and no previous studies on the impact on banks’ profitability. Our findings suggest that although macroprudential instruments can achieve its objective of preventing the build-up of financial system imbalances, as measured by the credit-to-GDP gap, yet it has significant and negative effects on banks’ profitability. Also, we found that there is positive/ negative interaction between macroprudential and monetary policies.