Macro-prudential and Micro-Prudential Regulations

While reading the business newspapers, we very often come across these two terms. The dictionary meaning of the term “prudential” something involving or showing care and forethought, especially in business and finance. The major focus of prudential regulations is to check the risks or limit the risk-taking behaviour of financial institutions and thus prevent potential financial crises. In this article, we try to understand the basic differences in the two and their link for financial soundness of an entity or system.

Microprudential versus Macroprudential Regulations

In simplest language, the Microprudential regulations seek to enhance the safety and soundness of individual financial institutions, while macro prudential regulations focus on the welfare of the financial system as a whole. The most important objective of both is to “mitigate risk”. Macroprudential and Microprudential regulations / policies generally complement and reinforce each other in pursuit of their respective goals. For instance, the health of individual institutions is a necessary, though not sufficient, condition for system-wide stability, while a stable system contributes to the health of individual institutions. However, in certain circumstances, there can be conflicts because of overlapping policy mandates and the way in which policies are applied.

The following table makes out the differences between the two:

Are Microprudential and Macroprudential Regulations complimentary?

The prudential policy instruments or tools that are applied to individual financial entities are micro-prudential; while those applied to the entire system are macro-prudential. One example of Microprudential regulations is Basel Regulations. As a part of the Basel requirements, RBI mandates each bank to adhere to norms which help the particular bank to ensure that the capital it holds is commensurate with the risks to which it is exposed. The other examples include the buffers (of two types viz. Capital Buffer and Liquidity Buffer), and balance sheet requirements.

The Macroprudential regulations adjust the overall levels of the banking system. This implies that success or failure of Macroprudential policy is dependent upon the Microprudential policy to a great extent. At the same time, both policies depend on capital and liquidity tools that are deployed at the level of the individual institution. Prudential standards are, in essence, safety standards providing a backstop of resilience both to the firm and to the system and are thus complimentary to each other.

Logic behind Regulations

Traditional Microprudential regulation of banks is based on the logic of reducing the risk profile of individual system. Macroprudential policy addresses the interconnectedness of individual financial institutions and markets, as well as their common exposure to economic risk factors. It also focuses on the procyclical behavior of the financial system in the effort to foster its stability. One of the key purposes of Macroprudential policy is to address negative externalities by acting as a countervailing force to the natural decline in measured risks in a boom and the subsequent rise in measured risks in the downturn. It also aims to mitigate risks linked to financial sector concentration and interconnectedness. As such, Macroprudential policy has both a time dimension and a cross-sectional (or structural) dimension.