A Study On The Fundamental Theory Of Macroprudential Banking Regulation

Macroprudential banking regulation is the most important topic in post-crisis financialregulation reform. Its goal is to manage systemic risk arising from the banking sectorand enhance the stability of financial system. Yet systemic risk lacks a clear andoperational definition and its measurement still at a premitive stage. Under thiscircumstance, it amounts to tautology to say that macroprudential regulation aims atsystemic risk management.While practices in macroprudential banking regulation keep developing afterfinancial crisis, there hasn’t been any big breakthrough in relevant fundamental theorystudies. This situation must be improved, which is the goal of this paper.In most cases, people’s understanding of macroprudential regulation is based onits difference with microprudential regulation. But this approach risksunder-appreciating their intrinsic links. For example, the most importantmacroprudential measures to date, namely Basel Ⅲ countercyclical capital buffer andcapital surcharge for systemically important financial institutions, both belong tocapital regulation, which has been the key microprudential tool ever since Basel Ⅰ.There are two alternative approaches to deal with the aforementioned problem.The first is a top down approach. Under this approach, the definition ofmacroprudential regulation is based on a definition of systemic risk, much the sameway as microprudential regulation on market risk, credit risk, liquidity risk,operational risk, etc. But unless systemic risk can be accurately measured, there willbe substantial ambiguity in defining macroprudential regulation. The second approachis a bottom up one. This approach starts with the links between microprudential andmacroprudential regulation and studies how to modify microprudential measures onboth cross-sectional and time dimensions to serve the purpose of systemic riskmanagement. It builds on solid research on the microprudential side and has the benefit of flexibility and extensibility. Before systemic risk measurement is welldeveloped, this approach has the potential to be the dominate approach inmacroprudential regulation research.This paper follows the second approach and carries out a study on thefundamental theory of macroprudential banking regulation. It aims to facilitate ourunderstanding of macroprudential banking regulation and come up with policysuggestions. It consists of nine chapters.Chapter Ⅰ is introduction. This chapter discusses the background and motivationof this paper, its relationship with existing literature, key issues to deal with, its logicstructure and major research methods employed.Chapter Ⅱ presents a comprehensive review of post-crisis microprudential andmacroprudential regulatory reforms. It serves as background materials and also scopesthe issues we intend to analyze in great details.Chapter Ⅲ is the nexus of this paper and does a gap analysis between the generaltheories of financial regulation and macroprudential regulation. By gap analysis, wemean the following questions: to study the fundamental theory of macroprudentialbanking regulation, what ideas can we learn from the general theories of financialregulation, and what extra research work is needed? We adopt the analysis frameworkof financial externalities and devise a general roadmap for studying macroprudentialbanking regulation. It goes as follows. First, we focus on three major externalitiesgenerated by banks, namely credit risk, liquidity risk and loan supply quantity(through its impact on money, inflation and economic growth). For each externality,we define its intrinsic magnitude and external impact. Then we show that from thecentral planner’s perspective, each externality can be internalized through a quota ofits intrinsic magnitude on banks and each quota is equivalent to some microprudentialregulatory tool. We also find a positive relationship between the external impactparameters and the optimal regulatory standards. Thus if the external impactparameters vary across different banks and at different stages of economic cycle,regulatory standards should be adjusted accordingly, which leads to macroprudentialregulation. So our key point is: microprudential regulatory measures can be modifiedon cross-sectional and time dimensions to serve macroprudential purpose. This chapter also identifies five questions for further research, which become the subjectsof Chapter Ⅳ-Ⅷ.Chapter Ⅳ analyzes the three major externalities from a macroprudentialperspective, including relevant transmission channels and the measurement of theirintrinsic magnitudes and external impacts. We show that the external impactparameters, which can also be termed banks’ contribution to systemic risk, can varyacross different banks and at different stages of economic cycle.Chapter Ⅴ studies macroprudential regulation on banks’ credit risk. We prove theeconomic rationale of Basel Ⅲ countercyclical capital buffer and captial surcharge forsystemically important financial institutions. This chapter also carries out an empiricalananysis of the effects of Basel Ⅲ countercyclical capital buffer. We find that Basel Ⅱhas a procyclical impact on loan supply. Basel Ⅲ countercyclical capital buffer hastwo major effects. One is to increase capital requirement by about1%and the other toreduce Basel Ⅱ’s procyclicality by about50%. But Basel Ⅲ countercyclical capitalbuffer probably has limited power in curbing credit expansion caused by asset price.In such circumstances, it is more appropriate to use monetary policy and thecoordination between monetary policy and countercyclical financial regulation shouldbe improved.Chapter Ⅵ studies macroprudential regulation on banks’ liquidity risk. Weexplore the fundamental theory of liquidity risk regulation. We prove the economicrationale of Basel Ⅲ liquidity risk regulatory tools (LCR and NSFR) and put forwardrules that should be obeyed when setting parameters in LCR and NSFR. We alsosuggest introducing macroprudential factors into LCR and NSFR.Chapter Ⅶ studies macroprudential regulation on banks’ loan supply quantity.We prove the economic rationale of PBoC’s dynamic adjustment mechanism fordifferentiated deposit reserve requirement. But based on empirical, we think thismechanism will only have limited power.Chapter Ⅷ studies the macroprudential regulation functions of financial safetynet measures and capital quality. We classify safety net measures into two types. Thefirst type is liquidity supporting measures. The second type is loss sharing schemesbetween government and financial institutions. We study the type two measures’ cost to government and impact on financial institutions’ solvency. We find a positiverelationship between them. For capital quality, we find capital instruments’ ability toabsorb loss on a going concern is determined by its ability to lower financialinstitutions’ probability of default, and the ability to absorb loss on a gone concern bytheir ability to lower loss given default. Thus raising capital quality amounts toutilizing private sector resources to achieve the goal of financial safety net measures.Chapter Ⅸ summarizes and discusses topics for future research.