Macroprudential Policy: Guarding the Whole Financial System

How regulators use tools like loan-to-value limits and countercyclical capital buffers to prevent financial booms and busts across the whole system.

Traditional bank regulation focused on making each individual bank safe. The 2008 financial crisis showed that the financial system as a whole can be fragile even when individual banks appear sound. Macroprudential policy aims to reduce systemic risk: risks to the whole financial system.

Why system-wide risks arise

Credit booms: when many lenders relax standards at once, debt and asset prices can surge, then crash.
Interconnections: problems at one institution can spread to others.
Herd behaviour: many institutions making similar bets.

Tools

Loan-to-value limits: capping how much can be borrowed relative to a property’s value, reducing risky mortgages. The RBI sets loan-to-value limits for home loans in India.
Debt-to-income limits: capping borrowing relative to income.
Countercyclical capital buffers: requiring banks to hold extra capital during booms, which can be released in downturns to support lending.
Higher capital for systemically important banks, whose failure would do the most damage. The RBI designates certain banks, such as State Bank of India, HDFC Bank and ICICI Bank, as domestic systemically important banks.
Risk weights: raising capital requirements on specific types of lending.

India’s example

In November 2023, the RBI raised risk weights on unsecured consumer loans, such as personal loans and credit cards, and on bank lending to non-banking financial companies, after rapid growth in these areas. The aim was to cool potentially risky lending before problems built up.

Who is responsible

Many countries have created bodies for macroprudential oversight, such as the Bank of England’s Financial Policy Committee and the U.S. Financial Stability Oversight Council. In India, the Financial Stability and Development Council coordinates regulators.

Cooling a housing boom

House prices are rising rapidly, and banks are lending up to 95 percent of property values. Regulators lower the maximum loan-to-value ratio to 80 percent. Buyers need larger deposits, borrowing slows, and the risk of widespread defaults if prices fall is reduced. The policy targets a specific risk without raising interest rates for the whole economy.

Thinking interest rates are the only tool to control booms

Raising interest rates affects the entire economy. Macroprudential tools can target specific risky areas, like mortgages or consumer credit, more precisely.

Key takeaways

Macroprudential policy aims to reduce risks to the whole financial system.
Tools include loan-to-value limits, countercyclical buffers and higher capital for key banks.
In 2023, the RBI raised risk weights on unsecured consumer loans to cool risky lending.
Specialised bodies coordinate macroprudential oversight.