In a time when the economy is experiencing an extended period of economic expansion and asset prices are at historically high levels, macroprudential policies are more important than ever. These policies help stabilize financial markets and increase macroeconomic stability by limiting the material vulnerabilities of financial institutions. These policies are generally implemented by financial regulatory authorities.
Several countries have implemented macroprudential policies, and empirical studies have shown their effectiveness in preventing banking crises. For example, Cihak (2013) has shown that macroprudential policies reduce capital ratios in countries with high levels of bad loans. Furthermore, macroprudential policies have reduced the incentives for private agents to monitor banks.
In addition, macroprudential policies are important tools of macroeconomic policy, and can help prevent a financial crisis from escalating to an economic one. These policies typically set rule-linked ceilings for LTV ratios, and they respond to developments in output and house prices in each country. Typically, the welfare-optimal LTV ratio is active, and the level of house prices and output are closely related.
In short, macroprudential policies are policies that aim to stabilize financial markets and prevent disruptions of vital financial services. When financial vulnerabilities are high, including high leverage, over-reliance on uninsured short-term funding, and complex financial interconnections, the stability of the financial system is put at risk. Ultimately, these policies are meant to ensure that banks can sustain themselves and their creditors.
Macroprudential policies also complement and counteract other policies. These policies affect credit growth and the probability of a banking crisis. Despite the importance of these policies, little empirical research has been conducted on the interaction between these policies. It is important to understand the relationship between macroprudential policies and other macroeconomic policies.