It is argued that financial institutions target leverage ratios that are constant (commercial banks) or procyclical (investment banks). Therefore, an increase in the value of financial assets causes financial institutions to increase their balance sheets to maintain their target leverage ratios, which puts further upward pressure on asset prices. This also causes an increase in the level of risk in the financial system because the availability of safe investments is limited, so banks must move up the risk spectrum towards risky borrowers when they increase their balance sheets. Macroprudential policy instruments can affect price stability Macroprudential policy instruments can also have an effect on price stability. This can be illustrated using a highly stylised view of the monetary policy transmission mechanism:  This equation describes how banks’ lending rates are a function of the central bank’s policy rate plus an interest rate margin or spread. The interest rate margin ( ) is a function of the compensation taken by banks for factors such as administrative costs, capital costs, risk premiums and the banks’ profit margins. The failure of macroprudential policy can affect the transmission mechanism of monetary policy by affecting the interest rate margin. For example, during a crisis, the relationship between the policy rate and market rates may diverge as market rates are increasingly governed by uncertainty over credit risk. But macroprudential policy can also affect the transmission mechanism outside of a crisis.

Indeed, we currently lack a precise but comprehensive definition of financial stability. In addition to giving the macroprudential agency a clear mandate, there should be a transparent decision-making process that avoids political and interest group pressure. This is necessary to ensure that the macroprudential agency is free to make interventions that impose short-term costs on financial institutions or the public in order to achieve long-term benefits through financial stability. 7 While the macroprudential agency must be independent, it must also be accountable for its actions (or lack of action). A clear mandate will help achieve accountability and make assessment of the macroprudential agency against its objectives easier. Information and analytical capability Effective governance arrangements must also ensure that the macroprudential agency has access to the information and analytical capability needed to quickly identify system-wide risks and to determine when and how instruments should be used in response to these risks. Information on exposures between institutions and on exposures commonly held by institutions is likely to be crucial for macroprudential supervision. Much of this information will need to be obtained from individual institutions and may overlap with the type of information collected for microprudential purposes. The collection and sharing of this information may be easier if the microprudential and macroprudential agencies are located together. An alternative approach would be to give a separate microprudential agency responsibility for collecting the information necessary for the conduct of microprudential and macroprudential policy.