Macro-prudential policy

The aim of macroprudential policy is to reduce the likelihood of a financial crisis, and to increase the resilience of banks and households, in order to limit the scale of severe economic downturns.

Financial stability

The purpose of macroprudential policy is to reduce the risk that the financial system amplifies a severe downturn in the real economy. An unsustainable boom in credit and asset prices can result in a bust that creates losses for banks, businesses and households, and hampers the ability of banks to continue lending to the economy.

This is important because financial instability – a disruption to the supply of essential services provided by the financial system – can have significant and lasting economic and social costs. Macroprudential policy aims to reduce the likelihood and severity of these costs.

Procyclicality

The financial system is inherently pro-cyclical (Diagram A). Booms in the financial cycle tend to be exacerbated due to banks, investors and households underestimating the level of risk. Investor and borrower behaviour can be shaped by an over-reliance on recent news and asset performance.

Diagram A: Boom-bust cycles

As asset prices rise, provisions for non-performing loans fall and credit spreads narrow, banks and households assume that risks are lower than they are. These benign indicators, together with low volatility in markets, not only lower risk perceptions but also encourage banks and households to become more leveraged.

This process can continue until a macroeconomic downturn occurs, whether due to a specific shock (eg, a global credit crunch) or a general economic slowdown that causes investors and borrowers to reconsider the serviceability of their debt. The process then works in reverse and the downturn in the financial cycle and the slowdown in the economy become mutually reinforcing.

Market failures

The pro-cyclicality of the financial system is exacerbated by market failures. Banks and households may act rationally to optimise their individual positions but if they all act in the same way, and invest in the same assets, they contribute to the pro-cyclicality of the financial system and increase the risk and scale of a correction in asset prices.

Macroprudential interventions are necessary when the Reserve Bank identifies that market failures are operating to amplify boom-bust cycles in the financial system.

The Reserve Bank has a defined list of macroprudential tools or instruments (see Table below). Other macroprudential instruments may be added over time – and there may be a role for these tools – as the financial system and risks evolve.

Capital and liquidity instruments

Countercylical Capital Buffer (CCyB)
An additional capital buffer the Reserve Bank can require banks to meet. The Reserve Bank can ease the requirement where there are signs of potential losses or deleveraging.
Sectoral Capital Requirement (SCR)
An additional capital buffer the Reserve Bank can require banks to meet due to the build-up of credit in a specific sector (e.g. lending to the dairy industry, residential mortgages or credit cards) that has systemic risk implications. The Reserve Bank can then ease the requirement where there are signs of potential sectoral losses or deleveraging.
Core Funding Ratio (CFR)
At present banks are required to source at least 75 percent of their funding from retail deposits, long-term wholesale funding or capital. The Reserve Bank can ease the requirement in the event of market dislocation.

Transactional instruments

Loan-to-value ratio (LVR) restrictions
A restriction the Reserve Bank can impose that limits the amount of credit that banks can extend to borrowers with high LVRs.
For more details, go to the Loan-to-value ratio (LVR) restrictions page.

For a description of how each macroprudential instrument transmits to financial stability see the Macroprudential policy framework document (PDF 1.4MB).

The Reserve Bank intends to publish guidance notes on the LVR and capital-based macroprudential instruments, with more detail on relevant macroprudential indicators.

Macroprudential instruments are implemented via changes to the Banking Supervision Handbook and banks’ conditions of registration.

For consultation papers, including in relation to the proposed Debt-to-Income ratio restriction see the Macroprudential policy consultation page.

The Reserve Bank’s approach to macroprudential policy decision-making involves:

  • systemic risk monitoring
  • policy design
  • policy assessment

The Reserve Bank then assesses the effectiveness of the policy once implemented.

The Reserve Bank keeps the Minister of Finance and the Treasury regularly informed on its thinking on significant macroprudential policy developments and of emerging risks to the financial system.

Systemic risk monitoring

The Reserve Bank uses the macroprudential indicators as the basis of three, inter-related, assessments:

  • Probability of a correction in the credit cycle: The Reserve Bank focuses on indicators of credit growth and of the levels of asset prices to assess the probability of a correction in the credit cycle. This provides an initial flag that systemic risks are increasing, and macroprudential intervention should be considered.
  • Financial system resilience: The Reserve Bank has a range of tools to assess financial system resilience. This includes monitoring bank capital and liquidity ratios, stress testing of the financial system, and undertaking analysis of the vulnerability of credit portfolios. Household indebtedness is an important indicator of the potential scale of losses that would need to be absorbed and therefore the likelihood of triggering pro-cyclical behaviour by banks. [add links to Dashboard and stress testing page]
  • Potential feedback effects with the economy: Bank lending standards form an important component of the assessment. An industry-wide easing of lending standards could reduce the resilience of the financial system over time. Lending standards are monitored through the credit conditions survey, loan-to-value and debt-to-income ratios of new lending, and supervisory interactions.

Policy design

If the Reserve Bank’s systemic risk monitoring suggests that a macroprudential intervention may be required, an options analysis will consider the most appropriate response.

The Reserve Bank will consider the extent to which the risk is accounted for by baseline prudential standards and how this affects the options analysis.

The Reserve Bank also monitors whether individual institutions are prudently managing their risks as part of its prudential supervision. Macroprudential intervention is likely to be preceded by supervisory discussions on lending standards and how individual banks are mitigating the identified risk. This may reduce the need for macroprudential intervention.

If the indicators suggest a lack of resilience in the financial system there could be a case for using a capital instrument (the countercyclical capital buffer or sectoral capital requirements or a liquidity instrument (the core funding ratio).

If our systemic risk monitoring suggests a high level of potential feedback between the identified risks and the economy then LVR restrictions (and other transaction instruments, should these become available) are expected to be a more effective mitigant than capital instruments.

Policy assessment

Once the Reserve Bank has identified that a macroprudential policy response appears to be necessary, and the macroprudential instrument(s) it intends to use, it will consult on its policy proposal.

Feedback from the public, regulated entities and other stakeholders also can help determine the scope and calibration of the proposal and any necessary exemptions.

Consultation will include a provisional cost-benefit analysis or, if appropriate, Regulatory Impact Assessment. These will be reviewed in light of consultation feedback.

Once a macroprudential instrument has been implemented, the Reserve Bank monitors its effects and publishes an assessment of those effects in the Financial Stability Report. The assessment will include consideration of whether:

  • the basis for the policy response has changed;
  • there are any material unintended consequences (eg, disintermediation); and
  • the mix of instruments used and/or their calibration is optimal,

and therefore whether, on balance, the policy response should be altered or discontinued.

The framework document for macroprudential policy outlines the purpose of the tools and how they transmit to financial stability. It is intended to improve the quality, predictability and transparency of the Reserve Bank’s decision making, and provides a basis for holding the Reserve Bank to account for its macroprudential policy decisions.

The framework document will be updated from time to time to reflect legislative and policy changes.

The Reserve Bank monitors a range of indicators that have been demonstrated to have some predictive power in terms of pointing to risks and vulnerabilities that can lead to systemic distress.

The Reserve Bank uses the indicators as the basis of its macroprudential policy decision making

The leading indicators are discussed in the Financial Stability Report.

The Reserve Bank has imposed restrictions on the amount of lending banks can do at certain loan-to-value (LVR) ratios.

A short video "Booms, busts and the way between" explains the role of macro-prudential policy and the tools the Reserve Bank has to smooth out boom-bust cycles.