Since the Global Crisis, prudential instruments to address financial stability concerns have been enhanced and broadly adopted across countries. Using the recently updated International Banking Research Network Prudential Instrument database, this column shows that by 2023 most of the 64 countries considered have implemented most of the instruments. During the 2021-2023 inflation episode, cyclical prudential instruments were tightened as average inflation and policy interest rates rose. Many open questions remain on the drivers, effects, and effectiveness of prudential regulation, not least because these policies may also have unintended consequences.
In the aftermath of the Global Crisis, one of the many policy developments was a recognition of the need for prudential instruments that could be targeted at some financial institutions (e.g. global systemically important banks), segments of financial markets, or specific activities generating financial stability externalities. Prudential instruments, especially those with a macro-financial focus, were enhanced and broadly adopted across countries. The newly updated International Banking Research Network (IBRN) Prudential Instrument database, a comprehensive collection of quarterly changes for seven broadly defined prudential instruments across 64 countries from 2000 to 2023, provides perspective on how instrument use has been evolving. As an important example, we find that some prudential instruments acted as complements to other macroeconomic tools, like monetary policy rates, in response to inflation dynamics.
The IBRN Prudential Instrument database
The seven instruments covered in the IBRN Prudential Instrument database, described in Table 1, 2 have recently been updated with information for 2020-2023, and a longer series has been added on the countercyclical capital buffer (CCyB) based on Basel III regulatory changes. Information in the database is sourced primarily from central bank reports and direct communications with national authorities, particularly those that are members of the IBRN. Secondary sources include the IMF’s Macroprudential Policy Survey and similar efforts by the European Systemic Risk Board. 3 To ensure accuracy, IBRN members review and verify the database’s content.
Table 1 IBRN Prudential Database instruments
Note: The last column of the table, ‘Changes as a share of total entries’, is defined as the number of quarters with an instrument change for countries with that instrument, divided by the total number of quarters in which the instrument has been available to policymakers. Instruments in grey-highlighted rows are classified as cyclical, while those in other rows are structural.
Policy changes are mapped into simple indexes, recording tightening as 1, loosening as -1, no change as 0, and missing (‘.’) if an instrument is not available for a given country and quarter. 4 Additionally, the database includes a cumulative index to reflect the overall direction of decisions on an instrument over time. The cumulative index provides some indication of the stance and directional insights of prudential actions. However, it is not necessarily a fully accurate approximation because the IBRN database indicators map the intensity of decisions for each instrument into a simple scale (i.e. although the indicators attempt to take into account equivalent changes to an instrument made via a single decision involving a large change or multiple incremental decisions, those mappings are imperfect) and there are differences across countries in the definition of each instrument (e.g. not all countries measure loan-to-value ratio limits in the same way).
Most of the 64 countries in the database have implemented most of the instruments (Table 1). Newer instruments, such as the countercyclical capital buffer, and other instruments that target specific sectors (e.g. loan-to-value ratio limits) have slightly lower rates of adoption. The last column of Table 1 shows a clear distinction between instruments that change frequently and those that change sporadically, especially after large financial stability events. Our interpretation is that these prudential instruments can be grouped into cyclical and structural depending on the frequency and objective of their use. Structural instruments are typically adjusted after financial crises, large coordinated regulatory changes, or after country-specific regulatory reforms, while cyclical instruments are adjusted through the business or financial cycle.
Prudential instruments and inflationary episodes
Monetary tightenings as a result of inflationary pressures are more likely to lead to financial stress if the financial sector is highly leveraged (Boissay et al. 2023). Using prudential instruments to enhance the resilience of the financial sector may allow monetary authorities to adjust their policy rates more aggressively to reduce inflationary pressures. Instruments may also be used as supplementary tools to support other macroeconomic policies.
