The role of central banks after the crisis
Speech by Mr Jaime Caruana, General Manager of the BIS, to the Observatory of the European Central Bank, Madrid, 19 January 2011.
The current crisis will have far-reaching consequences for the role and responsibilities of central banks. They will need to pay greater and more symmetric attention to financial considerations in framing their monetary policy. They will also need to play an important role in any macroprudential policy framework that is set up - even when they are not responsible for detailed implementation. But wider responsibility requires greater accountability. Strengthened governance arrangements must both ensure accountability and provide central banks with the autonomy needed to conduct monetary policy and financial stability policy.
Thank you very much for inviting me here and for the opportunity to return to the Observatory. It has been observing the ECB and other central banks for 12 years now, and I am sure that the past three years have been particularly intense, given the important role that central banks have played, and are still playing, in resolving the crisis.
The challenges central banks have had to face, and which they will soon have to confront as a result of the crisis, certainly merit a detailed analysis, but the question that I wish to discuss today is different. It is: what role will central banks play once the crisis has passed and the focus is on crisis prevention?
Past crises have altered the role of central banks significantly, and the current crisis will also have far-reaching effects. It is too early to set out in detail precisely how central banks' mandates and governance arrangements will change. Nonetheless, it is possible to identify some basic elements of the new landscape:
- Greater focus on financial stability. Financial stability will bulk larger in the minds of central bankers as they formulate monetary policy, not only in moments of crisis but also in normal times. The crisis demonstrated that central banks are the first port of call when systemic financial crises occur. In addition to their significant economic costs, crises also threaten the transmission mechanisms of monetary policy and central banks' own balance sheets, so central banks have an abiding and legitimate interest in preventing crises.
- Increased capacity to influence macroprudential conditions. Central banks will need adequate direct powers or channels of influence to promote financial stability and their own monetary policy. They need to be able to exercise these powers in their own right - or clear institutional arrangements should enable them to shape and contribute to the actions of others who control such tools. In addition, central banks will need a capacity to participate in regulatory design and macroprudential policy - something which is already occurring in most cases.
- Strengthened governance. Greater direct or indirect power requires greater responsibility and suitable accountability processes. The arrangements should protect central banks' independence while at the same time fostering effective cooperation with the government and other authorities at home and abroad. This requires clarity of roles and responsibilities and strong and effective accountability arrangements.
I shall structure the remainder of my remarks around these three topics.
In the future, central banks will need to focus on financial stability more than they did before the crisis, both in their formulation of monetary policy and in their macroprudential actions to limit systemic risk.
Monetary policy can and should promote financial stability by acting more symmetrically to address financial imbalances and help mitigate their accumulation. Macroprudential policies do not obviate the need for monetary policy to contribute to financial stability, although they can reduce pressure.
In general terms, prudential or macroprudential policies may not be sufficient to maintain financial stability. Ultimately, short-term interest rates determine the cost of leverage, and keeping them at persistently low levels can generate excess debt, relaxation of credit standards, and excessive maturity transformation and risk-taking.
It is thus not advisable or even possible to allocate instruments in a clear-cut way, so that interest rate policy seeks to guarantee price stability while prudential and macroprudential policies aim to ensure financial stability. Increasing interest rates to counter rapid credit growth and rising asset prices can be considered as a lengthening of the time horizon over which price stability is pursued.
All this presents significant conceptual and operational challenges. Articulating financial stability objectives is not easy. Financial stability is inherently less amenable to precise specification and measurement than price stability. In addition, due to its very nature, the responsibility for coping with systemic risk is shared with other authorities. The crisis has taught us that a narrow focus on the safety and soundness of individual institutions is not enough. The interlinkages and externalities are too great. In addition, the financial system tends to be procyclical and amplify macroeconomic or global financial shocks. Therefore, a broader, more systemic vision that integrates a macroprudential perspective into supervision and regulation is required.
Central banks must act according to a clear financial stability strategy, with properly formulated objectives and well defined functions and responsibilities of the central bank and other authorities.
Four jobs central banks are already doing make them well suited to playing a prominent role in a financial stability strategy that gives greater weight to systemic questions. First, central banks have considerable expertise in macroeconomic analysis, which they use in formulating monetary policy. It is natural for them to put it to good use in the prudential arena. Second, central banks have intimate knowledge of, and participate actively in, financial markets. Third, central banks play a key role in overseeing the payments and settlement infrastructure at the heart of the modern financial system. Finally, central banks in many jurisdictions have explicit responsibility for the regulation and supervision of financial institutions. The crisis has led to an expansion of this role.
The process of developing and implementing a financial stability strategy involves the identification of vulnerabilities, the evaluation of policies to mitigate them and the implementation of specific measures. The central bank naturally plays a prominent role in all these activities. Different jurisdictions are assigning different roles to the central bank in each phase.
In the EU, central banks will play a prominent role in diagnosis and prescription, but a more limited one in implementation. The European Systemic Risk Board (ESRB) will manage the process of identifying systemic risks and determining the most effective means for mitigating them. The President of the ECB chairs the ESRB, and the Governor of the Bank of England serves as its Vice-Chairman. The ESRB will draw heavily on the expertise of central banks and supervisors, and the ECB will provide the secretariat. The ESRB will not exercise direct authority over any policy instruments. Instead, it will make recommendations and warn the competent authorities. The recommendations will be difficult to ignore if they are made public and contain an injunction to "comply or explain". And in some circumstances the recommendations will be made public.
