While traditional monetary policy seeks to stabilize prices and the economy through policy rates, financial stability has also become an important requirement due to the increasing complexity and interdependence of the financial system since the global financial crisis. To this end, macroprudential policies have been introduced, which seek to promote financial system health and achieve economic stability through preventive regulation that takes into account economic fluctuations and financial system risks.
Traditional monetary policy aims to stabilize prices and promote economic stability by utilizing policy interest rates. Central banks seek to cool the economy by raising policy rates when it becomes overheated. When a policy rate hike increases market interest rates, the supply of credit shrinks by reducing lending to households and businesses. The reduction in credit supply reduces demand in the economy, which stabilizes prices and calms the economy. In a downturn, the opposite process is used to stimulate the economy. In this way, central banks maintain the stability of the economy and seek sustainable growth.
Traditional economics, which views finance only as a transmission channel for monetary policy, believes that financial supervision policy should focus on micro-prudential policies that aim to achieve financial stability by ensuring the health of individual financial firms. This view stems from the recognition that finance is not a direct means of production and therefore cannot affect economic growth in the long run, as opposed to the short run, and from the efficient market hypothesis, which states that asset markets do not have bubbles, where prices rise above their intrinsic value. Micro-prudential policies utilize policy instruments that are preventive in nature and regulate the health of individual financial firms, for example, minimum capital requirements that set a floor on a financial firm’s equity to protect against future losses.
This binary approach has traditionally been the dominant view in economics, with financial stability being achieved through financial supervisory policies and price stability through monetary policy. However, the disruption of the financial system following the global financial crisis and the spread of economic instability has led to a self-reflection on the traditional approach. At that time, there was a consensus that central banks’ low interest rate policies aimed at stimulating the economy could undermine economic stability by creating financial instability due to asset price bubbles. In addition, the size of financial firms emerged as a new risk factor for financial stability, as the failure of an individual financial firm could trigger the collapse of the financial system. It was realized that financial stability could not be secured by conventional policies, and that financial stability, as well as price stability, was an essential requirement for economic stability.
As a result, the view that economic stability should be achieved through the complementarity between financial supervisory policy, which is micro-prudential policy in addition to macroprudential policy, and monetary policy for price stability has become mainstream. This shift has become even more important given the increasing complexity and interdependence of financial systems, for example, the globalization of financial markets, which requires international cooperation and coordination in the event of financial instability in one country spreading to other countries. Against this backdrop, financial regulators are working to establish international regulatory standards to strengthen the stability of the financial system.
Macroprudential refers to the low probability of crisis at the level of the financial system, rather than at the level of individual financial firms, and macroprudential policy refers to activities such as regulation and supervision that pursue the health of the financial system. Macroprudential policy is logically based on the “fallacy of composition” that micro-prudentiality is not a sufficient condition for macroprudentiality. Macroprudential policy is differentiated from micro-prudential policy in that it seeks to promote the health of the financial system through preventive regulation of financial system risks.
To effectively achieve the objectives of macroprudential policy, it is necessary to adopt policy instruments that take into account the correlation between economic fluctuations and financial system risk factors. Financial system risks are pro-cyclical, meaning that in a boom, asset prices rise sharply as financial firms expand the supply of credit by lending more, which in turn overheats the economy, while the opposite happens in a downturn. One policy instrument that can mitigate this is a countercyclical buffer capital regime. In this system, policymakers curb excessive credit expansion during periods of overheating by requiring financial firms to build up additional equity capital, or buffers, above their minimum capitalization. The buffer can then be used to finance lending during a downturn, ensuring that credit remains plentiful.
To enhance the effectiveness of macroprudential policies, financial authorities also utilize a variety of data and analytical tools to continuously monitor the health of the financial system. This allows for early detection of potential risks within the financial system and appropriate policy responses to mitigate them. For example, efforts are being made to assess the resilience of the financial system through scenario analysis techniques such as stress testing to design more effective regulatory policies.
Overall, it is important to achieve economic stability and financial stability simultaneously through a complementary approach of conventional monetary policy and financial supervisory policy. This can only be achieved through close cooperation and coordination between central banks and financial regulators, which will enable sustainable economic growth.
