Why Does Financial Policy Work Better in Weak Economies?

Central banks increasingly use ‘macroprudential policy’ to prevent financial crises. Macroprudential policy (MaP) are rules that force banks to be more cautious with lending, like higher capital buffers or stricter mortgage standards.

But one size doesn’t fit all, discovered master’s student Francisco Botero. He analyzed data from over 6 million companies and reached a surprising conclusion: these measures work best in countries with weak institutions.

The Quest for Balance

‘During my studies, I became fascinated by what happens when banks lend too much money too quickly,’ says Francisco Botero, who completed two master’s degrees at the University of Groningen: Finance and Economic Development & Growth. ‘When businesses and consumers can borrow money too easily, bubbles form that can eventually burst – resulting in financial instability and recessions. Credit is essential for healthy, inclusive growth, so it’s important to get that balance right. But we still knew too little about how this policy affects individual companies.’

Botero filled this knowledge gap with the largest dataset ever used for this research: more than 6.25 million companies in 44 countries, over a fifteen-year period. He examined how company characteristics such as age, size, and profitability influence the impact of macroprudential policy.

Surprising Findings

One of the most striking findings: the policy actually works better in countries with weak institutions and less developed financial markets. ‘These policy measures are like a seatbelt,’ Botero explains. ‘In a country with weak institutions, the financial system is like a car without seatbelts or airbags. When the government then requires everyone to wear a seatbelt, it makes an enormous difference. Banks suddenly have to follow sensible rules, like conducting stress tests and setting aside money for bad times.’

In countries with strong institutions, the effect is less dramatic. ‘That’s like a car that already has good airbags and safety systems. An extra seatbelt is still good, but it doesn’t change the overall safety level as drastically.’

Good News for Entrepreneurs

For Dutch SMEs, Botero has reassuring news. ‘When regulators tighten the rules to keep the financial system stable, it has no significant negative effect on credit for smaller businesses. So entrepreneurs can rest easy.’

Moreover, when policymakers make credit more accessible – often to stimulate the economy – it has a powerful positive effect on smaller, younger businesses. ‘For entrepreneurs, this could mean better access to the financing they need to start, grow, and innovate.’

Tailored Approach is Essential

The research shows that policymakers must consider their local context. ‘Countries need to align their instruments with the national institutional environment and how their banking sector is structured,’ Botero emphasizes. ‘In countries with weaker institutions, macroprudential policy can play a crucial stabilizing role. It works there as a safety net: where banks normally can’t properly assess whether a company is creditworthy, or where there are no good rules for what happens when a company goes bankrupt, these measures force banks to be more cautious.’

His message to policymakers is clear: ‘Understand that the impact of these measures isn’t the same everywhere. Their success depends on the specific characteristics of the local business environment, the banking market, and the country’s institutional environment.’

Featured Quotes:

1. “Credit is essential for healthy, inclusive growth, so it’s important to get that balance right.”
2. “These policy measures are like a seatbelt in a car without airbags.”
3. “Entrepreneurs can get better access to financing to start, grow, and innovate.”

 About Francisco

This research was conducted by Francisco Botero from Colombia, who earned two master’s degrees at the University of Groningen in Finance and Economic Development & Growth. Inspired by Colombia’s economic challenges, he focused on how policy can foster development.

He now works as a quantitative intraday trader in the wholesale electricity market, combining his interest in sustainable growth, financial markets, and the energy transition.