​What is Macro-Prudential Analysis? ​There are two pillars of financial stability. One of these is the micro-prudential perspective. The other one is the macro-prudential perspective. They are mutually reinforcing and both are essential for ensuring financial stability. In short, the difference between the two pillars of micro-prudential and macro-prudential analysis is between ensuring that individual firms are inoculated properly from disease and a system-wide health check.
 
Macro-prudential analysis takes account of those risks (i.e., systemic risks) that may affect all, part, or most firms in the system—and not just individual firms. When looking at the health of the underlying financial institutions in the system, macro-prudential analysis uses indicators that provide data on the health of these institutions as a whole including capital adequacy, asset quality, credit exposures, management performance, profitability, liquidity and sensitivity to systematic risks. Macroeconomic and market data are also reviewed to determine the health of the current system. The analysis also focuses on qualitative data related to financial institutions' frameworks and the regulatory environment to get an additional sense of the strength and vulnerabilities in the system.
 
An important movement in the last decade has been a much more explicit emphasis being given to the macro-prudential aspects of supervision by central banks, regulators, academics and other market observers.
 
Effective Macro-Prudential Analysis Includes Four Key Traits:
 
1. to limit distress to entire financial systems rather than distress to individual institutions;
2. to avoid large and burdensome costs to the economy—such as expensive bank bailouts—rather than aiming to protect more narrowly the depositors of an individual bank;
3. to examine risks that arise from the interaction of firms as part of a financial system rather than on a firm-by-firm basis; and
4. to acknowledge that at least some of the risks faced by the system collectively differ from those faced by individual firms.
 
Macro-Prudential Analysis Cannot Stop with a Single Financial Sector or End at the Borders of a Particular Jurisdiction
 
In the past it might have been reasonable to think that systemic risk was something that began and ended with the banking system. As long as the banking system was—or at least appeared to be—sound, central bankers did not need to worry too much about what happened elsewhere in the financial system or the condition of the corporate sector or the structure of household balance sheets. But this is no longer true, if it ever was.
 
Take the role of the corporate sector in the Asian financial crises of a decade ago. The fact that it was the corporate sector rather than the banking sector that had assumed foreign exchange risk ultimately didn’t matter from the point of financial system stability. The effects were the same—or possibly were greater as the corporate sector was less well able to handle the risks than the banking sector might have been. From a macro-prudential analysis perspective this means that attention must also be paid to conditions in the corporate sector and the soundness of corporate balance sheets. Similarly consumer credit business and the condition of household finances are also important to understand from a financial system stability perspective.
 
In addition, the experience of the last decade has also shown that non-bank financial intermediaries matter for the soundness of financial systems. For example, there is plenty of evidence that insurance companies have been major sellers of credit derivatives, which passes credit risk from the banking system to the insurance sector. How well can the insurance sector manage such risk? And if bank-insurance linkages are strong (e.g. through financial conglomerate groups) can one be sure that the risk has really passed out of the banking system? Similarly, the role of hedge funds in financial systems has recently begun to receive a good deal of attention from central banks and regulators. The extent to which they increase the volatility of financial markets has long been the subject of debate. But increasingly this largely unregulated sector has become a major provider of credit—thus transferring risks out of the regulated banking sector and into a part of the financial system that is far from transparent. Macro-prudential surveillance cannot afford to ignore these innovations.
 
Finally, as the debate on hedge funds has also shown, financial stability analysis cannot stop at national borders or in particular jurisdictions. A hedge fund based in the Caribbean is capable of moving markets half way round the globe. In these circumstances, macro-prudential analysis must take into account the possibility of shocks originating outside domestic financial systems in today’s global, integrated financial marketplace. It also requires central banks and regulatory agencies to cooperate to develop policies to mitigate these risks.