Externalities and Macroprudential Policy

The recent financial crisis has led to a reexamination of policies for macroeconomic and financial stability. Part of the current debate involves the adoption of a macroprudential approach to financial regulation, with an aim toward mitigating boom-bust patterns and systemic risks in financial markets. The fundamental rationale behind macroprudential policies, however, is not always clearly articulated. The contribution of this paper is to lay out the key sources of market failures that can justify macroprudential regulation. It explains how externalities associated with the activity of financial intermediaries can lead to systemic risk, and thus require specific policies to mitigate such risk. The paper classifies externalities that can lead to systemic risk as: 1. Externalities related to strategic complementarities, that arise from the strategic interaction of banks (and other financial institutions) and cause the build-up of vulnerabilities during the expansionary phase of a financial cycle; 2. Externalities related to fire sales, that arise from a generalized sell-off of financial assets causing a decline in asset prices and a deterioration of the balance sheets of intermediaries, especially during the contractionary phase of a financial cycle; and 3. Externalities related to interconnectedness, caused by the propagation of shocks from systemic institutions or through financial networks. The correction of these externalities can be seen as intermediate targets for macroprudential policy, since policies that control externalities mitigate market failures that create systemic risk. This paper discusses how the main proposed macroprudential policy tools — capital requirements, liquidity requirements, restrictions on activities, and taxes — address the identified externalities. It is argued that each externality can be corrected by different tools that can complement each other. Capital surcharges, however, are likely to play an important role in the design of macroprudential regulation. This paper's analysis of macroprudential policy complements the more traditional one that builds on the distinction between time-series and cross-sectional dimensions of systemic risk