Macro vs microeconomic policy: is there a winner?

The objectives of macro- and microprudential policies have broadly coincided since the Global Crisis. With the turning of the financial, economic and political cycles, their objectives will conflict more in coming years, leading to difficult turf battles.

Before the Crisis, financial policy was dominated by microprudential regulations, the implicit assumption being that a successful micro policy was sufficient to maintain the efficient operation of the financial system, just as a successful anti-inflation policy was all that was required from monetary policy.

The limitations of both approaches became very clear during the Crisis and since then, macro has been a major part of financial policy. However, while the ultimate objectives and implementation tools of macro and micro are closely aligned, their intermediate objectives are not, setting the scene for conflict.

The potential for conflict

Both macro and micro serve the same ultimate policy objective of ensuring that the financial system provides the best service to the real economy, but in detail their objectives are quite different. Micro is motivated by consumer and client protection, and aims to encourage confidence in banking services and hence to increase their use and consequently value to society. Macro is focused on systemic risk and the stability of the entire financial system.

A micro regulator might argue that as long as each institution is made to act prudently, the entire financial system is safe so therefore there is no need for macro. A macro regulator might counter by pointing that it is easy to construct models in which this is not true.

In a stress scenario, if prices start falling, prudent financial institutions will have no choice but to sell into a falling market, causing prices to drop more and spreading contagion. The resulting vicious feedback loop is a direct consequence of prudent self-preserving behaviour and amplified by harmonised micro prudential regulations.

Similarly, micro regulators would always see margining and margin calls as beneficial, while macro authorities might be concerned with the resulting forced selling and contagion.

Such fallacies of composition suggest that one cannot at all times achieve financial stability by the micro alone.

Top-down and bottom-up

Claudio Borio noted in 2003 that micro is bottom-up, with the focus on individual behaviour aggregated up to the level of the institution. In some circumstances, the legal person that is regulated is the institution and it takes responsibility for the behaviour of its employees; or employees and the institution may both be regulated and share responsibility. In both cases, conduct is regulated and sanctioned. Implemented by lawyers and accountants, micro is essentially retributive.

Macro is different. It is more supportive rather than retributive, being based on support for the financial system as a whole and the need to maintain its healthy operation at times and under circumstances when market forces do not on their own appear capable of achieving this. The institution is conceptually the smallest unit considered and it is interactions between institutions rather than their internal functions that are of most interest.  Consequently, it is more influenced by economists.

The banks prefer micro in upturns

In good times, banks love micro regulation because it creates barriers to entry and hence increases profits.

If micro regulation is great for business, macro is bad and to the banks it is just a long list of old-fashioned proscriptions on profitable things they want to do.  Perhaps a 1990s bank can’t buy a securities business because of the 1933 Glass-Steagall Act, or it can’t buy these high-yielding structured AAA credits because of ancient leverage limits.

If macro regulation has not proved its worth in a long while it will be seen as pointless and restrictive, so inconvenient rules will be steadily pared back by a powerful bank lobby.

During good times micro regulation will always come to the fore.

In bad times the roles reverse

Bad times reveal bad practice and the micro regulator is naturally inclined to retribution –when banks do not meet their obligations, fines and penalties result.  The macro regulator, however, is tasked to keep the system running and is now the banks’ friend – it will help to supply capital as required and it wishes to forgive and forget transgressions as rapidly as possible so that banks can play their part.

This explains why the regulators always seem to be on the banks’ side – in each state of the world, the banks have a friend calling the regulatory shots, whether macro or micro.

Toolkits and turf battles

Quite how separate micro and macro regulation are has of course changed substantially over time. Over the past few decades, most regulatory efforts were on the micro side. For example, the Basel accords have always been much more micro-focused than macro-focused, even though calling them only microprudential is misleading. This changed with the Crisis.

