May 27, 2010
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As Prepared for Delivery
Good evening. Let me start by saying that it is an honor to speak before such a distinguished audience. This evening, I would like to share with you my thoughts on the lessons from the crisis for central banks and for central bankers.
Specifically, I will focus on three key questions: First, why were central banks and supervisors unable to prevent the crisis? Second, what role should central banks play in promoting financial stability? And third, how should central banks handle crises when they happen, despite our efforts at preventing them?
A. Why were central banks and supervisors unable to prevent the crisis?
Beginning in the 1990s, most advanced economies adopted a fairly standard monetary policy framework with price stability as the primary objective, independence to pursue that objective, stronger accountability and, more recently, enhanced communication. Associated with the adoption of this policy framework was a dramatic improvement in macroeconomic performance in most countries, which led some to refer to this period as the “golden years” of central banking.
Although it was recognized that financial sector developments could pose macroeconomic risks, most central bankers felt that their role was mainly to provide a stable macroeconomic environment conducive to financial stability, and to “clean up” if a crisis occurred. Preventing financial crises was seen as the specific task of regulatory and supervisory bodies.
Regulation and supervision of financial institutions increasingly moved towards a “light touch” approach, relying heavily on what were believed to be self-correcting market forces. Efforts to improve capital standards emphasized bringing regulatory requirements into line with bank’s own, risk-based, assessment of capital needs. Crucially, regulation and supervision did not keep up with the growing risks associated with increasingly complex interactions between institutions and markets. The effectiveness of regulation and supervision was further undermined by expansion of the non-bank financial sector and activity in the “shadow banking system” beyond the regulatory perimeter.Paradoxically, the success of monetary policies in promoting macroeconomic stability may have contributed to the build-up of financial imbalances. Low interest rates globally in the context of a prolonged economic expansion during the early 2000s may have led market participants to underestimate risks in many asset classes. At the same time, a compression of yield curve spreads, associated with the global savings glut and widening current account imbalances encouraged financial institutions to increase leverage and investors to take on increased risks.
However, with hindsight it is clear that ineffective regulation and supervision, rather than loose monetary policy in key countries, was the main culprit in allowing the build-up of financial imbalances to go unchecked. Monetary policy kept interest rates where they should be to preserve price stability while financial policies clearly failed to preserve financial stability.
B. What role should central banks play in promoting financial stability?
This question lies at the core of the design of central banking in the post-crisis period. It has two different dimensions. One is whether and how central banks should formulate monetary policy in light of financial stability concerns. Another is how central banks should contribute to macro-prudential policies. Let me start with the latter.1. How should central banks contribute to macroprudential policies?
In the wake of the crisis, it is increasingly recognized that new prudential tools will need to be developed and applied as part of the larger policy effort to mitigate systemic financial risks. These new tools are often collectively referred to as “macroprudential regulation.” Financial regulation and supervision needs to increasingly take a systemic view, over and above addressing individual institutions.
While considerable work still remains to be done to make the tools of macroprudential regulation operational, the concepts are increasingly well understood. Here, it is useful to distinguish the cross-sectional and time dimensions of systemic risk. While both are equally important, from the point of view of macro management a key role of macroprudential policies is to address the time dynamic aspect of systemic risk, in other words, its inherent “procyclicality.” Financial imbalances tend to build up in good times, as leverage increases and financial institutions become overexposed to aggregate risks. Well-designed macroprudential tools can target procyclicality at its root and operate in three main, complementary ways.
One is to prevent the excessive buildup of leverage by strengthening and adding a countercyclical dimension to capital standards. Another is to encourage financial institutions to make provisions through the cycle and retain their earnings to build up better loss-absorbing buffers. Encouraging prudent lending standards and collateral policies—such as loan–to-value ratios— is a third option that has already been tested in a number of emerging market economies.
These regulatory tools can work as automatic stabilizers, since they will tend to become tighter as financial imbalances build up. They would surely need to be complemented by some flexibility and careful judgment by policy-makers adjusting prudential policy settings in response to macroeconomic developments—such as credit growth and high leverage—or the build-up of risks in particular sectors.
Central banks can provide important inputs into the calibration and use of macroprudential tools. Central banks are likely also to take a strong interest in the design and effective application of macroprudential tools. Specifically, if such tools fail to prevent financial crises from arising, central banks will continue to be burdened in crisis times with the pursuit of unprecedented measures to maintain financial stability. As we know, some of the measures are not without risks to the integrity of central banks’ balance sheets and may complicate the conduct of monetary policy.
