On Monetary and Financial Stability—Past, Present and Future, Remarks by José Viñals, Financial Counsellor and Diretor, Monetary and Capital Markets Deparmtnet, IMF

November 23, 2009

Remarks by José Viñals, Financial Counsellor and Director,
Monetary and Capital Markets Department, IMF
Robert Marjolin Lecture, delivered at the 28th SUERF Colloquium on “The Quest for Stability”
At the Utrecht University School of Economics
The Netherlands, September 4, 2009

A. Introduction

Good afternoon,

Let me start by saying that it is both an honor and a privilege to be here today to give the Marjolin Lecture on the very timely topic of this conference, and to follow in a long line of highly distinguished speakers. As the title of my speech suggests, I will focus on the interplay between monetary and financial stability.

Since the summer of 2007 the world has switched from highly favorable macroeconomic and financial conditions to extreme financial turbulence and global recession. The sequence of rather extreme events that we have witnessed in the past two years provides a unique learning opportunity for us all, and it is from this crucible that we can draw broader lessons on the effectiveness of the policy framework in attaining monetary and financial stability, both domestically and globally.

In my talk I will first throw a spotlight on conditions before the crisis. These appeared to be consistent with both monetary and financial stability in what has been termed the “golden age” of central banking. I will then cover the challenges that were brought on for both monetary and financial stability through the crisis. Finally, I will offer some reflections on how policy frameworks could be enhanced in the future to achieve both monetary and financial stability in a lasting manner, which are necessary for sustained economic growth.

B. The Past (before the crisis) —what we thought went right

It seems a long time ago, but let us recalls that before the crisis we were happy: we thought we had both monetary and financial stability.

Monetary stability: achieved through better policy frameworks

Since the late 1980s there had been a substantial decline in inflation across the industrialized world and beyond. Many countries saw inflation fall into the low single digits. Moreover, inflation rates became increasingly stable and less dispersed across countries. Non-monetary factors, such as globalization, surely played a role in bringing down inflation, but more important were changes to the monetary policy framework.

There are three key aspects here, which I want to recall because at present they are again being discussed.

The first was the introduction of central bank independence. Many, if not most advanced countries enshrined in law the central bank’s independent conduct of monetary policy. Even in countries where no formal change in legislation took place, such as in the United States, it became generally accepted that political considerations should not interfere with monetary policy.

The second was enshrining price stability as a formal and overriding monetary policy objective. Before the breakdown of the Bretton Woods regime exchange rate pegs had provided a nominal anchor. Since the late 1980s nominal anchors were reinstated in the form of explicit and well–articulated price stability objectives.

A third element was fiscal consolidation and the general improvement in the macroeconomic policy framework in many countries, which provided the basis for monetary independence. This was coupled with fiscal reforms and restrictions, in some countries, on central banks’ ability to purchase public debt and lend to the government.1 These provisions bolstered central banks’ independence and reduced the risk that pressure is put on the central bank to monetize public debt.

While the reforms I have just outlined refer to the institutional framework for monetary policy, there were also important advances in the strategic framework. While the strategies of major central banks (like the FED, ECB, or Bank of England) differed formally, they all emphasized constrained discretion. And the same development happened in many emerging markets, which formally shifted to inflation targeting.

Financial stability: also ‘somehow’ achieved

We also thought we had ‘somehow’ achieved financial stability. By and large, the period since the late 1990s was characterized by decreasing macroeconomic volatility globally. The perception of low risk translated into lower volatility in financial markets and led many to believe that financial stability had also been achieved in a durable manner.

Financial innovation was thought to have led to a beneficial dispersion of risk through increasingly sophisticated financial instruments, even though this belief was not underpinned by hard evidence.

In turn, financial regulation increasingly relied on private sector inputs (Basel II) and self-regulation, reflecting a belief that private actors knew best how to manage risk.

On the other hand, we need to recall that financial stability frameworks were not as developed as monetary policy frameworks.

Relative to monetary stability frameworks, financial stability frameworks were seen as lacking a clear operational objective, as even the definition of financial stability remained a subject of debate. Financial stability policies relied on much looser conceptual frameworks where the relationships between goals and instruments were much less precise.

