Monitoring Risk Across the Financial System
The Federal Reserve and other regulators have long supervised individual banks and other critical financial institutions to make sure they are operated in a “prudent” and “safe and sound” manner and are not taking excessive risks. Whereas that traditional—or microprudential—approach to supervision and regulation focuses on the safety and soundness of individual institutions, the Dodd-Frank Act required the Federal Reserve and other financial regulatory agencies look across the entire financial system for risks, adopting a macroprudential approach to financial stability.
For instance, the failure of a large financial institution can significantly weaken the condition of other firms that borrow from or lend to it. Therefore, the supervision and regulation of large firms should account for these potential externalities.
In addition, supervision and regulation of financial institutions and markets should try not to contribute to the tendency of the financial system to take on additional risk during good times; that is, to be countercyclical. One way to accomplish this goal is for supervision and regulation to become progressively more stringent during good times in order to build resilience that helps avoid the need for supervisors or financial institutions to take steps that would cause an unwarranted tightening of financial conditions during bad times. The countercyclical capital buffer is an example of a countercyclical macroprudential tool. This buffer allows the Board to increase the amount of high-quality capital that large banks are required to maintain when vulnerabilities are materially above normal and then to decrease the required amount when vulnerabilities decline.