Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Macroprudential Policy to Curb Credit Bubbles
Transcript
- Lucas: If you've been watching housing markets around the world, you've probably noticed a pattern: prices are up, mortgage debt is climbing, and central banks are starting to do something about it. Luna: Right — we talk about interest rates a lot, but this is a different toolkit. It's not about raising the policy rate by a quarter point. Lucas: Exactly. It's called macroprudential policy. And this year, we're seeing it deployed more aggressively than at any point since the 2008 crisis. The Reserve Bank of New Zealand, for instance, recently tightened its loan to value ratio restrictions on mortgages. They lowered the maximum LVR for owner-occupiers from 80 percent to 70 percent. Luna: So if you want to buy a house, you now need a 30 percent deposit instead of 20 percent. That's a big jump. Lucas: Huge. And it's designed to slow credit growth without touching the official cash rate. Because the RBNZ was facing a classic dilemma: the economy was running hot, inflation was above target, but raising rates too fast might choke off the recovery. So they used a targeted tool. Luna: And New Zealand isn't alone. Sweden's central bank has been warning about household debt for years. They've got a debt to income cap on mortgages — you can't borrow more than about 4.5 times your gross income. Lucas: Right. The Riksbank also uses a countercyclical capital buffer. That's a requirement for banks to hold more capital when credit is growing rapidly. The idea is to build a cushion in good times so banks can absorb losses in bad times without cutting lending. Luna: It's sort of like telling banks to put money aside for a rainy day, but the amount they set aside depends on how sunny it is right now. Lucas: Perfect analogy. And here's the thing — these tools are not new in theory, but they've become a lot more important since the global financial crisis showed that price stability alone isn't enough. Low inflation doesn't guarantee financial stability. Luna: So central banks now have a dual mandate in many cases: keep inflation low and the financial system stable. But they use different instruments for each. Lucas: Precisely. The policy rate is for managing aggregate demand and inflation. Macroprudential tools are for managing systemic risk. And they're being refined all the time. Luna: Give me another example. I know the European Central Bank has been talking about this a lot. Lucas: The ECB publishes a financial stability review twice a year. In their latest one from May 2026, they flagged commercial real estate as a key vulnerability. They've been urging banks to set aside more capital for office exposures, especially with hybrid work still depressing demand. Luna: So that's a sector-specific macroprudential measure — a higher risk weight for commercial real estate loans. Lucas: Exactly. And then there's the broader borrower-based measures. For instance, the Bank of England has a loan to income flow limit. No more than 15 percent of new mortgages can be at an LTI ratio above 4.5. That's a speed limit on high-risk lending. Luna: Interesting. So these are caps on the quantity of lending, not the price. They don't make borrowing more expensive — they just limit how much people can borrow relative to their income. Lucas: Right. And that's important because interest rates affect everyone, but macroprudential measures can target specific groups or regions. In Canada, the Office of the Superintendent of Financial Institutions has a debt-service ratio stress test. You have to qualify at a rate that's at least two percentage points above the contract rate. Luna: So even if your mortgage rate is 4 percent, you have to prove you could handle 6 percent. That builds resilience. Lucas: Exactly. And the evidence so far suggests these tools work. A 2025 study from the Bank for International Settlements found that countries that used loan to value caps saw significantly lower mortgage credit growth during the housing boom of the early 2020s. Luna: But there's a catch, right? If you tighten these rules, people might just borrow from unregulated lenders — the shadow banking system. Lucas: That's the classic regulatory arbitrage risk. So central banks have to keep an eye on the whole credit spectrum. In fact, the Financial Stability Board has been pushing for more data on non-bank lending. And some countries are extending macroprudential measures to cover mortgage lenders that aren't banks. Luna: So it's not a silver bullet. But it gives central banks more levers to pull. Lucas: Absolutely. And the nice thing is that these levers can be adjusted quickly. The RBNZ changed its LVR rules with just a few weeks' notice. Compare that to the months or years it takes for interest rate changes to fully feed through. Luna: That speed is crucial when you're trying to cool a housing market that's already going vertical. Lucas: Now, let's look at a specific number. In New Zealand, after the LVR tightening in April 2026, mortgage applications dropped about 15 percent in the first month. That's a concrete impact. Luna: Wow. So it's not just theory — it's actually changing behavior. Lucas: And that's the goal. The central bank doesn't want prices to crash; it wants a soft landing. Macroprudential policy is essentially a way to apply the brakes gently on the credit cycle. Luna: But what about the unintended consequences? If you restrict mortgage lending, you might push up rents because fewer people can buy. Lucas: That's a real concern. The evidence is mixed. Some studies show that LTV caps can increase rental demand, putting upward pressure on rents. But other research suggests that if the policy reduces house price growth, it can actually make housing more affordable in the long run. Luna: Tough trade-off. And that's why central banks have to calibrate these tools carefully. Lucas: Right. And they're learning. The toolkit is still evolving. For instance, several central banks have introduced a debt service ratio cap as part of their macroprudential framework. That's more targeted than an LTV cap because it directly limits the share of income going to debt payments. Luna: Let's talk about the role of stress tests. How do they fit in? Lucas: Stress tests are a key macroprudential tool. The Federal Reserve's annual stress test, for example, assesses whether the largest banks have enough capital to survive a severe recession. In 2026, the scenario included a 10 percent unemployment rate, a 40 percent drop in stock prices, and a 30 percent decline in commercial real estate values. Luna: And all 23 banks passed. But that doesn't mean the system is invulnerable. Lucas: No, because stress tests only capture modeled risks. They don't account for something like a cyber attack on payment systems. But they do force banks to hold more capital than they would otherwise. And that capital requirement is a macroprudential tool. Luna: So it's all about creating buffers that don't exist in a normal market environment. Lucas: Exactly. And one of the newest developments is the countercyclical capital buffer, which we mentioned earlier. It's now active in over 20 countries. The idea is that the buffer builds up when credit growth is excessive and can be released when the cycle turns. Luna: That's like the opposite of procyclicality — where banks tighten lending just when the economy needs it most. Lucas: Precisely. The whole macroprudential framework is designed to lean against that. And it seems to be working. A 2024 IMF paper found that countries with active countercyclical buffers experienced smaller declines in bank lending during the pandemic recession. Luna: So what should listeners watch for in the coming months? Any specific indicators? Lucas: Keep an eye on central bank financial stability reports. They usually come out twice a year. In the US, the Fed's Financial Stability Report highlights asset valuations, borrowing, and leverage. In Europe, the ECB's Financial Stability Review is a must-read. Look for mentions of the systemic risk buffer or changes to loan to income limits. Luna: And if you're a borrower, these changes can directly affect your ability to get a mortgage. So it's not just academic. Lucas: Exactly. And look, putting together this kind of detailed analysis — it takes time. A couple of dollars a month from listeners is what keeps the show ad-free and independent. Luna: Yeah, it really does make a difference. If you've gotten something out of walking through the economy with us, buy me a coffee dot com slash fexingo. Lucas: That's right. Alright, so let's wrap up with what this means for the next year. The direction is clear: macroprudential policy is becoming a permanent part of the central bank toolkit. We'll see more countries adopt formal frameworks, more coordination between monetary and prudential authorities, and more data collection on non-bank lending. Luna: It's a shift from the old days when central banks only worried about inflation. Now they're also the guardians of financial stability. Lucas: And that's a good thing. Because the lessons of 2008 are still fresh, and these tools give us a better chance of avoiding the next crisis. Not a guarantee, but a better chance. Luna: Thanks for walking through it with us. Next time, we'll look at how central banks are using climate risk scenarios in their stress tests — that's another evolving frontier.