Growth and Welfare Effects of Macroprudential Regulation

by | Jun 2, 2016 | Papers | 6 comments

Pierre-Richard Agénor

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.

Policy Lessons

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.



  1. Alessandro Flamini

    This is Alessandro Flamini, University of Pavia, Italy. My question for Professor Agénor is the following. The paper’s goal (as stated in the introduction) is to discuss the trade-off between growth/welfare and financial stability in setting macroprudential instruments. But as far as I could tell financial stability is not explicitly defined and modeled; is that an issue? Thanks.

    • Pierre-Richard Agénor

      This is an important question. In the model developed in the paper, the reference to financial stability is indeed only indirect; it is not measured by a specific variable. The first reason is that, to this day, there is still no consensus among economists and policymakers as to what constitutes “financial stability.” We continue to define it often as the absence of a (bad) event–a bank run or a full-blown financial crisis. Some recent contributions have attempted to measure financial (in)stability by introducing an explicit measure of the probability of bank default; I am quite sympathetic to this approach although others are not. Other contributions, mostly empirical in nature, used composite measures with a number of variables (the share of nonperforming loans, bank leverage, etc.), but often with no clear underlying theoretical rationale about the relative importance of each. Moreover, these composite measures are difficult to implement in stylized theoretical models.
      The second reason is that the implicit treatment provided in the paper is actually sufficient for the purpose at hand. Indeed, the focus of the paper is to study what happens to long-run growth when a macroprudential instrument (the required reserve ratio) is set by the financial regulator with mainly “short-run” considerations in mind. The idea is that the financial regulator, by forcing banks to hold higher liquid reserves than they would otherwise and thereby providing partial deposit insurance to savers, may help to mitigate the risk of bank runs and potential default. So the benefit of the regulation is the very fact that the financial system is able to operate and to extend credit.
      The reason why this is sufficient is because the model helps to highlight an important trade-off in setting reserve requirements when bank monitoring intensity is endogenous. On the one hand, requiring them to put away a fraction of the deposits that they receive reduces the supply of loanable funds and thus investment. On the other, however, a higher reserve requirement rate also mitigates banks’ incentives to monitor. This reduction in monitoring intensity translates into lower monitoring costs, which frees up resources to increase loans and mitigates the adverse direct effect of a higher reserve requirement rate on lending. This trade-off can be internalized by the financial regulator by setting the required reserve ratio optimally.
      Even though this trade-off, and the policy response that it should generate, are fairly clear, it would be fruitful to extend the analysis in the paper and consider explicitly a measure of the risk of default by banks. This is high on my research agenda.

  2. EL MOKRI Karim

    This is Karim El Mokri, Senior Economist at the OCP Policy Center in Rabat, Morocco. My question is related to Professor Agénor’s policy brief associated with his contribution “Growth and Welfare Effects of Macroprudential Regulation.” The brief focuses rightly on policy lessons for low-income countries, but in many middle-income countries (including Morocco) reserve requirements have also been actively used–albeit often for macroeconomic stability reasons, rather than financial stability considerations. Are the lessons drawn for low-income countries also applicable to a country like Morocco? Thank you.

    • Pierre-Richard Agénor

      Mr. El Mokri, you are right to point out that reserve requirements have been used extensively in recent years in many middle-income countries–often during “emergency” or “unusual” situations to either inject or withdraw liquidity quickly. In Brazil for instance, in the immediate aftermath of the global financial crisis, the authorities lowered reserve requirement rates on short-term deposits. In Morocco, by contrast, the authorities raised these rates when the country faced massive capital inflows in the early 2000s, associated with large privatization operations.

      The key issue here, however, is whether longer-term considerations should also be factored in when setting reserve requirements in that group of countries, independently of short-run, stabilization objectives. The answer is yes; growth is an important consideration for middle-income countries, just as it is for low-income countries. The trade-off emphasized in the paper (balancing the benefits of high reserve requirements in terms of financial stability and their effect on financial intermediation, growth and welfare) is an equally fundamental concern for policymakers.

      That being said, however, the question is to what extent the larger range of macroprudential instruments that middle-income countries often have access to creates trade-offs between these instruments, and whether a combination of tools may not be more appropriate to promote longer-term goals than reliance only on reserve requirements. Addressing this issue should be high on the research agenda.

  3. Keyra Primus

    This is Keyra Primus, Economist at the International Monetary Fund. My question, Professor Agénor, is the following: some recent contributions to the literature on banking regulation have assumed that there is an inverse relationship between bank monitoring and risk taking; is this appropriate in the context of your paper? Thanks.

    • Professor Agénor

      It is true that a number of recent contributions (some from IMF researchers, actually) have focused on the case where bank monitoring and risk taking (by borrowers) are inversely related. This may be because with more scrutiny from lenders (onsite inspection, review of books and accounts, etc.), borrowers are less able to divert the resources that they’ve borrowed to engage in other (less productive) activities. So from that perspective, my response is yes–this interpretation is appropriate in the context of my analysis. Specifically, this interpretation implies that if a higher required ratio mitigates banks’ incentives to monitor (as shown in the model) risk taking may increase–thereby mitigating the benefits of the increase in that ratio in the first place, in terms of promoting financial stability.

      However, I would not push the idea of a “one to one” relationship between monitoring and risk taking too far. The key reason is that risk taking can take a range of forms, which cannot be necessarily mitigated by increased monitoring. In particular, risk taking may take the form of borrowers choosing a risky(although more productive) technology, whose probability of failure may depend on factors or shocks that are largely exogenous (the “state of nature”) upon which banks may have little impact ex post (after a loan is made) through monitoring. The proper policy in that context is to mitigate in the first place (ex ante) bank incentives to lend for investment in the risky technology–and this calls for instance for higher capital requirements on risky loans. By reducing the degree of riskiness of bank assets these policies would also contribute to making banks safer, something that (ex post) monitoring may not be able to achieve.


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