# **_5.1 Trade-offs over the business cycle_**

In order to properly assess how the use of different macroprudential tools may affect individual banks’ risk taking incentives we need to move away from the standard modelling of macroprudential policies in the DSGE literature that, due to just focusing on externalities, ends up treating all prudential instruments as alternative forms of Pigouvian taxation. Different prudential instruments do affect financial intermediaries’ incentives to take on risk differently and, in certain instances, the micro and macro prudential properties of specific policies may not go hand in hand.

To be able to discuss some of the trade-offs that regulators may face along the business cycle,<sup>38</sup> it is important to focus on a few critical distortions that justify the presence of an active prudential regulation. More precisely, we should keep in mind that: (1) because of limited liability, individual banks take on excessive risk; (2) because of deposit insurance, they opt for cheap, short term, and unstable sources of funds, transferring to the public the cost of liquidity insurance; and (3) because of externalities, they do not internalize the effect of (i) their lending policies on the stability of the financial system (and tend to lend too much in good times and too little in bad times), (ii) they do not internalize the effects of their funding strategy on other banks’ liquidity risk.

In the current jargon, the first two distortions call for microprudential policies, the third for macroprudential ones. Of course, this categorization, like all categorizations, is somehow arbitrary. However, it could be helpful in understanding different rationales for the countercyclical use of prudential measures. We will start by taking the macroprudential policy stance as given and will discuss in more depth the possible trade-offs at the end of the section.

Building on Cordella and Pienknagura (2013), we now discuss whether macroprudential policies implemented either through RR (as discussed in previous sections), through countercyclical capital requirements as in Spain, Colombia, and Peru,<sup>39</sup> or through other forms of taxation may affect individual banks’ risk taking incentives.

We start our analysis by focusing on the microprudential dimension in order to understand how individual banks’ risk taking incentives may vary across the credit cycle. When the credit cycle is driven by the project cycle, that is, if it is driven by the relative abundance or scarcity of quality projects, then banks tend to be naturally prudent on the upside not to lose their profit opportunities. This suggests that tensions may arise between the stance of macro and microprudential policies and that the regulator should carefully assess the nature of the financial frictions (principal agents versus externalities) in order to properly set the policy stance. This finding is not as surprising as one may think, and there is plenty of evidence that in periods of economic boom (that is, when there is abundance of good projects, or at least of projects perceived as good) supervisors are usually satisfied with the levels of banks’ capital and

> 38The focus of this section is to discuss the policy trade-offs that may arise between different instruments when prudential regulation has to be adjusted along the business cycle. In other words, we focus on changes rather than on levels.

> 39For a comprehensive discussion of these experiences, see Fernández de Lis and García-Herrero (2013).

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