There was also a recognition that financial stability analysis needed better data. While aggregate data were available at a sufficiently high frequency for monetary policy purposes, these data were not fit for financial stability analysis, and authorities needed to rely on survey data and public accounts—available at best at a 3 month frequency—or alternatively to turn to market data.

While after much debate the policy rate was accepted as the key instrument to conduct monetary policy, there was limited debate on the range of instruments needed to achieve financial stability. Almost by default the discussion centered on capital requirements and their refinements, an area where the 1988 Basel accord had delivered a useful precedent in international cooperation.

Finally, while monetary policy was embodied within a clear institutional framework (central bank independence and price stability), there was no agreement on which institutional framework was best for achieving financial stability. Some countries continued to have a fragmented regulatory and supervisory structure, others developed integrated supervisors or twin-peaks models, while some reduced the role of the central bank in supervision and regulation.

C. The Present (the crisis) — what went wrong?

The crisis shattered the belief that we had ‘somehow’ achieved financial stability. What went wrong? Was monetary policy a factor in causing the crisis? Was financial policy a factor? And while financial stability was clearly gone during the crisis, was monetary stability kept? Let me discuss these questions in turn.

What went wrong?

In my view, there were four main sources of fragility, and I will only mention them briefly, as there have been many excellent discussions on the causes of the crisis. The main underlying factors were increased leverage, increased maturity transformation, increased exposure to aggregate “tail-risk”, and lack of transparency. The overextension of risk combined with a lack of transparency to create uncertainty about counterparty exposures, which in turn led to runs on wholesale funding, failures and near-failures of individually systemic institutions and a near breakdown of the global financial system.

But what role did financial and monetary policies play in laying the ground-work for the crisis.

Were financial policies a factor in generating the crisis?

The answer is “Clearly yes.” Although it is the financial institutions who are mainly to blame for having taken the decisions that ultimately led to the crisis, this was made possible by the inadequacy of regulatory and supervisory frameworks along several key dimensions.

First, there were enormous failures in the regulation of the most regulated financial intermediaries. Many of the largest banks had become vulnerable to funding crises through an enormous increase in total leverage, funded in wholesale markets. For too long, sufficiently stringent capital standards that could have prevented the build-up of leverage in the system had been missing. And while Basel II was being developed, it focused on ever more sophisticated risk weights for credit risks in the banking book, and paid insufficient attention to liquidity risk and credit risks outside the banking book.

Second, supervision based on existing rules had been weak. While supervisors were waiting for Basel II to be introduced, many of them took their eyes off the ball. For example, a well-known deficiency of Basel I was that it applied a zero risk weight to contingent exposures of less than one year in maturity. This was exploited by banks in structuring support for the special purpose vehicles they created off-balance sheet. Supervisors needed to have applied higher capital charges on these exposures or forced the banks to consolidate the vehicles. In addition, in the absence of internationally agreed rules on liquidity, national supervisors left unquestioned business models that relied increasingly on the continued liquidity of wholesale funding markets. More active use of supervisory discretion would have required a more thorough assessment of risks, thorough off-site and on-site examinations, and the determination to take follow-up action as needed.

Third, and most important, there had been a lack of a macro-prudential perspective in financial policies. Policies lacked a system view and failed to address increasing within- and cross–sector linkages in financial markets. There was a failure to appreciate that policies that seek to ensure the stability of a single institution may on occasion have adverse consequences for the economy as a whole, for example when they result in a reduction of funding for the economy at large (procyclicality).

And fourth, no one was looking to see if the domestic financial stability policies and the macro perspectives were adding up globally. Were global prudential and global macro policies consistent to produce global financial stability?—clearly not.

Was monetary policy a factor in generating the crisis?

