The Conceptual Foundations of Macroprudential Policy: A Roadmap

Abstract

AbstractThe global financial crisis unleashed a flurry of academic literature and regulations addressing macroprudential issues. However, reflecting weak links between research and policy as well as varying risk environments (across countries and over time), policy remains exposed to pitfalls, including overreacting, underreacting and applying the wrong or untimely medicine. To help policy makers navigate through the maze, this paper proposes a broad typology of financial frictions that classifies the root causes of socially pernicious financial dynamics under four ‘paradigms’, with distinct grounds, implications and aims for macroprudential policy: (i) offsetting the moral hazard implications of bailouts; (ii) protecting unsophisticated market participants from abusive practices; (iii) inducing market players to internalize the systemic consequences of their individual actions; and (iv) tempering destructive mood swings. As policies to curb one source of systemic risk can exacerbate others, the macroprudential policy challenge is to strike a sensible balance among complicated trade‐offs.