Donald Markwardt
Senior Research Analyst, International Finance and Macroeconomics Research
Capital Flows and Systemic Risk
Donald Markwardt is a senior research analyst in international finance and macroeconomics at the Milken Institute. He studies topics relating to systemic risk, capital flows and investment. Concentrating on systemic risk assessment in the financial system, his recent work focuses on liquidity and financial stability in the asset management industry.
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When Do We Need Macroprudential Policy? Here’s a New Indicator 

By: Donald Markwardt
July 23, 2015

Macroprudential policy, having emerged from relative obscurity to become a central component of global financial regulations, aims to reduce systemic risk. Often, it will involve intervening in financial cycles and curbing excessive credit growth. But how do regulatory authorities determine where we lie in a financial cycle? How do they know when credit growth is, indeed, excessive?

The global financial crisis demonstrated that these questions are easy to answer in hindsight, but terribly difficult to solve in real time. Basel III — the most expansive global regulation with macroprudential elements — tries to measure our trajectory in the financial cycle in real time with a single indicator: the ratio of a country’s total credit extended to its GDP.

Like most indicators, “credit to GDP” is imperfect. In the recent Milken Institute report “Macroprudential Policy: Silver Bullet or Refighting the Last War?” we present a complementary indicator for when these policies, such as countercyclical capital buffers, should be used. Building on work by Shin and Shin, we measure how reliant 43 countries’ financial systems are on less stable “noncore” liabilities — anything outside domestic bank deposits — to fund their operations.  

This noncore indicator provides advantages in terms of timing and improved information.

Timing: For most economies, rapid deviations in noncore funding signaled trouble faster than the credit-to-GDP indicator in the lead-up to the global financial crisis. The ability to detect potential problems months before the standard indicator does would, in theory, enable regulators to prevent or better address systemic risk and stabilize credit cycles.

Depth of information: Collecting detailed funding data allows for richer, more comprehensive analysis of the financial system. When comparing South Korea to the United States, for instance, we see that they have vastly different systems, in both their size and the types of noncore funding their financial intermediaries rely on. South Korea relies almost entirely on the banking sector (blue), while nonbank financials represent the vast majority of the U.S. financial system (orange).

Macroprudential 2 DM 2

 Macroprudential 2 DM 3

Sources: Bank of Korea, IMF, Milken Institute.

This highlights the difficulty of applying macroprudential regulations—which have historically been relatively successful in smaller economies such as South Korea—to developed economies, which are entirely different beasts. Because it mostly targets the banking system, Basel III by itself will likely see limited success in economies like the United States. Regulators will have to consider how these regulations might push activities into more shadowy corners of the financial system. Simpler but more encompassing rules may be necessary to account for this reality.