I agree with Claim 1-the main purpose of macro-prudential regulation is to prevent
banks from engaging in behavior that leads to credit crunches and fire sales of bank
assets.
Financial system regulation has always been crucial for central banks. On one hand,
central banks depend on financial system as a whole to conduct monetary policies as
well as fiscal policies. On the other hand, financial system regulation is among the
original duties of central banks.
The traditional approach implemented by central banks before worldwide financial
crisis was mainly micro-prudential in nature. “The micro-prudential objective can be
seen as limiting the likelihood of failure of individual institution…So defined, this
objective is in turn probably best rationalized as a means of protecting depositors”
(Crockett, 2000). Government expect banks to internalize losses instead of simply
relying on deposit insurance system. Therefore, regulators require banks to maintain
capital ratio to a certain level, and banks thus build more powerful capital cushion in
preparation for future fluctuations. Once hit by a shock, banks could either raise fresh
capital or reduce assets to restore capital ratio. The regulators do not actually care how
the troubled bank choose. As long as only a small number of banks are experiencing
trouble at one time, this approach is sound and efficient.
However, if multiple financial institutions are influenced by a common shock and many
of them decide to shrink assets, costs imposed on society due to their responses may be
quite large. These costs include credit crunch and fire-sale effects. Credit crunch refers
to an economic condition in which investment capital is difficult to obtain. Banks and
investors become wary of lending funds to corporations, which drives up the price of
debt products for borrowers (Investopedia, credit crunch term). If sufficiently many
banks try to shrink assets by reducing new lending, corporations are...