No. 140 - Macroprudential, microprudential and monetary policies: conflicts, complementarities and trade-offs

We review the recent literature on macroprudential policy and its interaction with other policies, extracting several points. First, there are externalities in the financial sector, often in the form of excessive credit growth. Second, monetary policy needs to take financial stability into account. Third, macroprudential instruments can moderate the financial cycle. Finally, there are complementarities between monetary and macroprudential policies, but also potential conflict. We then relate these points to recent events in the euro area where, following the sovereign debt crisis, a retrenchment of finance within national borders is taking place, amplifying the divergences across economies. We argue that in principle national authorities would like to adjust macroprudential instruments to compensate for the highly heterogeneous financial conditions, but at present they have little leeway to do so, since in the run-up to the crisis insufficient capital buffers had been accumulated. Various factors may explain low bank capitalization levels worldwide. We discuss the role of risk-weighted assets, which may have inadequately captured actual risks in many jurisdictions; we also document that European and US banks' capital ratios decline monotonically with bank size. This confirms that key features of the microprudential apparatus are crucial for preventing financial instability.