Macroprudential Policy: Case Study from a Tabletop Exercise

Abstract

1.INTRODUCTIONSince the global financial crisis of 2007-09, policymakers around the world have advocated the use of prudential policy tools to promote financial stability-that is, to reduce risks that could inhibit the financial sector's ability to intermediate credit (Bernanke 2008; Bank of England 2009; Basel Committee on Banking Supervision 2010; Tarullo 2013). Prudential policy tools are rules or requirements that enhance the safety and soundness of specific firms, sectors, or practices. The use of such prudential policy tools for financial stability purposes is often called macroprudential policy. Academic work on the implementation of macroprudential methods has flourished recently,1 and even prior to the crisis, some researchers and policymakers argued for a macroprudential approach to financial regulation.2This article describes a inquiry into macroprudential tools that was conducted by members of the Financial Stability Subcommittee of the Conference of Presidents (COP) of the Federal Reserve Banks in June 2015.3 In the tabletop exercise, Federal Reserve Bank presidents were presented with a plausible, albeit hypothetical, scenario of financial market overheating. They were asked to identify the risks to financial stability present in the scenario, and to review a variety of possible macroprudential and monetary responses to those risks. In exploring the actions and tools available to policymakers, the participants drew conclusions about the advantages and the limitations of the different approaches.Before describing the hypothetical scenario, the available policy tools, and their transmission mechanism in detail, we define the macroprudential objectives that guided the exercise and the framework used in assessing financial vulnerabilities.In the tabletop exercise, the primary macroprudential objective is to reduce the occurrence and severity of major financial crises and the possible adverse effects on employment and price stability. The macroprudential objective, because it focuses on economy-wide financial stability, differs from the Federal Reserve's monetary policy objectives of full employment and stable prices and goes beyond its microprudential objective of ensuring the safety and soundness of individual firms. However, the objectives and transmission mechanisms of microprudential, macroprudential, and monetary policies are intertwined, generating the potential for trade-offs among objectives. For example, trade-offs may arise between preemptive macroprudential actions and the cost of financial intermediation, because preemptive macroprudential actions that reduce vulnerabilities may slow economic performance in the short term.4 Furthermore, the trade-off between macroprudential and microprudential objectives might be more severe in busts than in booms, while the trade-off between macroprudential and monetary policy objectives might be more severe in booms than in busts. Therefore, a secondary objective is to manage such trade-offs-in other words, to mitigate the side effects of macroprudential policy actions through time. Financial system disruptions that macroprudential objectives aim to avoid include fire sales in financial markets, destabilizing runs on banking and quasi-banking institutions, shortages of money-like assets, disruptions in credit availability to the nonfinancial business sector, spikes in risk premia, disorderly dissolution of systemically important financial institutions, excessive spillovers from disruptions in international funding and currency markets, and disruptions of the payments system.Our assessment framework of financial vulnerabilities follows Adrian, Covitz, and Liang (2013). The framework is a forward-looking monitoring program designed to identify and track the sources of systemic risk over time and to facilitate the development of policies to promote financial stability. Under this framework, macroprudential tools and actions can be classified according to whether they serve preemptive or resilience goals. …