Macroprudential policy and addressing procyclicality

28 June 2010

The stability of the financial system is undermined by distorted incentives and procyclical feedback effects. Macroprudential policy, which broadens the perspective of traditional prudential policy, can readily strengthen the resilience of the financial system to procyclicality by adapting conventional prudential tools. Countercyclical capital buffers, for example, can be built up when credit growth rises above trend during a boom, and released during the downturn. Other measures such as ceilings on loan-to-value (LTV) ratios for mortgage lending can act as automatic stabilisers because they will bind more during a boom when banks typically seek to expand property loans by accepting high LTV ratios. Such approaches could help to restrain credit and asset price excesses and thus mitigate the build-up of systemic financial vulnerabilities.

Addressing procyclicality is closely linked to traditional macroeconomic stabilisation policy. A more resilient financial system complements countercyclical monetary and fiscal policy, helping address threats to financial stability in the downturn. That said, monetary policy does need to lean more against the build-up of systemic financial vulnerabilities during the boom. That can be done by lengthening the policy horizon, thereby promoting long-term price stability more effectively.