Central banks therefore have good reasons to be involved in macroprudential policies, but how? The answer will depend on existing regulatory and supervisory structures as well as the state of development of the financial sector. Whatever the starting point, institutional arrangements need to recognize the interaction of monetary and macroprudential policies, while ensuring independence of the conduct of monetary policy.
More concretely, where both monetary policy and macro-prudential policies are conducted by the central bank, the latter should be governed separately from monetary policy, to reduce any potential threat to the independence of the conduct of monetary policy that might otherwise arise from an enhanced role in regulation. Where monetary policy is institutionally separate from prudential regulation or supervision, the institutional arrangements need to ensure that the views of the central bank are adequately taken into account in the conduct of macro-prudential policies.
2. Should monetary policy frameworks be changed?
I will now turn to the issue of what lessons we should draw from the crisis for monetary policy. It is clear nowadays that the macro-financial policy framework needs to be enhanced so as to deliver both price and financial stability in a lasting manner. The next question is how can this be best done and what adjustments are needed for monetary policy?
In my view, the appropriate arrangements are for monetary policy to continue to be geared to preserving price stability and for financial policy to be geared to preserving financial stability. As I have already discussed, the main measure to restoring financial stability must come from the enhancement of the regulatory and supervisory framework.
Thus, price stability must remain the primary objective of monetary policy, supported by central bank independence, as well as strong accountability and clear communication. These factors are all the more important in the post-crisis environment, where much more difficult fiscal positions, and the associated rise in sovereign risk, have the potential to undermine confidence that price stability will be maintained.
However, this does not mean that no adjustments at all are needed concerning the conduct of monetary policy in the post-crisis world. After all, monetary policy does affect and is affected by financial conditions. In my view, the key lesson for monetary policy from the crisis is the need for central banks to integrate macro-financial linkages and vulnerabilities much more systematically into macroeconomic analysis and monetary policy decision making. This will require strengthening monitoring and analysis of financial developments and vulnerabilities at the systemic level.
Additionally, the macroeconomic models used for policy analysis and policy formulation need to be modified to include explicitly financial intermediation, balance sheets, default risks and major assets such as housing and equities. Without this kind of structural detail in the models, it is very hard to use them to analyze the implications for monetary policy of financial developments and vice versa. I know that efforts in this direction are already underway in a number of central banks, but I am also aware that this is not easy work—if it were it would have been done long ago.
A particular challenge for monetary policy makers is how to deal with financial imbalances that develop only gradually, so that their potential impact on macroeconomic performance—and specifically on price stability—lies beyond the 1 to 3 year horizon usually considered as most relevant for monetary policy decisions. One approach to dealing with this problem is for central banks to extend their policy horizons for price stability so as to allow them to non-mechanistically lean against financial imbalances. This would imply a more symmetric monetary policy over the business cycle with more “leaning” in good times, and hopefully, less “cleaning” in bad times.
However, this could lead to somewhat greater short-term variability of inflation. To avoid undermining policy credibility, central banks would need to be very transparent about how financial stability concerns are factored into policy decisions and the consistency of their actions with price stability over the medium-term. In this regard, inflation expectations can play a very relevant role in facilitating the monitoring of monetary policy. Having said all this, I think more research is needed to make these ideas operational.
C. How should central banks prepare for the next crisis?
During the recent crisis, several central banks provided liquidity on an unprecedented scale not only to banks—which is standard—but in certain cases also to non-banks for systemic reasons. These efforts have substantially contributed to stabilizing financial conditions and supporting economic recovery. However, some of these actions can blur the policy role of central banks and create moral hazard. Central banks are now meeting these challenges by developing an understanding of good practices and operational procedures for crisis response measures.In my view, any measures taken by central banks in this domain must be fully consistent with their policy goals. Their objectives should be clearly communicated and operations arranged to reflect them. This would facilitate proper understanding by markets and the public, which is essential not to de-anchor inflation expectations. Second, central banks should have all the necessary information at hand to judge if the intervention is necessary and valid. This point can be critical in providing emergency financing to individual institutions, but systemic implications should also be well-analyzed for market-wide interventions. Third, the regulatory perimeter should be widened to encompass any institution or market that could potentially require lender of last resort support. Finally, measures should be designed as well as implemented to mitigate moral hazard and market distortions.
Another important lesson from the crisis is that collaboration on the domestic and international level is critical. Information sharing and “war games” involving key authorities can help facilitating crisis management.
Finally, the enlarged role of central banks during the crisis must not be allowed to pose risks to their independence. Consequently, the policy roles of the central bank, the government, and other entities need to be clearly delineated.
Thank you.
