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The Effect of Microprudential and Macroprudential Regulation On Economic Development

By: Josef Kefas Sheehama

Namibia felt the effects of the global recession both quickly and deeply when some of the major markets in the world were struck by the economic meltdown.

Namibia slipped into a technical recession at the end of 2016. Major sectors within the Namibia economy began to retrench employees. Namibia’s annual consumer price inflation hit a high of 5.60 per cent in April 2022.

One does not need to look back far in history to see the economic damage. The Bank of Namibia Act (Act No. 1 of 2020) provides the Financial System Stability Committee (FSSC), which serves in an advisory capacity.

Prudential policy rules as a set of regulatory requirements have been applied to credit institutions and investment companies in the long run. The concepts of macroprudential and microprudential supervision, rules, and policy are reflected in the financial sector’s institutional structure of regulation and supervision.

Microprudential and macroprudential approaches mutually influence each other. Therefore, the development of supervisory approaches confirms the need to limit regulatory arbitrage and respect the existence of financial groups that are often active on a supranational level.

Nevertheless, it is not a substitution of supervision on an individual basis, which has remained the basis of supervisory activity. Similarly, a microprudential approach is a crucial method in regulation. The measurement difficulties often lead to risk being underestimated in booms and overestimated in recessions.

In a boom, this contributes to excessively rapid credit growth, inflated collateral values, artificially low lending spreads, and financial institutions holding relatively low capital and provisions. In recessions, when risk and loan defaults are assessed to be high, the reverse tends to be the case.

Macroprudential policy has thus become an overarching public policy in achieving financial stability across the world. This new perspective has profoundly impacted our understanding of how the whole economy functions when the effects of financial policies and actions are considered.

This is the role of a monetary policy in the presence of macroprudential policies and the institutional framework for an optimal policy coordination and cooperation between monetary, fiscal and prudential policies.

However, macroprudential regulation is still very much a work in progress. Macroprudential policy’s interaction with monetary and fiscal policies, links with microprudential regulation, and external shocks such as capital flows affect policy tools and institutional frameworks. The objectives of Namibia’s macroprudential policies included not only achieving financial stability but also achieving smoother economic and financial cycles, price stability, and specific industrial policies.

However, developing macroprudential policies is a work in progress since there are a number of issues related to the use of macroprudential policies.

To introduce economic rationale into the discussion of macroprudential policies and assess their effectiveness, one can view them as a tool to correct externalities that create systemic risk or financial instability.

Specifically, this approach maps externalities related to strategic complementarities. The credit booms are associated with financial liberalization, buoyant economic growth, fixed exchange rate regimes, weak banking supervision and loose macroeconomic policies.

It is important to note that not all credit booms are bad, with only one in three booms ending up in crises. It is difficult to identify bad booms as they emerge. Unlike monetary and fiscal policies, macroprudential policies can effectively contain booms and limit the consequences of busts. But circumvention of these macroprudential policies can undermine their effectiveness. In addition, monetary policy should act first and foremost when credit booms coincide with periods of a general overheating in the economy.

Effective macroprudential policies can help cushion the economy from volatile capital flows. Now policymakers understand the macroprudential approach should be adopted to enhance the financial stability and keep the financial risk at a prudent level with the aid of tighter regulations and supervision. Macroprudential policy tools diminish financial imbalances and protect the soundness of the economy.

Moreover, microprudential regulation and supervision is generally developed based on a view that it can improve economic welfare by providing monitoring functions that dispersed counterparts are unable or unwilling to perform. However, this monitoring function also inherently poses a moral hazard risk. The monitoring can blur the supervisors’ responsibilities with that of management, shareholders and depositors for oversight of the financial institution.

Thus, if the institution is assessed to be following the microprudential regulations, investors may conclude that they are relieved of the responsibility to conduct their own due diligence. Should the institution fail, the depositors and investors will place the responsibility for the failure at the supervisor’s door, with the expectation that the public sector should bear the cost of the failure rather than the investors and depositors. During downturns, by contrast, diverging micro and macroprudential approaches could generate frictions. This, in turn, could lead to inefficient outcomes, especially as microprudential policies may inadvertently cause negative externalities on the financial system as a whole.

Therefore, in the current work aimed at creating macroprudential regulations, more attention should be focused on instruments which have the potential to reduce borrower risk. Both microprudential and macroprudential authorities use prudential policy instruments and tools that are applied at the level of the individual firm, such as buffers and balance sheet restrictions. Macroprudential regimes will be at their most effective when policies are set in a broadly symmetric fashion. In practice, that means tightening macroprudential policy tools when lending practices are exuberant but, just as importantly, loosening those tools either when risks recede or when credit conditions need a boost.

To this end, there is a broad consensus that strong and effective micro and macroprudential policies are needed to assure a robust and resilient financial system. Microprudential regulation and supervision will, for the foreseeable future, be the bulwark against systemic risks.

Nonetheless, macroprudential approaches are increasingly being integrated into the regulatory framework, and this process is sure to continue, albeit in a manner reflecting the unique aspects of Namibia.

Julia Heita

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