Was it a main factor? My answer is: “No”. Was it a facilitating factor? I believe the answer is: “Probably yes at the global level,” Specifically, low nominal interest rates and stable economic conditions led to a search for yield by investors and financial institutions globally. This led to increased demand for complex structured products (particularly mortgage-based assets), promoted carry trades (or exposures to high yielding assets funded in low yielding currencies), and through exchange rate pegs created conditions of excess liquidity globally. This facilitated a build-up of leverage, and in turn increased the vulnerability to a reversal of stable macroeconomic conditions.

Overall, my impression is that many central banks did not pay enough attention to the consequences of monetary policy for financial sector developments, both domestically and globally, showing up the lack of a macro-prudential perspective in monetary policymaking. This added to the already mentioned problems coming from a lack of macro-prudential perspective in financial policy.

Was monetary stability kept during the crisis?

One aspect that I think is worth emphasizing is the very different course taken by monetary and financial stability during the crisis. While financial stability was clearly gone, monetary stability appears to have been kept, overall, in the sense that inflation expectations have remained stable and close to inflation objectives across advanced economies.

But the crisis has also complicated monetary policymaking in a number of important ways.

Throughout the crisis the monetary transmission mechanism was affected. Since the unwinding of financial imbalances created enormous demand for precautionary liquidity and put in doubt the solvency of counterparties in money markets, unsecured interbank money markets dried up and term spreads remained elevated, despite significant cuts in policy rates.

The increases in commodity prices between the fall of 2007 and the summer of 2008 resulted in substantial increases in inflation pressures, prompting some central banks to increase rates in the midst of the crisis. This highlights the tension between the need to ensure that inflation expectations remain well-anchored and the need to counter adverse macro-financial feedback loops. In the event, the threat of stagflation subsided quickly, as commodity prices fell sharply from the second half of 2008.

Since then, and consistent with the absence of inflationary risks, monetary policies have helped to support the financial sector and sustain aggregate demand, with policy rates cut to record low levels and central banks expanding their balance sheets, through both quantitative easing (QE) and credit easing (CE). However, with financial sector balance sheets continuing to be weak, monetary policy continues to be less effective, as the pass-through of policy rates to credit extended by the financial sector (the bank lending channel) is diminished.

D. The Future (after the crisis)—Can monetary stability be kept? Can financial stability be regained?

Looking forward, there are a number of challenges that need to be considered. In the shorter-term, can monetary stability be kept as we transition out of the phase of extraordinary public support provided during the crisis? And in the medium-term, what changes are needed in the macro-financial policy framework in order to secure both monetary and financial stability? Let me take these issues in turn.

Short-term challenges

There are several challenges confronting monetary policymakers after the unprecedented support from low interest rates and unconventional measures, and associated increases in the balance sheets of major central banks.

While monetary policy will have to remain accommodative for some time, a first challenge is removing the monetary stimulus provided by low interest rates as economic and financial conditions improve, so as to keep inflationary expectations anchored. Although the difficulties of getting the timing of interest rate increases right should not be underestimated, this seems a rather manageable task if the main reason behind future price pressures is the recovery of demand. A more difficult situation could arise if there remains economic and financial weaknesses but inflationary pressures come to life as a result of substantial increases in commodity prices due, for example, to unfavorable supply developments. This would be similar to the challenges faced by some central banks in the early phase of the present crisis until the fall of 2008.

A second and less easy challenge is bringing back central bank balance sheets towards more reasonable levels so as to avoid the risk of future losses resulting from the “unconventional” assets accumulated during the crisis. These losses could even affect the financial independence of some central banks. The unwinding of unconventional policy measures is easier and more automatic in those cases—like the ECB—where the central bank has operated within the existing implementation policy framework. In other cases, the accumulation of riskier assets with longer maturities—like in the FED—makes it more complex to reduce the size of the central bank balance sheet. It is thus of paramount importance that measures be taken in these cases so as to protect the integrity of central banks’ balance sheets.

Preserving central bank independence in all of its dimensions is most important at the present time where governments have accumulated very substantial amounts of public debt during the crisis, which is likely to imply heavy debt servicing costs going forward. Debt to GDP ratios are projected to rise to average well over 100 percent of GDP by 2014, up from 75 percent in 2007. Given this unprecedented debt accumulation, strong central bank independence is most needed to avoid any temptations to lean on the central bank to keep refinancing costs low and lower debt burdens through inflation.

