Christian Noyer: International financial stability and the role of central
banks in the crisis
Address by Mr Christian Noyer, Governor of the Bank of France, at the Plenary session: "The
international economy in transition" of the Montreal Conference, Montreal, 9 June 2008.
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Ladies and gentlemen,
It is a great honour for me to take part in this conference and to set out, before such a
distinguished audience, my thoughts on the role of central banks regarding financial stability
in the current environment.
I should like to organise these thoughts around the following five questions:
1) Do central banks have a role to play regarding financial stability?
2) What have they done since the start of the financial turmoil in the summer of 2007?
3) Were they right to take these steps?
4) Why have they responded differently as regards their monetary policy stance?
5) What lessons can we learn for the future?
1) Do central banks have a role to play regarding financial stability?
This question might appear paradoxical when we recall that historically the raison d'être of
central banks has been to ensure financial stability, that is, the smooth functioning of
financial markets and payment systems. In this context, they play the role of the ultimate
liquidity provider, in other words, of lender of last resort.
However, some people now regard this role as inconsistent with that which in the meantime
has universally become the primary task of central banks, i.e. ensuring price stability. Three
main arguments are generally put forward to support this view:
- The first is that central banks have only one instrument at their disposal, i.e. the
interest rate, and that this instrument, by virtue of Tinbergen's Principle, can only be
assigned to a single objective, that of price stability. Other means - particularly
regulatory or prudential measures - would be better suited to and more effective in
ensuring financial stability. But the current crisis demonstrates that central banks
actually have several instruments at their disposal. Indeed, liquidity management in
periods of financial turmoil needs to be separated from the issue of the monetary
policy stance. To put it more clearly, the monetary policy stance simply consists in
setting key interest rates at a level consistent with the central bank's
macroeconomic objectives, whilst liquidity management aims to enable the money
market, and financial markets in general, to function "normally" so that monetary
policy impulses may be efficiently transmitted to the rest of the economy.
- The second argument is policy-based in nature and postulates that monetary
stability is a necessary and sufficient prerequisite for ensuring financial stability. The
latter would then be a welcome consequence of the implementation of an inflation
targeting strategy, which consists in only responding to shocks that have a lasting
impact on medium-term price stability. Here again, the argument does not hold up in
the face of the facts since the financial crisis unfolded in an environment of low
interest rates and contained inflationary pressures in spite of soaring property and
commodity prices, in short, in a context where price stability seemed well secured.
The same was true for the previous bubble that formed on stock markets. A low
interest rate environment, which often makes agents less vigilant about risk or
makes them less able to gauge it, combined with very strong central bank credibility,
is in no way a guarantee of financial stability. This is one of the manifestations of
what some economists have termed the paradox of credibility.
- The third argument relates to the extraordinary transformation that our financial
systems have undergone over the past few years, with a growing, if not
predominant, role for market financing at the expense of bank intermediation. Yet
the operational framework of central banks, by means of which they perform their
role of lender of last resort, is mainly focused on banks, and retail banks in
particular. Here again, the facts prove the opposite. The crisis has shown that banks
remain at the heart of the financial system and that, as a consequence, the
operational framework of central banks remains entirely effective. In addition, this
framework makes it possible to reach other market participants, such as
brokerdealers and investment banks.
2) What have central banks done since the start of the financial turmoil?
The overall impression in the press is that central banks have injected vast amounts of
liquidity into the banking system in order to face up to the crisis. This is not true to reality. In
volume terms, the amount of liquidity allocated by the Eurosystem has posted slow growth
since the summer of 2007.
On the other hand, during the crisis, some central banks, such as the Fed and the Bank of
England, have had to make adjustments to their operational framework, while others, like the
ECB, have been able to rely on their existing framework, up until very recently. This has
resulted in a remarkable convergence of central banks' operational frameworks and fields of
intervention around four main areas:
- a lengthening of maturities for central bank lending: these maturities have been
increased from a few weeks to a few months. In the case of the Eurosystem, a
major share of refinancing operations have a maturity of three months, and,
recently, a six-month facility has been introduced;
- a widening of the range of eligible collateral, i.e. the securities used as collateral.
