Impact case study database

Macroprudential policy is an approach to financial regulation that aims to detect and mitigate risks to the financial system as a whole (or "systemic risk"). A variety of tools of macroprudential policy have become available to central banks and regulators since the subprime crisis in 2008, which may have cost the UK over 16% of GDP in terms of growth foregone. The eventual fiscal cost of the crisis could exceed GBP100,000,000,000. However, further research on economic outcomes from macroprudential policies is essential, given the recent introduction of macroprudential policy and the relative scarcity of existing studies of its effect on credit, asset prices and the wider economy. Accordingly, the appropriate macroprudential tools and the effectiveness of such tools remain open questions. These issues have been addressed by Prof Davis’ and Dr Karim’s research in this area.

Together with Dr Carreras and Dr Piggott from the NIESR, Prof Davis for the Horizon 2020 grant “Firstrun” notes that existing work on effectiveness of macroprudential policy may be vulnerable to bias due to omission of long run cointegration effects (Ref. 4). The paper offered a fresh baseline for work in this area by adopting a robust cointegration framework. Using data for up to 19 OECD countries, evidence was found that macroprudential polices remain effective in both short- and long-run at curbing house price and household credit growth even within a cointegration framework. However, some tools are more effective than others, such as taxes on financial institutions, general capital requirements, strict loan-to-value ratios and debt-to-income ratio limits.

Prof. Davis subsequently undertook additional research with Dr Liadze and Dr Piggott from the NIESR for “Firstrun,”as a development of the National Institute Global Econometric Model (NiGEM) (Ref. 5). NIGEM is used by central banks in most developed countries and international organisations. Detailed banking sectors and addition of a macroprudential block to the model, with a focus on country models for Germany, Italy and the UK, enabled effects of macroprudential policies to be captured.

Together with Dr Liadze from the NIESR and Prof. Davis and Prof. Barrell from Brunel, Dr Karim had earlier conducted research into a systemic risk index which tracks the likelihood of the occurrence of a banking crisis and establishes thresholds at which macroprudential policies should be activated by the authorities (Ref. 1). Using this index as part of the new banking and macroprudential blocks of NiGEM (Ref 5), it was found that capital adequacy impacts the economy by acting on the spread between borrowing and lending of corporates and households, while loan-to-value transmits through its impact on the housing market. Introduction of macroprudential policy prior to the crisis would have led to improvement in a number of key macroeconomic measures and might thus have reduced the incidence of the crisis.

Prof. Davis offered the first systematic approach to assessing the usefulness of Concentration and Distribution Measures (CDMs) of Financial Soundness Indicators (FSIs) as indicators in macroprudential surveillance for the IMF (Ref. 3). Examples of such CDMs are the skewness, standard deviation and interquartile range, while the FSIs are the leverage ratio (unweighted bank capital/assets); liquidity (banks’ liquid assets/short term liabilities); banks’ return on assets; banks’ return on equity; banks’ Tier 1 equity capital/risk weighted assets and the banks’ non-performing loans/gross loans. Prof. Davis’ research (Ref. 3) uses an experimental data collection by the IMF from 36 countries and shows that a range of these CDMs can help to predict system wide vulnerabilities, with appropriate control variables. Leverage and the Tier 1 ratio, which are both principal macroprudential tools to indicate banking sector financial stability, were key to the collection of those FSIs. Overall, the exercise suggests CDMs provide a valuable supplement to traditional average measures of macroprudential indicators and would accordingly allow regulators and policy makers to better identify potential build-up of systemic risks, thus providing additional inputs for macro-financial management.

Finally, Prof. Davis, Dr Karim and Dr Noel observe that extant research on credit-market effects of macroprudential policy focuses largely on bank credit and credit to households. Their research (Ref. 2) was to their knowledge the first paper to assess policy’s effects on the broader total non-financial private sector credit-to-GDP gap. Prof. Davis, Dr Karim and Dr Noel found that a number of macroprudential tools are effective in influencing the gap, notably when the gap is positive or growing. Focus of existing macroprudential policy - and most research - on bank and household lending, a subset of the total captured by the credit-to-GDP gap and Prof. Davis’, Dr Karim’s, and Dr Noel’s research, raises important issues. Their work shows economy-wide effect of macroprudential measures in a way that studies focused on narrower measures of credit, which may be subject to disintermediation, may not. Furthermore, neglect of types of lending such as to commercial property, which have been critical in past episodes of financial instability, implies a risk of excessive focus of researchers and policymakers on the most recent crisis. Further work by Prof. Davis, Dr Karim and Dr Noel (Ref. 6) has shown the negative effect of some macroprudential policies on bank profitability, a subject of potential concern if it limits banks’ scope for capital accumulation.