Sustaining a political consensus in favor of low inflation requires a forceful reminder that high inflation is very costly to bring down. Moreover, if higher inflation expectations were to take hold, providers of credit are sure to immediately price these into nominal rates, increasing the cost for debtors to roll-over existing debt and obtain new funding. Indeed, once a firm nominal anchor is lost, the risk of further increases in inflation will be reflected in risk premia, further pushing up long-term rates. This is sure to create a long-lasting drag on growth and will increase rather than ease fiscal pressures.

Instead, on the fiscal side, credible fiscal adjustment is needed once the recovery is underway to offset key sources of spending pressure over the next decades, such as health care and pensions. To buttress fiscal adjustment, institutional arrangements, such as medium term fiscal frameworks, should be strengthened.

Medium-term challenges

Going to the medium-term, the main challenge is to enhance the macro-financial policy framework so as to deliver both monetary and financial stability in a lasting manner. As the crisis has shown, it is financial stability that was badly broken and thus needs to be fixed. The next question is how can this be done, and what role can central banks play in this regard.

To anticipate the conclusions, let me just state the following:

• The first best is for monetary policy and financial policy to be geared to preserving price and financial stability respectively. Thus the main measures to restoring financial stability must come from the enhancement of the regulatory and supervisory framework.

• While monetary policy should remain geared towards delivering price stability, recent experience shows that it should take better account of macro-financial linkages, and particularly of how its interest rate decisions have consequences for price stability through its impact on financial stability. In principle, regulation and supervision should fully take care of financial stability concerns; however, in practice—in a second best world—this may be difficult. Consequently, central banks ought to more fully consider the risk of financial imbalances when setting interest rates, which may lead them to “lean” more against these imbalances in good times and “clean” less in bad times, thus making monetary policy more symmetric over the business cycle. Similarly, the regulatory and supervisory framework should take better account of the systemic consequences of financial policies, and thus include a more macro-prudential perspective.

Let me develop these two ideas in what follows.

Regulation and supervision

For the financial and regulatory framework, there are five areas that should be on top of the reform agenda for regaining financial stability:

• Increasing the quantity and quality of capital and liquidity in the banking system

• Expanding the regulatory perimeter to cover all systemically important institutions, markets, and activities

• Dealing with excessive procyclicality in the financial system

• Improving financial disclosure

• Ensuring more effective cross-border regulation, supervision, and resolution of systemically important institutions like those too big to fail.

Let me look at each in turn.

The crisis has clearly demonstrated the potential macroeconomic consequences of insufficient capital and liquidity buffers. It is clear that we need a gradual increase in both the level and the quality of regulatory capital in the banking system. To me, requiring banks to hold more high quality capital is a sine qua non for the future.

A closely related issue is the need to promote the holding of more robust liquidity buffers in the system. So far, many had bought into the idea that monitoring liquidity risk was sufficient prudence and that temporary asset illiquidity could be substituted by funding liquidity. Now, there is greater realization that holding a buffer of liquid assets provides a strong shock absorber and can provide useful insurance against funding liquidity shocks.

Regarding the second question, the expansion of the perimeter of financial sector regulation and oversight, reliance on market discipline proved to be ineffective in constraining risk taking outside the banking sector. Supervision, too, was unable to get a complete picture of the exposure of regulated institutions to less regulated institutions and products. The failure of several nonbank financial institutions, which disrupted key financial markets, had systemic repercussions. Hence, increasing the likelihood that the systemic risks posed by unregulated or less-regulated financial sector segments are identified and addressed alongside risks in the regulated sector will be a key step towards ensuring financial stability. We should also acknowledge that there were clearly many instances in which the supervision of even regulated financial institutions (like deposit taking banks) was inadequate. Therefore, as we expand the perimeter of regulation, this must be accompanied by more effective implementation of rules. Not just good rules, they have to be applied effectively.

