Financial Stability Paper No 21: How could macroprudential policy affect financial system resilience and credit? Lessons from the literature

The existing literature suggests that a macroprudential policy authority could affect the resilience of the financial system and the flow of credit to the real economy through two main channels. The first, the allocation channel, operates through the constraints and incentives of financial institutions. By employing regulatory tools that affect the cost-benefit trade-offs of financial decisions, the authority would incentivise financial institutions to reallocate their resources across alternative investments. During credit booms, for example, raising the countercyclical capital buffer would help enhance resilience and could dampen excessive balance sheet expansion. Conversely, lowering this buffer during a downturn would discourage banks from excessive deleveraging, provided that the remaining capital buffer is judged to be adequate to absorb future losses with a sufficiently high probability. In a post-crisis environment, however, some banks’ pre-crisis capitalisation may prove to be insufficient to absorb losses and confidence in the sector could, as a result, be low. Low capital levels may hamper banks’ access to funding markets and, ultimately, impair bank lending. Requiring undercapitalised banks to raise their capital levels could, in such circumstances, help underpin a sustained recovery of credit growth. The second is the signalling channel. By releasing policy signals about the costs and benefits of alternative actions, the authority would allow institutions to make better-informed financial decisions. In a post-crisis environment of heightened uncertainty, announcing clear and objective standards against which banks’ capital adequacy is judged could help lower sound banks’ funding costs while forcing weaker banks to recapitalise in order to meet the standards, thus restoring the banking system’s ability to provide credit to the real economy.