Externalities and Macroprudential Policy

24 Pages Posted: 13 Jun 2012

See all articles by Gianni De Nicolo

Gianni De Nicolo

Johns Hopkins University - Carey Business School; CESifo (Center for Economic Studies and Ifo Institute)

Giovanni Favara

HEC University of Lausanne; Ecole Polytechnique Fédérale de Lausanne; International Monetary Fund (IMF)

Lev Ratnovski

International Monetary Fund; European Central Bank, Financial Research Division

Multiple version iconThere are 2 versions of this paper

Date Written: June 7, 2012


The recent financial crisis has led to a reexamination of policies for macroeconomic and financial stability. Part of the current debate involves the adoption of a macroprudential approach to financial regulation, with an aim toward mitigating boom-bust patterns and systemic risks in financial markets. The fundamental rationale behind macroprudential policies, however, is not always clearly articulated. The contribution of this paper is to lay out the key sources of market failures that can justify macroprudential regulation. It explains how externalities associated with the activity of financial intermediaries can lead to systemic risk, and thus require specific policies to mitigate such risk.

The paper classifies externalities that can lead to systemic risk as: 1. Externalities related to strategic complementarities, that arise from the strategic interaction of banks (and other financial institutions) and cause the build-up of vulnerabilities during the expansionary phase of a financial cycle; 2. Externalities related to fire sales, that arise from a generalized sell-off of financial assets causing a decline in asset prices and a deterioration of the balance sheets of intermediaries, especially during the contractionary phase of a financial cycle; and 3. Externalities related to interconnectedness, caused by the propagation of shocks from systemic institutions or through financial networks.

The correction of these externalities can be seen as intermediate targets for macroprudential policy, since policies that control externalities mitigate market failures that create systemic risk.

This paper discusses how the main proposed macroprudential policy tools — capital requirements, liquidity requirements, restrictions on activities, and taxes — address the identified externalities. It is argued that each externality can be corrected by different tools that can complement each other. Capital surcharges, however, are likely to play an important role in the design of macroprudential regulation.

This paper’s analysis of macroprudential policy complements the more traditional one that builds on the distinction between time-series and cross-sectional dimensions of systemic risk.

Keywords: Externalities, systemic risk, macroprudential policy

JEL Classification: G20, G28, E32

Suggested Citation

De Nicolo, Gianni and Favara, Giovanni and Ratnovski, Lev and Ratnovski, Lev, Externalities and Macroprudential Policy (June 7, 2012). IMF Working Paper No. SDN/12/05, Available at SSRN: https://ssrn.com/abstract=2083302 or http://dx.doi.org/10.2139/ssrn.2083302

Gianni De Nicolo

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States
(410) 234-4507 (Phone)

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679

Giovanni Favara

HEC University of Lausanne ( email )

Unil Dorigny, Batiment Internef
Lausanne, 1015

HOME PAGE: http://www.hec.unil.ch/gfavara/

Ecole Polytechnique Fédérale de Lausanne

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900

International Monetary Fund (IMF)

700 19th Street, N.W.
Washington, DC 20431
United States

Lev Ratnovski (Contact Author)

International Monetary Fund ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

HOME PAGE: http://ratnovski.googlepages.com

European Central Bank, Financial Research Division


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