The third area for reform is addressing excess procyclicality in the financial system, which aggravated the macroeconomic impact of the current crisis by both promoting very rapid asset price increases and credit growth when the economies were booming, and then severely restricting credit and leading to sharply falling asset prices when economies faced a down turn. In addressing procyclicality in the norms governing capital, provisions, liquidity, and incentives in general, regulators will need to balance carefully the trade-offs between rules and discretion. There is work underway in the standard-setting bodies to develop appropriate countercyclical standards, such as capital requirements and through-the-cycle provisioning, which I think are highly desirable.

Promoting more effective disclosure is the fourth area for reform. Disclosure is important for market discipline, but we also need to ensure that disclosed information is both accurate and informative. Requiring financial institutions to provide massive amounts of information can be just as ineffective as too little. Therefore, a concerted and consistent approach to disclosure on a global basis would strengthen market discipline, as would be the development of a common database of comparable financial statistics for all globally active banks.

I now come to the final question, which is also the one that requires the hardest effort.

This has two aspects: first, how should we deal with systemically important institutions which are viewed as too-big or too interconnected to fail; and second, how should we deal with the cross-border dimensions of their life and death – i.e. ongoing operations and failure resolution.

While there is broad agreement on the undesirable moral hazard issues that very large systemic institutions pose, there is less agreement on how they should be dealt with both in preventing crises and in their resolution. I believe that it is time that public policy took a more active stance in discouraging institutions from reaching such a hallowed status in future, but I also believe that this is an issue that has to be handled very carefully and gradually. As a first step, I would agree on greater use of preventive measures such as higher capital and liquidity requirements related to their contribution to systemic risk and more intensive supervision.

The cross-border dimension presents even more difficult terrain. Addressing this inadequacy will require actions on two fronts – coordinating preventive supervision and crisis management arrangements. On supervision, first steps have already been taken by the establishment of supervisory colleges for the large international banks. On the second front, some progress has been made in promoting international consistency in approaches to deposit insurance through the announcement of the IADI core principles. However, the Achilles heel of cross border arrangements remains the lack of agreement on insolvency frameworks and resolution arrangements. While the need for greater compatibility in cross-border resolution frameworks has been recognized for many years, with this crisis, the time has come for concrete action. I recognize that such frameworks are integral parts of national regulatory and legal traditions, so advancing in this area will require strong political will.

I find it very encouraging that actions are being taken on all these fronts by the standard setters, guided by the G-20 and the Financial Stability Board. The evolving macroprudential approach which aims to bridge the gaps in addressing systemic and cyclical aspects of regulation covers many of the areas that I have highlighted. In implementing this approach, both supervisory agencies and central banks, where they are separate, must develop frameworks for working better together, and sharing critical information and analysis. There are significant challenges to be met before a true macroprudential approach can be made operational consistently across countries, but nevertheless it will be a significant addition to the regulatory arsenal to combat future crises.

However, as we have learnt time and time again, having the right rules and tools in place is no guarantee that they will be used effectively. One of the key lessons of the crisis is that supervisors and regulators were not as effective as they should have been in identifying risks and acting on them even under the existing standards and with their current set of tools. In short, implementation was lacking.

Effective application of rules requires a strengthening of the ability and accountability of regulatory and supervisory agencies to undertake timely and credible action. The supervisory response to the vulnerabilities that emerged ahead of the present crisis varied widely. In some countries supervisors used existing regulations to require banks to hold capital against a range of risks (like off-balance sheet structures such as SIVs or conduits), effectively reining in the build-up of risky exposures. But in many jurisdictions, supervisors faced impediments to enforcing fully all supervisory regulations.

So, we must find ways to promote the required operational independence of supervisory agencies, their ability to hire and retain skilled supervisors, and their capacity to take corrective actions.

Monetary policy

From my examinations of the needed changes in the framework for regulation and supervision it is clear that financial policies should not just enhance their micro-prudential dimension but add a much needed macro-prudential dimension that adequately integrates system-wide considerations. This is very important also as concerns the linkages between monetary and financial policies.