Even when both are actively practiced and are located in the same government organisation, macro and micro are likely to be in separate silos, despite the overlap of their toolkits. Micro regulation operates on a clear legal basis with defined rules, investigative powers and penalties. While many of the micro tools are specific to the micro objective, many are also useful and even necessary for macro.

That is one source of conflict, since micro regulators may resent having to share their enforcement tools with macro regulators and the conflict between the two becomes most visible when the macro and micro authorities want to push the levers in opposite directions.

Conflict and cycles

The degree of conflict between macro and micro depends on the state of the financial and economic cycle, as noted by Schoenmaker et al. (2011, 2013). It also depends on the political support cycle and the direction of bank lobbying.

The conflict between the two is lowest when their objectives coincide and both enjoy a high degree of political support, as in the past few years. Both the macro and micro policymakers have wanted to de-risk the financial system, both wanted to increase capital. Their regulatory efforts have enjoyed a level of political support that comes only in the aftermath of crisis.  However, this happy coincidence of the economic, financial and regulatory cycles is already starting to break down.

In times of severe stress or crisis, a micro authority might want to increase margins and collateral to mitigate risk, while a macro authority could be concerned with fire sales, wanting to decrease margins and collateral. However, we do not need times of acute stress for the conflict to emerge. In an economy suffering from low growth, a macro regulator might prioritise the health of the economy and seek a loosening of capital constraints to encourage more risky lending.

If it opted to do so, a macro regulator would receive strong political support.

The European Commission has increasingly sought to improve the investment climate to overcome sluggish economic growth and high unemployment, for example through its capital markets union initiative.

Related is the appeal from the European Commission in September for evidence of “unnecessary regulatory burdens” and “other unintended consequences” of banking and markets laws. In the words of Jyrki Katainen, vice-president of the commission responsible for jobs and investment, “[d]uring the past five years… regulators at European level have concentrated on crisis management. Stability has come back… now we are in the situation where we have to use the European regulatory power to create new markets”.

Furthermore, France, Germany and Italy recently intervened directly in macro prudential regulations by undercutting global bank capital standards, relaxing rules on total loss absorbing capacity. The motivation for this is probably macroeconomic, and the banks’ ability to make risky loans to small and medium-sized enterprises, but it comes at the expense of more risk and the undermining of the macro authorities.

The micro regulator is always concerned primarily with institutional stability and naturally tends to oppose any such moves.

Conclusion

While the macro and micro objectives have always been present in the regulatory design, their relative importance has waxed and waned according to the changing requirements of economic, financial and political cycles.

Before the Crisis, macro regulation was on the back burner, with only micro actively pursued.  During the Crisis, only macro regulation mattered. Since, we have a rare situation in which all three cycles coincide – micro and macro pull in the same direction and this masks the potential for conflict

However, that coincidence has been dependent on the political, economic and financial imperative to clear up the aftermath of Crisis, and this imperative is starting to weaken.  While the macro concerns that resulted remain important, distinctly micro ones are growing while the macro objectives are being undermined by the political leadership.

This presents a difficult challenge for the macro authorities. They can opt to incorporate macroeconomic targets into macroprudential policies, but that risks undermining the credibility of the macro agenda, and hence the erosion of political support. Alternatively, the macro authorities may resist incorporating economic targets, but this also risks loosing political support.

Either way, the conflict between macro and micro seems set on deepening.

It will be interesting to see how the macro and micro authorities manage their conflicts as the situation evolves, and the position of the political leadership. Our hope is that whatever the outcome, it will not lead to the undermining of the central bank’s execution of monetary policy, as discussed by Chwieroth and Danielsson here on Vox in 2013.

This article is published in collaboration with VoxEU. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Jon Danielsson is a director of the ESRC funded Systemic Risk Centre at the London School of Economics. Morgane Fouché is a researcher at the Systemic Risk Centre at the London School of Economics. Robert Macrae, CFA, is the managing director of hedgefund manager Arcus Investment.

Image: Silhouetted workers walk in front of office towers in the Canary Wharf. REUTERS/Luke MacGregor.