IMF Counsellor on Macroprudential Policy and Financial Vulnerabilities

Cyclical macro-prudential policy is often described as mitigating systemic risk in the time dimension. Mr. Adrian said, "I distinguish financial vulnerabilities from financial conditions." Financial conditions refer to the ease of financing across funding markets, including credit, equity, money, and foreign currency markets, reflecting the pricing of risk and underwriting standards in different asset markets. When financial vulnerability is high and financial conditions are loose, risks to financial stability are likely higher than when financial vulnerability is high and financial conditions are broadly neutral. The key frictions such as extrapolative expectations, competition leading to excessive risk-taking across institutions, and the leverage cycle due to risk management practices can lead to excessive variation in financial conditions that can be fueled by certain market failures. In the face of these frictions, the tasks of cyclical macro-prudential policies are two-fold: to lean against the buildup of financial vulnerabilities for reducing macro-financial amplification mechanisms and to build temporary buffers when financial conditions are overly easy and financial vulnerabilities are growing.

He further noted that there is clearly a close connection to monetary policy, which acts by impacting financial conditions. Monetary policy can also be steered deliberately to offset changes in financial conditions. As per Mr. Adrian, "The advantage of using monetary policy more systematically to steer financial conditions is that it can get into all of the cracks, while macro-prudential policy can be arbitraged across jurisdictions, markets, or institutions. There are also limitations to using monetary policy. Monetary policy cannot induce changes in resilience, unlike macro-prudential policy. Monetary policy is not targeted enough to address differential financial conditions across sectors of the economy. Furthermore, monetary policy has price stability as primary mandate. It may not be able to respond enough to offset a build-up of risks given trade-offs relative to its inflation objective." Talking about the way forward, he argued that cyclical macro-prudential policy might aim at mitigating sharp movements in financial conditions, even if those do not entail system disruptions in the intermediation capacity of the financial system. There is ample evidence that adverse movements to financial conditions impact risks to GDP growth adversely, even in the absence of systemic disruptions.

Related Link: Speech

Keywords: International, Banking, Macro-Prudential Policy, Financial Vulnerabilities, Financial Stability, IMF