On October 18th, Policy@Manchester organised a Paris conference on Financial Volatility and Macroprudential Regulation in Low-Income Countries. The conference, held in conjunction with the French foundation FERDI and a Moroccan think tank, the OCP Policy Centre, was attended by a number of senior policymakers from Africa and France. In this blog Professor Pierre-Richard Agénor discusses the purpose of, and the main policy lessons from, the event.
- Macroprudential regulation is essential in striking the right balance between financial stability and increasing credit; and should go beyond short-run financial stability considerations to internalise potential trade-offs between financial stability and growth
- Credit information sharing schemes should be developed further even though they on their own are not sufficient in reducing harmful credit booms and busts in the poorest countries.
- Further research is needed on the link between macroprudential policies and fiscal policy as well as the issue of the level of coordination of macroprudential policies in a currency union that is, whether from the perspective of financial stability it is better to conduct these policies at the level of the national regulators or the union-wide regulator.
Purpose of the conference
The growth effects of financial volatility, and ways to mitigate them, were largely absent from the initial 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 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. For low-income countries, where promoting growth is essential in order to increase standards of living and reduce poverty, understanding the nature of this trade-off, and how to address it, is critical.
The conference presented a selection of papers from an ESRC-DfID research project on financial volatility, growth, and macroprudential regulation featuring researchers from around the world. The goals of the project were to a) shed light on the links between financial volatility (possibly induced by international capital flows, including foreign aid) and economic growth, and how macroprudential regulatory rules (including those embedded in the recent Basel III banking agreement) affect this link; b) provide new evidence on the determinants of financial volatility and the impact of financial volatility on economic growth, specifically in relation to low-income countries in sub-Saharan Africa; and c) develop case studies for Francophone sub-Saharan African countries (especially those belonging to the Western African Economic and Monetary Union, WAEMU), focusing on the links between macroprudential regulation and growth and offering concrete policy recommendations to the policymakers of the region.
Key issues discussed at the conference
Participants engaged in a lively discussion on the implications and relevance of the key findings of the project for the debate on the link between finance and growth, and the management of capital flows.
Three key points emerged:
- macroprudential regulation is essential in striking the right balance between financial stability and increasing credit;
- the setting of macroprudential instruments should go beyond short-run financial stability considerations and internalise potential trade-offs between financial stability and growth;
- that credit information sharing schemes should be developed further even though they on their own are not sufficient in reducing harmful credit booms and busts in the poorest countries.
Point (ii) was the subject of extensive discussion. Participants acknowledged 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 Project’s contribution on this issue focused on a particular instrument – reserve requirements, aimed at providing partial deposit insurance to savers – it was pointed out that similar results are likely to also characterize the choice of other macroprudential tools, such as bank capital requirements and loan-loss provisions. However, it was also pointed out that an important caveat to this conclusion relates to the fact that this result did not account explicitly for the possibility that even though macroprudential instruments can be 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, that is, risks to the financial system as a whole. The possibility that “leakages” of this type may occur means therefore that financial sector supervision may also need to be strengthened, and the perimeter of regulation broadened, when macroprudential policy reforms are implemented. This is an important message for policymakers.
Another topic that received much attention during the conference was the need to reform the macroprudential regime in WAEMU countries. The Project’s contributions on this issue helped to highlight the current limitations of the prudential framework in that region, due to: (i) a low degree of financial development; (ii) a lack of consistency in the overall financial stability framework, that is, between the macroprudential scheme and others tools of financial stability, microprudential framework, information sharing system, crisis resolution schemes, but also monetary policy; and (iii) the potential undesired effects of countercyclical macroprudential tools. Specific proposals were discussed and are under consideration by the regulatory authorities in the region.
In the closing debate, Professor Diane Coyle expressed doubts about whether the prudential reforms of the past few years have been significant enough to mitigate the risk of future financial crises. My view is that there are two issues for further research: the link between macroprudential policies and fiscal policy, given that financial volatility may be the result of real shocks and procyclical spending behaviour by governments (especially in countries where commodity exports are a key resource for the government); and the issue of the level of coordination of macroprudential policies in a currency union (such as the CFA franc zone, to which WAEMU countries belong), that is, whether from the perspective of financial stability it is better to conduct these policies at the level of the national regulators or the union-wide regulator.