The pervasiveness and relevance of asset price booms and busts in modern economies has now been fully acknowledged. So has the case for combining prudential regulation and monetary policy in the complementary pursuit of financial and macroeconomic stability. This is a key issue particularly for policy makers in emerging markets, where the interaction of real and financial cycles tends to be sharper than in advanced economies, with both recessions and recoveries often overlapping with financial events and much larger real-side impacts.
The devil is in the details, however. There are still serious questions on how to proceed with the complementary use of prudential regulation and monetary policy. While there are already lessons from emerging markets' use of the macroprudential policy toolkit, more experience and analysis, particularly on its interaction with monetary policy is needed.
To this point, recent experiences of Brazil and Korea, as reported in two chapters of a newly released book on macro-financial linkages in emerging markets -- edited by my World Bank Group colleague Swati Ghosh and I help fill that gap. They offer complementary examples of the learning-as-you-go process, by which the various components of macroprudential regulation are put in place. This contrasts with the advanced stage of policymaking blueprints that have been attained on the monetary-policy front.
Furthermore, those country experiences also illustrate how both time-series and cross-section dimensions of macrofinancial risks must be on the radar of policy makers. As Matheus Cavallari and I have remarked:
Reflecting the two types of macrofinancial risks, macroprudential instruments can either assume a time series or a cross-section dimension. When systemic behavior over time is considered, the key issue is how risks can be amplified by interactions within the financial system and between the financial system and the real economy. On the other hand, the cross-section dimension relates to the common exposure of institutions at each point in time. Correlated assets, or even counterparty interrelations, create such a link among financial institutions.
Brazil and Korea present seemingly opposite but complementary examples of the relevance of taking both dimensions into account.
Consider that after the 2008 global financial crisis, Brazilian policy makers deployed macroprudential policies in articulation with monetary policy while jointly pursuing anti-inflation and financial stability objectives. The economy had over-rebounded and started to exhibit signs of overheating in 2010 as a result of fiscal and monetary policies implemented after the global shock. Global liquidity, high commodity prices and strong capital inflows further fueled aggregate demand expansion through domestic credit -- which had been rising already at high rates since 2005. It was clearly an opportunity when monetary and prudential instruments could appropriately be combined in unidirectional retrenching, avoiding simultaneous build-up of both inflation and financial fragility. After all, any use of either monetary or prudential policies on their own under those circumstances might have led to contradictory and self-defeating impacts on those two objectives: simply hiking interest rates would attract more capital inflows; and restraining credit supply with no policy interest rate increase would lead to channeling demand for credit to other intermediation vehicles.
Instead there was a combination of policy interest rate hikes and an announced fiscal tightening along with several macroprudential policies. These included: higher bank reserve requirements to curb the transmission of excessive global liquidity to domestic credit markets; stronger terms for specific segments of the credit market to stem the deterioration in the quality of loan origination; reserve requirements on banks' short spot foreign exchange positions; and taxes applied to specific types of capital inflows to correct imbalances in the foreign exchange market and to dampen intensified, volatile inflows of capital.
Those measures succeeded in slowing the growth of household credit to a more sustainable pace. Nevertheless, partly as a consequence of a second dip of the global financial crisis associated with political and policy stalemates in the US and the Euro zone, and partly because of domestic developments, Brazilian policy-makers were pushed to not only suddenly reverse its monetary-policy stance in 2011, but also felt the need to rapidly fine-tune its macroprudential toolkit, given the unevenness of results. Reflecting on this time, Pereira da Silva and Harris note that:
Most of the macro prudential measures applied in Brazil since 2010 related to the time dimension of systemic risk, in other words to "leaning against the wind" and dealing with the cyclicality of the financial system. However, experience gained from the 2008 crisis has illustrated that, as the financial system becomes more complex and sophisticated, risks can arise not only in a single sector but also as an interlinked, system-wide issue. In fact, the Brazilian financial system is characterized by a high degree of conglomeration and concentration. (...) Therefore, another challenge is to develop effective indicators and to monitor cross sectional risks related to the interconnectedness of the financial system and the real economy.
Korea in turn, had acquired some experience with several macroprudential policy instruments much prior to the 2008 global financial crisis. Liquidity ratio regulations had long been in place in response to the 1997 financial crisis. Furthermore, as signals of euphoria in the housing market became clear in the 2000s, loan-to-value and debt-to-income control ratios were also enacted. But unlike Brazil, Korea lacked specific measures aimed at the time-series risk dimension. This left loopholes for banks to raise excessive leverage through funding with "non-core liabilities" -- instruments banks would not draw on during normal times, such as retail deposits by households -- leading to a round of crisis-like events in 2008. As Jong Kyu Lee points out regarding the focus of Korea's regulation on ratios:
(...) a liquidity ratio is unable to fully and flexibly reflect all aspects of structural changes in the related financial markets, and cannot prevent accumulation of financial imbalance. Reliance on a few ratios, (...) even though applied from the [macroprudential policy] perspective is not sufficient for securing financial stability.
Let me highlight three of many lessons stemming from Brazil's and Korea's recent experiences.
First, while some division of labor between monetary policy and macroprudential regulation may be maintained in their combined application (Canuto and Cavallari), policy-makers need to make sure that prudential policies are mutually consistent and comprehensive enough to avoid regulatory arbitrage and exploration of loopholes. Second, a balance must be struck between the need for policies to be ahead of the curve, and the fact that learning-as-you-go is unavoidable.
Finally, communication by policy makers becomes trickier as they move from the clarity of rule-based monetary policy to its combination with macroprudential regulation. In the case of Brazil, for example, markets required an extraordinary effort from the Central Bank to clarify that macroprudential regulations were being implemented as a complement -- rather than a substitute - to monetary policy.