How macroprudential policy works
A short video ‘Booms, busts and the way between’ explains the role of macroprudential policy and the tools we have to smooth out boom-bust cycles.
Macroprudential policy is one part of our toolkit for maintaining financial stability—the consistent supply of financial services that the economy relies on. It can reduce the impact of a stress scenario on the financial system by:
building additional resilience in the financial system, so that banks can support the economy even when it is under stress
reducing risky lending during booms, so that in the case of a bust, banks have fewer losses to absorb and households are less likely to default on their loans.
The financial system is procyclical
The financial system by its nature is procyclical (see Diagram A). This means financial cycles tend to be self-reinforcing and amplify economic cycles in both upturns and downturns.
Booms in the financial cycle can be made worse if banks, investors and households underestimate the level of risk. Investor and borrower behaviour can be shaped by relying too heavily on recent news and asset performance.
Diagram A: Boom-bust cycles
As asset prices rise, provisions for non-performing loans fall and credit spreads (the gap between yields/interest rates on riskier debt and low-risk debt) narrow. This in turn may encourage banks to relax their lending standards and households to take on more debt.
This cycle can continue until a macroeconomic downturn occurs, whether due to a specific shock (for example, a global credit crunch) or a general economic slowdown that causes lenders and borrowers to reconsider whether debt levels are sustainable. Businesses and households may cut spending and sell assets to pay down debt, while banks tighten standards for new loans.
The cycle then works in reverse and the downturn in the financial cycle and the slowdown in the economy become mutually reinforcing.
The procyclicality of the financial system is intensified by market failures. Banks and households may act rationally to make the best of their individual positions, but if they all act in the same way and invest in the same assets, they contribute to the system's procyclicality and increase the risk and scale of a correction in asset prices.
Macroprudential interventions may be necessary when we identify that market failures are operating to amplify boom-bust cycles in the financial system.
Read about how we use a range of macroprudential tools to maintain the stability of the financial system
Macroprudential policy decision-making
Our approach to macroprudential policy decision-making involves monitoring systemic risk, policy design and policy assessment. We then assess the effectiveness of the policy once implemented.
We regularly inform the Minister of Finance and the Treasury about significant macroprudential policy developments and any emerging risks to the financial system.
Also, a Memorandum of Understanding between the Minister of Finance and our Governor defines macroprudential policy and has guidelines for how we use the policy.
Read the Memorandum of Understanding between the Minister of Finance and the Governor of the Reserve Bank on macroprudential policy and operating guidelines.
We monitor a range of indicators that have been shown to have some ability to predict risks and vulnerabilities that can lead to system-wide distress.
We use the indicators as the basis of our macroprudential policy decision-making. We discuss the leading indicators in the Financial Stability Report.
We publish a chart pack of indicators every quarter.
Systemic risk monitoring
We use the macroprudential indicators as the basis of three inter-related assessments:
- Probability of a correction in the credit cycle: We look at the indicators of credit growth and the levels of asset prices to assess the probability of a correction in the credit cycle. This provides an initial red flag that systemic risks are increasing and that we should consider macroprudential intervention.
- Financial system resilience: We have a range of tools to assess the resilience of the financial system. This includes monitoring bank capital and liquidity ratios, stress testing of the financial system and analysing the vulnerability of credit portfolios. The level of household debt is an important indicator of the potential scale of losses that would need to be absorbed and therefore the likelihood of triggering procyclical behaviour by banks.
Potential feedback effects with the economy: Our 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. We monitor lending standards through the credit conditions survey, loan-to-value and debt-to-income ratios of new lending, and supervisory interactions.
If our systemic risk monitoring suggests we may need to apply a macroprudential intervention, we use an options analysis to decide on the most appropriate response. We consider how much the risk is due to baseline prudential standards and how this affects the options analysis.
As part of our supervision of banks, we also monitor whether they are managing their risks wisely. Before applying any macroprudential tools, we have discussions with individual banks on their lending standards and how they are mitigating identified risks. This may reduce the need for macroprudential intervention.
If the indicators suggest a build-up of risk in the financial system generally, there could be a case for using a capital instrument such as a countercylical capital buffer. If the risks are focused on a particular sector like agriculture, sectoral capital requirements may be more appropriate.
If our systemic risk monitoring suggests an elevated risk of a correction in the housing market, with borrowers taking on excessive mortgage debt, then we would consider LVR restrictions (and other transactional instruments that may be available in future) to be more effective than capital tools.
Once we have identified that a macroprudential policy response appears to be necessary, and the macroprudential tools we intend to use, we will consult on our policy proposal.
Feedback from the public, regulated entities and other stakeholders 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 we have implemented a macroprudential tool, we monitor its effects and publish an assessment of those effects in our Financial Stability Report. Our assessment will consider whether:
- the basis for the policy response has changed
- there were any significant unintended consequences (for example, avoidance activity)
- the mix of tools used and/or their calibration is optimal.
Based on this assessment, we will decide whether 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 our decision-making and provide a basis for holding us to account for our macroprudential policy decisions.
We will update the framework document from time to time to reflect legislative and policy changes.