Growth and Welfare Effects of Macroprudential Regulation
The growth effects of financial volatility, and ways to mitigate them, have been largely absent from recent discussions about the implications of the global financial crisis for financial reform. However, understanding the longer run effects of financial regulation is essential because of the potential dynamic trade-off associated with the fact that regulatory policies, designed to reduce procyclicality and the risk of financial crises, could well be detrimental to economic growth, due to their effect on risk taking and incentives to borrow and lend. This paper studies the growth and welfare effects of macroprudential regulation in an overlapping generations model. When the optimal monitoring intensity is endogenously determined, it finds that an increase in the reserve requirement rate (motivated by systemic risk considerations) has ambiguous effects on investment and growth. However, the trade-off between ensuring financial stability and promoting economic growth can be internalized by choosing the reserve requirement rate that maximizes growth and welfare.
Macroprudential Regulation, Growth, and Welfare
Much of the recent debate has focused almost exclusively on the implications of financial volatility for short-term economic stability and on the short-run benefits of financial regulation–especially macroprudential policies, which take a systemic approach in addressing financial vulnerabilities–in terms of mitigating procyclicality of the financial system and dampening short-run fluctuations in credit and output. However, understanding the longer run effects of financial regulation is essential because of the potential dynamic trade-off associated with the fact that regulatory policies, designed to reduce procyclicality and the risk of financial crises, could well be detrimental to economic growth.
In low-income countries, where sustaining high growth rates is essential to increase standards of living and escape poverty, understanding the terms of this trade-off is particularly important. These countries are often characterized by an underdeveloped formal financial system, and thus limited opportunities to borrow and smooth shocks. The real effects of financial volatility on firms and individuals can therefore be not only large but also highly persistent. As such, the benefits of regulatory measures aimed at promoting financial stability could be fairly substantial.
The key insights from the analysis are as follows:
- When the monitoring costs that financial intermediaries face are exogenous, an increase in the reserve requirement rate—motivated by the desire to constrain banks’ capacity to lend, reduce the private sector leverage ratio, and mitigate systemic risk—has unambiguously negative effects on investment and economic growth.
- However, when the optimal monitoring intensity is endogenously determined, an increase in the reserve requirement rate (motivated by systemic risk considerations) has ambiguous effects on investment and growth.
- The trade-off between ensuring financial stability and promoting economic growth can be internalized by choosing the reserve requirement rate that maximizes growth and welfare.
The study suggests that the trade-off between financial stability and economic growth that policymakers typically face when setting macroprudential instruments can, in principle at least, be addressed by setting these instruments in such a way that they balance positive and negative effects on growth and welfare. Although the discussion focused on a particular instrument—reserve requirements aimed at reducing banks’ capacity to lend, private sector leverage, and mitigating systemic financial risks—it is very possible that similar results may also characterize the choice of other macroprudential tools, such as bank capital requirements and loan-loss provisions. However, an important caveat to the analysis relates to the fact that the model did not account explicitly for the possibility that even though reserve requirements are set optimally, their level may be so high that they may foster disintermediation away from the formal banking system and toward less regulated channels. Even though the impact of this shift on investment and growth may be muted, it may exacerbate systemic risks. The possibility of leakages means therefore that financial sector supervision may also need to be strengthened, and the perimeter of regulation broadened, when aggressive macroprudential policy reforms are implemented. This is an important message for policymakers.