Macroprudential Policy and Its Instruments in a Small EU Economy

This paper focuses on the way the macroprudential policy framework in a small EU economy should be designed. With reference to the experience of the Czech Republic's financial system and the Czech National Bank it provides definitions of financial stability and macroprudential policy as well as of their objectives. It then explains how systemic risk evolves over the financial cycle and outlines approaches to preventing systemic risk in the accumulation stage of the cycle and subsequently mitigating the materialisation of such risk if prevention fails. The paper argues that for the establishment of a macroprudential policy framework in a bank-based economy with a relatively simple and small financial sector, the phenomenon of procyclical behaviour has to stand centrally. Correspondingly, a macroprudential authority in such an economy has to look primarily at cyclically induced sources of systemic risks. Nevertheless, structural sources of systemic risks and associated instruments are discussed as well. The arguments for the recommended arrangements are supported by empirical investigations into the extent of procyclicality in European banks' lending behaviour and the contribution of the regulatory and accounting framework to it.