Why macroprudential policy fails?

Financial system is once more at risk under the COVID-19 threat. Since 2008, little has been done to develop a ‘’macro’’prudential approach.

Both the European Central Bank (ECB) and the International Monetary Fund (IMF) advocated for a macroprudential approach that focuses on the stability of the financial system as a whole, rather than just safeguarding individual institutions.

Most tools remain micro-oriented, systemic threats are poorly measured, and regulatory gaps persist—particularly regarding non-bank financial institutions and over-the-counter (OTC) derivatives markets.

The COVID-19 crisis has once again exposed the fragility of the system and the shortcomings of regulatory responses. 

The Promise of Macroprudential Policy

The ECB defines macroprudential policy as pursuing three primary goals:

1. Prevent excessive risk-taking,

2. Limit contagion effects,

3. Create the right incentives for the market.

These objectives aim to prevent the buildup of vulnerabilities across the financial system and to reduce the likelihood and impact of future crises.

Why the Goals Fall Short

1. Preventing Excessive Risk-Taking: Still Micro in Practice

One of the central responses to the GFC was the Basel III framework, which imposed higher capital and liquidity requirements on financial institutions. While these rules improve resilience at the firm level, they remain microprudential tools, focused on individual balance sheets.

This fails to capture systemic dynamics such as herd behavior, correlated exposures, and feedback loops—core features of modern financial instability. In highly interconnected systems, risk can amplify even when each institution appears sound in isolation. Macroprudential oversight should address emergent risk patterns, not just entity-level metrics.

2. Limiting Contagion: The Flawed Focus on “Too Big to Fail”

The introduction of Systemic Risk Buffers (SRBs) for Systemically Important Banks (SIBs) was intended to limit contagion by insulating the most critical nodes of the financial system. Yet the concept of "too big to fail" is fundamentally flawed. Lehman Brothers was not the largest financial institution in 2008, but its collapse triggered a global panic. As Ben Bernanke later revealed, 12 of the 13 largest U.S. banks required bailouts after Lehman's default (Carney, 2011).

This case demonstrates that size alone is not a reliable indicator of systemic importance. A smaller institution, if highly interconnected or exposed to key markets, can pose an existential threat to financial stability.

Moreover, the 2020 COVID-19 shock once again underscored vulnerabilities among non-bank financial institutions (NBFIs). In the U.S., the Financial Stability Oversight Council (FSOC) removed the "systemically important" designation from major NBFIs—including Prudential Financial (2017), AIG (2017), and GE Capital (2016)—just before the pandemic (U.S. Treasury, 2018). As a result, regulators were ill-prepared to respond to distress in non-bank sectors, which proved once again to be weak links in the financial chain.

3. Mitigating Interconnectedness: CCPs and Derivative Markets

Another major post-2008 reform was to shift OTC derivative transactions onto central counterparties (CCPs). While this step reduced bilateral counterparty risk, it also centralized systemic risk within a few institutions.

According to the Bank for International Settlements (BIS), counterparty risk remains a serious issue. In fact, concentrating transactions within CCPs introduces a new layer of vulnerability: if a CCP fails, the damage could be catastrophic.

"In September 2018, a single trader’s default wiped out roughly two-thirds of the commodities default fund at Nasdaq Clearing AB, a Swedish CCP"— BIS (2018)

Thus, interconnectedness has not been eliminated—only reconfigured.

4. Creating Market Incentives: Unintended Consequences

The third goal—shaping market behavior through incentives—is perhaps the most elusive. While setting rules to encourage prudent behavior is laudable, it is difficult to engineer incentives without producing perverse effects.

For example, requiring banks to issue mortgages only to borrowers with strong credit profiles may reduce default risks, but it could also dampen housing demand, inflating prices in a supply-constrained environment. Similarly, encouraging certain asset allocations may contribute to crowding risks or mispricing.

Macroprudential policy lacks a mature framework for assessing the second-order effects of these incentive structures.

5. Measuring Systemic Risk: The Blind Spot

A final and crucial limitation is the inability to effectively measure systemic risk. Despite improvements in data collection and reporting, real-time visibility into the network of financial exposures remains limited. This is especially true in shadow banking and derivatives markets.

As Schinasi (2004) pointed out, crises often emerge when policymakers are overly confident in the system’s resilience. Effective macroprudential oversight requires a centralized authority with legal access to granular market data, particularly for OTC transactions. Despite the establishment of monitoring missions post-2008, these bodies often lack the jurisdiction and resources to be proactive.

Conclusion: Transactional, Not Entity-Based Regulation

Macroprudential regulation has failed to meet its stated goals because its tools remain micro-characterized, its frameworks overly focused on entity size, and its data blind spots unresolved. The COVID-19 crisis has made it evident that systemic risk does not originate solely from the largest institutions or from banks at all—it emerges from transactional structures, network dynamics, and information gaps.

For macroprudential policy to succeed, regulators must:

• Shift focus from entity-based to transaction-based risk monitoring,

• Expand systemic designations to non-bank financial institutions and market infrastructures like CCPs,

• Integrate real-time systemic risk analytics into decision-making,

• Build adaptive incentive structures that anticipate market feedback.

The future of financial stability lies not in harder rules for banks, but in smarter rules for systems.

References

Armour, John, Dan Awrey, Paul Davies, Luca Enriques, Jeffrey Gordon, Colin Mayer, and Jennifer Payne. 1999. Principles of Financial Regulation. Oxford University Press, pp. 416–422.

Carney, John. 2011. Bernanke’s Mystery: 12 Out of 13 Major Firms at Risk in 2008. CNBC. https://www.cnbc.com/id/41310901

Faruqui, Umar, Wenqian Huang, and Előd Takáts. 2018. Clearing Risks in OTC Derivatives Markets: The CCP-Bank Nexus. BIS Quarterly Review, December. https://www.bis.org/author/wenqian_huang.htm

Schinasi, Garry J. 2004. Defining Financial Stability. IMF Working Paper No. 04/187. https://www.imf.org/external/pubs/ft/wp/2004/wp04187.pdf

U.S. Department of the Treasury. 2018. Financial Stability Oversight Council. https://www.treasury.gov/initiatives/fsoc/designations/Pages/default.aspx#nonbank