In the United States, the central bank will play a different role, according to the framework established by the Dodd-Frank Act. The Financial Stability Oversight Council (FSOC) will provide the diagnosis, and will also make some broad political decisions, such as designating particular firms as systemic and therefore subject to more intensive supervision by the Federal Reserve. The Secretary of the Treasury chairs the FSOC. While the Chairman of the Fed is only one of 10 voting members, the Fed's command of analytic resources suggests that its perspective will have special weight. The Fed will continue to play an important role in the implementation of policy, using expanded supervisory powers provided under the Dodd-Frank Act to address the risks that arise from the size, business models and the interconnectedness of systemically important financial institutions.
If the central bank must play a more prominent role in financial stability policy, it needs the appropriate tools and the capacity to use them. Because we are still learning the lessons from a crisis, we cannot yet exhaustively list the instruments in the ultimate macroprudential toolkit. Still, this toolkit clearly will include measures that make the system more robust structurally, as well as countercyclical measures. Some will be automatic; others will be discretionary.
One of the key tasks is to strike the right balance between discretionary decisions and built-in automatic stabilisers that can dampen systemic risk without further policy decisions. How far can macroprudential policy rely on rules embedded in regulation as opposed to discretion in supervisory decisions? Fiscal policy works countercyclically even in the absence of explicit changes in tax rates or discretionary changes in expenditure thanks to strong built-in stabilisers. Similarly, we can design prudential rules to exert powerful stabilising forces. Central banks are well placed to insist that macroprudential factors be given due weight in setting prudential regulations. In the EU, the ECB must be consulted as a matter of law.1
The design of the macroprudential toolkit can draw very usefully on the work done in support of the Basel Committee on Banking Supervision's proposal to strengthen capital and liquidity standards. Various elements of the Basel III package - the increased leverage ratio and capital margins, funding and liquidity requirements, etc - help, through both their design and their calibration, to lower systemic risk by reducing leverage and excessive maturity transformation on bank balance sheets.
In the past, we set the target level of capital for the banking system as a whole purely by looking at the appropriate level for individual institutions, on a bank by bank basis, and then aggregating up. Now, for the first time, we have calibrated capital and liquidity requirements, and guided their pace of implementation, by top-down macroeconomic studies that link proposed standards to economic activity. In the process, we are beginning to learn about how regulatory changes affect the course of credit and output over the cycle. This work should pay dividends when the time comes to use macroprudential tools actively.
The Basel Committee seeks to embed in regulation the macroprudential principle of increasing capital buffers in good times that can be drawn upon during periods of stress. The Governors and Heads of Supervision have endorsed two capital buffers. First, a conservation buffer has been created to conserve capital. This buffer above the minimum requirement is purely rule-based, as it is set as a fixed proportion of risk-weighted assets. The buffer can be run down during a period of stress, lessening pressure to restrict credit. But its primary objective is to ensure that banks that incur losses and approach the minimum do not pay out capital, which would further weaken their capacity to lend. Second, an additional countercyclical buffer has been created to build up capital in good times when risk accumulates. This buffer is much more based on discretion. Through similar restrictions on dividend payments, banks would be constrained to accumulate this buffer during periods of unusually rapid credit growth in order to mitigate the build-up of systemic risk. Supervisors would then release the buffer as strains materialised in order to absorb losses and allow banks to continue to extend credit.
There are also other tools available, and a larger toolkit offers distinct advantages. Central banks can target the source of a problem more precisely. For instance, using loan-to-value ratios for mortgage lending might protect the quality of bank assets and mitigate demand for them by complementing other measures which affect prices or supply. If the central bank targets specific sectors, it will need to avoid distorting credit allocation and inducing banks to seek ways around such measures. We should not forget that monetary policy in developed economies has moved away from direct instruments to avoid such distortions and inefficiencies.
Some final words are warranted on the risk of watering down macroprudential policies by extending their use too widely, to include all types of measures that affect systemic risk in some way. I believe we should delimit the definition of macroprudential policy not only according to its objective, but also according to the instruments used and its governance.
A wider financial stability mandate implies significant changes in the structure and operation of the central bank. The wider the scope of the central bank's financial stability mandate, the greater will be its scrutiny in the political process. Financial stability decisions require greater interaction with the government than monetary policy decisions. Determining how to organise such interaction in a manner that provides the central bank with the autonomy needed to achieve price stability will not be easy.
Greater interaction with the government need not compromise central bank autonomy, but it does require well specified mechanisms for coordination. Indeed, the arguments in the area of monetary policy in favour of making the central bank independent from the political cycle apply with equal force in the area of financial stability. In addition, there is a need to shield day-to-day decision-making from the commercial interests of the financial industry. In fact, one argument for assigning financial stability responsibilities to the central bank is that it already has independence to conduct monetary policy.
Clarity about the central bank's financial stability mandate and strategy will help promote accountability. Although it is not possible to set out measurable financial stability objectives, it is possible to make the decision-making process and ultimate actions transparent. Well specified roles and responsibilities within a clearly articulated strategy for promoting financial stability will make this form of disclosure meaningful. The central bank can then be held to account. Public disclosure and legislative oversight can promote accountability. Both procedures are widely used for both monetary policy and financial stability policy. To date, however, disclosure in normal times of information on financial stability actions has been less extensive and less frequent than such disclosure on monetary policy.
The financial crisis carries significant implications for central banks as public policy institutions. They will need to pay greater and more symmetric attention to financial considerations in framing their monetary policy. Central banks will play an important role in any macroprudential policy framework - even when they are not responsible for its detailed implementation. But wider responsibility requires greater accountability. Financial stability actions by their nature involve more politics than do monetary policy decisions. The challenge will be to develop the governance mechanisms for central banks so that they retain the independence needed to conduct both monetary policy and financial stability policy. This will require greater clarity about their financial policy strategies.
1 See Articles 127(4) and 282(5) of the Treaty on the Functioning of the European Union, and Article 2(1) of Council Decision 98/415/EC of 29 June 1998 on the consultation of the ECB by national authorities regarding draft legislation.