Macroprudential modesty
Introductory remarks by Klaas Knot, at the 82nd
Plenary Meeting of the Group of Thirty
Federal Reserve Bank of New York, 6 December 2019
At the G30 meeting, hosted by the Federal Reserve Bank of New York, a panel session was held on
'The Future of Macroeconomic Policies'. Klaas Knot was one of the panelists. In his opening statement
he discussed the role of macroprudential policies in addressing financial vulnerabilities. He stressed the
need to be realistic in our expectations on what macroprudential policies can deliver under the current
circumstances. The macroprudential toolkit, Mr. Knot said, is limited in scope and impact to mitigate
systemic risks. He stressed that financial stability has to be a relevant factor to take into account in
the overall macroeconomic policy mix.
Introduction
What a difference a year can make. In December 2018, the ECB decided to end its net purchases
under the Asset Purchase Program and it was believed that 2019 would focus on steps towards
monetary policy normalization.
Now, one year later, rates have been cut both in the US and in Europe and net asset purchases have
restarted in Europe. The main theme in international discussions at the FSB and IMF is the prolonged
nature of low interest rates. These discussions focus on the structural level of the natural interest rate
and are reflected in terms as 'low-for-long' or even 'low forever'. The weakening of the economic
outlook and shift in financial conditions have increased stability risks in the global financial system.
I will argue today that we need to be realistic in our expectations on what macroprudential policies can
deliver under the current circumstances to safeguard financial stability. The macroprudential toolkit is
limited in scope and impact to mitigate systemic risks. Following this observation, it also raises
important (and sometimes new) questions on the implications for the overall macroeconomic policy
mix.
I. Vulnerabilities in the financial system
In order to discuss the role of macroprudential policies in current economic circumstances, let's first
take a look at the main pockets of vulnerabilities featuring prominently in the FSB's semi-annual
exercises. As my goal is to map macroprudential policies onto these vulnerabilities, I will abstain from
geopolitical risks such as trade disputes and Brexit.
Credit growth / leverage
First of all, the low-interest rate environment leads to a search for yield, which can lead to a situation
where returns no longer reflect underlying risk fundamentals. For example, at the FSB, we are closely
monitoring developments in leveraged finance and the CLO market. This market has grown to an
estimated total of 3.2 trillion USD and has been accompanied by declining lending standards and
higher corporate leverage. Covenant-lite loans were rare prior to the crisis, but since 2009 its share of
issuance has increased to 50-80%. Moreover, there has been an increase in leverage and deterioration
in credit quality. Over 60% of outstanding loans has a single B credit rating or lower. Needless to say,
such lending activities are vulnerable to a sudden change in market sentiment, a rise in interest rates
or deterioration of the economic situation.
Public and private indebtedness
A second important effect is that the low interest rate environment has led to a strong increase in total
debt, both within the public as well as the private sector. Total debt-to-GDP ratios stand at 350% for
Japan, and around 250% for the US, the UK and the Euro Area.
Higher debt levels may reflect a response to structurally lower interest rates and therefore structurally
higher sustainable debt levels, but they can also create vulnerabilities. For example, despite the
favorable economic conditions in recent years, very few countries have actually reduced their public
debt ratio. In the current environment, governments do not face financing constraints. Debt
sustainability issues could however resurface when market sentiment shifts and risk premia were to
increase.
Sovereign debts are particularly prominent in Europe, where the preferential treatment of sovereign
exposures effectively implies zero-risk-weighting at the banks.
Corporate indebtedness in advanced economies has also been rising and has peaked over 160% of
GDP. This might result in a debt trap where corporates can only service their debt because of the low
interest rates, but do not have sufficient underlying earning capacity to cope with an unexpected rise
in interest rates (zombification).
Real estate markets
The third systemic risk that I want to mention is the strong increase in both residential housing prices
and commercial real estate in recent years. Real estate markets have traditionally been an important
factor in the development or amplification of financial crises. Several jurisdictions show increased
signals of overvaluation in significant segments of the market.
II. Macroprudential toolkit
Given the current stance of monetary policy and the outlook of a prolonged period of low interest
rates, it is logical to first look to what extent macroprudential policies would be able to mitigate these
systemic risks. The figure below provides for a mapping of our current macroprudential toolbox, based
on EU/Dutch legislation. The green boxes indicate the instruments that most central banks have at
their disposal. The salmon colored boxes are measures that can be applied by macroprudential
authorities, but whose effectiveness in mitigating systemic risks is generally perceived to be limited.
The red boxes indicate instruments that could be applied, but are currently not within the remit of
most central banks. Finally, there are several white boxes which indicate that no specific
macroprudential instrument is available.
Figure 1: Curent macroprudential toolbox based on EU/Dutch legislation

Source:basedonbrochureDNB'sfinancialstabilitytask
So what do we conclude from this overview? Allow me to make three observations.
First, the macroprudential framework does not provide a fully-covered system. Contrary to monetary
policy that 'gets into all the cracks', macroprudential policies are limited to specific parts of the
financial system. Available measures are also almost exclusively targeted towards banks, which implies
a potential for risk-shifting beyond the banking sector.
Second, macroprudential measures are mostly targeted at strengthening resilience, but not at
addressing the build-up of underlying vulnerabilities. Current available instruments create buffers to
better absorb losses when they occur, but they neither improve the functioning of the real economy,
nor do they stem the origination of losses. For example, an important systemic risk like corporate
indebtedness cannot be directly addressed by macroprudential authorities.
Thirdly, potentially very effective measures often do not fall within the remit of macroprudential
authorities. Such measures are often considered too important from an electoral perspective to
delegate their activation to independent authorities. These include sovereign risk weights,
borrowerbased limits and preferential tax incentives. They are often part of broader economic trade-offs,
thereby however creating a reality that macroprudential authorities cannot employ full ammunition to
address systemic risks.
III. Policy implications
So my main message today is that of macroprudential modesty. Although important frameworks have
been developed in the aftermath of the global financial crisis, we cannot regard them to be at par with
monetary or fiscal policies. The impact of macroprudential measures are unlikely to be as forceful as
monetary policy, as they at their very best slow down the build-up of stability risks within the financial
system.
This has several important policy implications. For one, despite of the limitations I sketched, we should
remain committed to full implementation of the international reform agenda. Limitations in scope and
impact cannot be an argument to deregulate. But on top of this, we should continue to work on
structural challenges within the economy and its financial system.
Importantly, we should also continue to think about the implications for the overall macroeconomic
policy mix. The observation that macroprudential policies cannot be fully relied upon to contain
systemic risks would also have to be taken into account in the conduct of monetary and fiscal policy.
To be clear: it should not have an impact on the mandate or direction of monetary policy, which would
continue to be fully geared towards price stability. However, financial stability would have to be a
relevant factor to take into account within the design and the proportionality of policy measures.
Obviously, these are complex observations that require further analysis. I look forward to discuss
these and related matters in our quest for further operationalization of effective macroprudential
policies.