Macroprudential regulation and financial imbalances Macroprudential regulation of banks must be based on an understanding of how systemic risk arises. This understanding has been brought a step further since the financial crisis. There is a growing academic literature on the basis for macroprudential regulation. One of the main themes is how systemic risk can arise in the interaction between the financial sector and the real economy. Research is at an early stage, and so far no specific framework stands out. Some conclusions seem, however, to be robust across the various approaches. Many studies single out rapid credit growth in particular as a symptom of rising systemic risk. The theoretical literature is based on the principle that credit is a good. Borrowing enables households to smooth consumption over the life cycle and businesses to finance investments, thus promoting prosperity. But the literature also shows that debt can lead to vulnerability. Risk can be priced too low as a result of market failures of various kinds. Mispricing can contribute to excessive debt and the build-up of financial imbalances. Regulations that counteract credit swings may lead to fewer and less severe economic downturns. Chart: Rapid credit growth leads to deeper downturns The relationship between debt and systemic risk also finds support in many empirical studies. This chart shows the results of a study conducted by Jordà, Schularick and Taylor on downturns in 14 advanced economies, including Norway. 1 The study covers the period from 1870 to 2008. The chart illustrates two important findings.
The interest rate works through different channels, such as the house price channel. A lower key policy rate may lead to higher house prices via lower lending rates. This may, in turn, have a positive impact on consumption. If the ability to borrow against home equity is reduced, the house price channel will become weaker. Monetary policy, for its part, can be one of several factors that lead to a build-up of financial imbalances. History has shown that long periods of low interest rates can increase the risk that debt and asset prices reach unsustainable levels. Expectations of low interest rates may become entrenched among banks and borrowers when interest rates remain low for a long period. This may result in rapidly rising house prices. With low interest rates and rising house prices, banks may apply more lenient credit terms. We have also witnessed that low interest rates can prompt financial market participants to search for higher yields from alternative and often risky assets. Macroprudential regulation and monetary policy will often pull in the same direction. If the economy is booming, with rising inflation prospects and the risk of a build-up of financial imbalances, a tightening of monetary policy and capital requirements can underpin both objectives at the same time. Likewise, a pronounced downturn with increased banks losses can be addressed by lowering both the key policy rate and capital requirements. But in some situations, it may be appropriate to reduce the key policy rate at the same time as the capital requirements are tightened.