Figure 1a plots the evolution of tightenings and loosenings of cyclical instruments since the 2000s, with the average inflation rate across countries shown as a solid line overlay. There is a correlation between inflationary periods and tightenings in cyclical instruments; however, the same pattern is not observed for structural instruments as shown in Figure 1b. Instead, the broad tightening period after the global crisis was associated with the implementation of the Basel III agreement.
In the 2021-2023 inflationary episode, average inflation across a sample of 52 countries was associated with more cyclical instrument changes in both advanced and emerging economies, as shown in Figure 2. These countries tightened their loan-to-value ratio limits, reserve requirements, and the countercyclical capital buffer in this episode. Cyclical prudential instruments acted more as complements to monetary policy at a time when central banks around the world raised rates to curtail price increases.
Figure 1 Prudential instruments and inflation
A) Cyclical instruments
B) Structural instruments
Note: Panel (a) of this figure reports the total number of countries tightening or loosening any cyclical prudential instrument in a given quarter. Panel (b) captures the same counts, but for structural instruments. These instruments are classified as defined in Table 1. The figures in both panels include the average inflation rate (year-on-year) for countries with available cyclical or structural instruments.
Figure 2 Inflation and cyclical prudential instrument changes, 2021-2023
Note: This scatterplot presents the average inflation rate for countries with cyclical prudential instruments between 2021 and 2023, and the total count of changes in those instruments in the same period. Countries are divided into advanced and emerging economies following the classification used by the International Monetary Fund in the World Economic Outlook. Argentina and Turkey are excluded from the figure.
Recent patterns of use in prudential instruments follow some of the premises established in Boissay et al. (2023). As inflation rises and monetary authorities need to increase interest rates, prudential instruments can be used to enhance the resilience of the financial sector to increased borrowing costs and perhaps complement the reduction in credit growth to stabilise the increase in overall prices. 5 It is relevant to note that prudential instruments can also work against the near-term objectives of monetary policy, such as when central banks try to stimulate the economy by lowering rates, while prudential instruments are tightened to attempt to limit excessive credit growth (Laeven et al. 2022).
Prudential instrument effectiveness
Many open questions remain about the most effective use of prudential instruments. The IBRN Prudential Instrument database provides a tool for exploring these questions in a cross-country context and has already shown its utility. For example, an IBRN initiative using data for the pre-pandemic period, summarised by Bussière et al. (2021), found evidence that prudential instruments can be used to dampen monetary policy spillovers from large countries to destinations of credit flows. Domestic prudential instruments in large countries can also affect the cross-border transmission of domestic monetary policy through lending abroad by limiting the increase in lending by less strongly capitalised banks. The database has also been used in an additional IBRN initiative focused on analysing the domestic and cross-border spillovers of prudential policy stances, summarised by Buch and Goldberg (2017). Many other applications are also possible.
Going forward, at the country level, research could examine the way instruments are used, asking about the prevalence of easing or tightening decisions, and conditions for changes in the direction of decisions taken. For instance, has the prudential framework followed the business and financial cycles symmetrically or not? The response to the COVID pandemic is a relevant example as it included a rapid release of prudential capital buffers and an easing of the stance of other prudential instruments. Outside of crises, analytical work could study the activity of the prudential framework of a country with a focus on the frequency and conditions for types of instrument changes.
Countries may adopt different approaches to using prudential instruments, potentially resulting in asymmetric policy stances and cross-border spillovers (Buch et al. 2021). Such questions can be considered with different cuts of country types: from advanced economies to emerging market economies, and from large to small economies. One could consider, for example, what the IBRN prudential data reveals about the conditions for implementing a certain measure or the drivers behind the policy choices of different countries, including potential cross-border spillovers.
At a high level, we observe large differences in how countries use prudential instruments: major emerging economies have tended to use cyclical prudential instruments more than both advanced economies and other emerging and developing economies, but that may be changing with the active use of the countercyclical capital buffer. Questions on the drivers, effects, and effectiveness of prudential regulation are of policy relevance, not least because they may also have unintended consequences.
Source : VOXeu