Specifically, financial policies must take into account the systemic consequences of monetary policy actions such as, for example, the higher risk taking and increased leverage resulting from a period of low interest rates in a low inflation environment, like the one that preceded the current crisis. This macro-prudential focus would help contain the financial imbalances and the systemic risks that otherwise may arise, thus preventing the onset of a financial crisis or, at least, reducing its impact.

Similarly when setting monetary policy, the central bank should take financial stability considerations more fully into account and also bear in mind that its interest rate decisions have consequences for its ultimate goal of price stability through its impact on financial stability.

Consequently, central banks ought to fully consider the risk of financial imbalances when setting interest rates, which also requires that they receive adequate information from the supervisory authorities concerning the state of the financial system. This does not mean that they should target any specific asset price level, but rather that they should be more willing than in the past to lean non-mechanistically against large increases in credit and indebtedness (e.g., leverage).

This can be justified as a “pragmatic” adjustment to traditional monetary policy so as to better take into account the sort of financial interactions that the current crisis has brought out very clearly but which are only imperfectly incorporated into the models and structures guiding monetary policy decisions. While somewhat higher interest rates than otherwise may lead to somewhat lower inflation than desired say, next year, they may lower the risks of an eruption of financial instability and deflation later on, and thus help maintain price stability over the medium term. Consequently, this would not involve adding another objective or lessening the role of price stability as the primary goal of monetary policy, but merely ensure that the latter is more effectively pursued over the medium term.

Let me be very clear in reiterating that financial stability should be the primary responsibility of financial policies and that little would be gained on this front if the regulatory framework is not enhanced as it should. But if the adequate reforms come through, monetary policy can also be supportive by incorporating a macro-prudential dimension in its pursuit of price stability.

There are clearly a number of difficult issues involved in putting these suggestions into practice with regard to monetary policy. For instance, it is important to make sure that the lengthening of the time horizon to achieve price stability is accompanied by a reconsideration of the framework for monitoring central bank performance relative to its objectives. If the operational horizon is extended, it may become more difficult to judge the performance of the central bank, and so it may be necessary to rely more on variables such as the stability of inflation expectations.

Also, there may be different ways of achieving the same purpose. As a number of European central bankers have noted, the monetary pillar of the European Central Bank’s monetary policy strategy can be used in a way that helps to conduct monetary policy in a more symmetric manner over the cycle, and more fully take into account financial stability considerations in the monetary policy making process. The monetary pillar puts a special emphasis on the evaluation of monetary and credit developments, with the aim of detecting medium-term inflation risks. But this is just one particular approach and other models are possible. As practitioners and academics, we need more research and debate to develop these ideas further before we adopt reforms.

E. Conclusions

I would like to conclude by painting a picture of the idealized macro-policy framework of the future. We may never get there, but it should be the goal. In this world fiscal policy becomes truly countercyclical by accumulating high enough surpluses in good times that can be drawn from in bad times; financial policy mitigates excessive procyclicality by accumulating cushions in good times that can be used in bad times; and monetary policy pays more attention to financial imbalances by “leaning” more against them in good times and thus having less of a need for “cleaning” after they explode in bad times. In my view, such a framework can significantly contribute to sustained growth around a more stable path by better grounding macro-economic stability, and it is an ideal that we should keep in mind as we undertake the necessary reforms in the years ahead.

In closing, I hope that all the efforts that are being undertaken to find solutions to preventing future crises from having such devastating effects will bear fruit. I am heartened by the renewed vigor in national efforts towards international collaboration and coordination, which are the most essential ingredients in the recipe for stability in an interconnected world. Still, we must together enlist the support of all stakeholders to counter the emerging forces of pushback and complacency – the two factors most likely to derail the reform agenda so instrumental to our pursuit of future financial stability. Otherwise, our efforts will be like that of the mythical Sisyphus, and in every future crisis we will once again begin our uphill task of pushing the heavy agenda of major regulatory reform.

Thank you.

1 These restrictions are often not very hard. For example, in the EU central banks can buy government paper “for monetary policy purposes”. Elsewhere, such as in the US and Japan, there are no legal restrictions, and the central bank has the practice to hold Treasuries against cash in circulation.


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