Macroprudential and Microprudential Policies: Toward Cohabitation
Financial stability is generally considered to be one of the objectives of microprudential policy. Through its focus on the risks and resilience of individual institutions it makes an important contribution to ensuring resilience of the system as a whole.2 The health of individual financial institutions is a necessary condition for a sound financial system. However, it is not sufficient unto itself due to the complexity of the financial system and to ―fallacy of composition‖3 issues that can arise.4 Actions apparently suitable at the level of individual institutions can destabilize the system as a whole (Hanson, Kashyap, and Stein, 2011) because of their interaction on financial markets, the structure of the network of which they are part, and the behavior of other financial institutions. In the context of general equilibrium theory (Allen and Gale, 2009), it could be argued that macroprudential policy takes into account general equilibrium effects, whereas these are usually ignored by microprudential supervisors. To achieve resilience and robustness within the financial system, the focus on individual institutions needs to be complemented by a system-wide perspective. In particular, microprudential supervision should be supplemented with macroprudential policies aimed at increasing the resilience of the system as a whole, calming booms and softening busts, while mitigating systemic risks resulting from fallacies of composition associated with concentration and interconnectedness in the financial system.
This paper analyzes the interactions between microprudential and macroprudential policies to identify complementarities and potential conflicts, and to propose mechanisms for aligning both policies.5 Such complementarities and potential for conflict are inherent in the effects of system-wide actions on the health of individual institutions, as well as in the effects of actions by individual institutions on the system, especially if the system is materially concentrated or interconnected.
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