provisioning rules. These are standard prudential measures to prevent moral-hazard lending by the domestic financial system in the presence of asymmetric information and contract enforcement costs. Their absence or imperfect enforcement may create the distortions in the financial system that give rise to immiserizing external borrowing by encouraging excessively risky lending. But such distortions may also have macroeconomic implications. Micro-prudential policies can interact with the macroeconomic policy challenge in at least two ways. First, capital inflow episodes may be caused by distortions in the domestic financial system that attract foreign capital. For example, government guarantees of bank liabilities without adequate regulatory and supervisory restrictions on bank lending may induce banks to raise interest rates on their liabilities to attract external capital for the purpose of moral hazard lending. In this case, the adoption of appropriate micro-prudential policies may ease the macro-level policy challenge by reducing the inflow pressure. Second, an inappropriate financial system regulatory environment may induce banks to undertake an excessive expansion of credit with the external funds that they receive from capital inflows attracted to the country for other reasons—e.g., due to reduced risk or lower interest rates abroad or because an improved domestic macro policy environment improves the country’s creditworthiness. In this case, the credit boom and likely associated assetprice bubbles may magnify both overheating and vulnerability challenges. Again, appropriate prudential policies, by mitigating credit booms, would help mitigate macroeconomic policy challenges. In this sense, Ostry et al. (2011) note that capital inflow surges are often associated with credit booms and greater reliance on foreign exchange credit, but countries that make more extensive use of non-foreign exchange related prudential measures have a lower incidence of domestic credit booms. Prudential policies toward the financial system that are adopted primarily to deal with the macroeconomic challenges posed by capital inflows—either by reducing the scale of such inflows or by avoiding the magnification of their macroeconomic effects by the financial system—have recently come to be referred to as macroprudential policies. 13
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The term “macroprudential” has come into wide usage, but there is little agreement on its definition. I use it here to refer to prudential policies toward the financial system that are adopted for their macroeconomic implications. Others (e.g., Hanson, Kashyap and Stein 2010) use the term microprudential to identify policies aimed to avoid the failure of individual financial institutions, and denote as macroprudential policies intended to safeguard the financial system as a whole. My definition is broader than that of Hanson, Kashyap and Stein, since it encompasses policies that prevent the financial system from unduly magnifying the effects of macroeconomic shocks, even if its doing so would not necessarily imperil the financial system itself.
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