Securities such as ABS and RMBS, which have always been accepted by the
Eurosystem, are now accepted by all other major central banks;
- an extension of the list of eligible counterparties, in particular in the United States,
where investment banks now have access to the Fed's lending facility;
- a greater degree of coordination between central banks: this not only includes joint
statements aimed at reassuring the markets about the provision of liquidity when the
need arises, but also the signing of swap agreements between central banks. This
facility enables any European bank which needs US dollars to pursue its activities to
secure this funding from the ECB or the SNB.
3) Were central banks right to take these steps?
The fast spillover of the US subprime crisis to other market segments, and subsequently to
other countries through the seizing up of the commercial paper market and the major strains
on money and interbank markets, called for rapid central bank intervention. This not only
included providing liquidity to the market as a whole but also, in some countries, granting
emergency liquidity assistance to systemic institutions.
These interventions have raised a number of questions: did not central banks, by adapting
their operational framework to fit the circumstances, increase moral hazard? Did they not
unduly save institutions that did not deserve to be saved, in particular those which had taken
excessive risks? Did they comply with the traditional principles expounded by Bagehot many
years ago, i.e. lend to temporarily illiquid but solvent financial institutions, lend at penalty
rates against sound collateral, and provide liquidity to any institution satisfying the
aforementioned solvency and collateral criteria?
These essential questions are, however, mainly academic. Today, they take on different
dimensions. Indeed, all financial crises cause a downward spiral in asset prices, which
before long transforms a temporarily illiquid institution into an insolvent institution, making
Bagehot's initial distinction difficult to apply. This situation is exacerbated in our developed
financial systems by the joint application of new accounting standards requiring fair value
measurement for financial assets and prudential arrangements that may prove partly
procyclical. In this context, central banks have the clear duty of preventing the market from
seizing up, with incalculable consequences for other financial players and more generally for
the real economy.
However, it should be borne in mind that the central banks' criteria for accepting assets as
collateral for their refinancing operations are particularly restrictive and penalising, and
comply with the traditional principles that I have just mentioned. In particular, the value of
these securities must be at least equal to the amount lent and the accrued interest, after
applying a haircut to take account of a possible decline in their market value during the repo.
4) Why have the central banks responded differently as regards their monetary
policy stance?
As regards the central banks' response to the crisis, although they converged in their
shortterm liquidity management methods, they nonetheless responded differently in terms of
monetary policy.
The underlying reasons for this divergence are both due to the nature of the shocks that the
economies are facing and the mechanisms of their propagation to the real economy and to
nominal variables.
Over the recent period, the industrialised economies have undergone three common shocks:
rocketing real-estate prices at least in a number of countries, soaring commodity prices and
finally the financial crisis triggered last summer.
They have also experienced specific shocks: the real-estate crisis in the United States in a
context of household overindebtedness, for example. In the latter case, the economic
slowdown already underway since mid-2006 and the expected consequences of the credit
crisis on economic activity over the medium term has led the US monetary authorities to
change their monetary policy stance. The very different situation in the euro area, where
activity remained favourable, has led the ECB to keep its monetary policy stance unchanged
in spite of the uncertainties generated by the financial crisis in a context also characterised
by persistent inflationary tensions.
5) What lessons can we learn for the future?
At the current juncture, financial turmoil is still affecting the markets. However, after more
than nine months, I think it is already possible to draw first conclusions in three main areas:
- First, the close co-operation between central banks on the one hand and between
the supervisory authorities and central banks on the other hand seems, in my
opinion, to be a determining factor for efficient crisis management. This point was
indeed underscored during the recent work carried out by the Financial Stability
Forum. I must say in this respect that the French model of banking supervision, in
which banking supervisors have close ties with the central bank, has once again
proven its worth in the current context. The necessity of this proximity has also been
increased by the new accounting and prudential standards which have proven to be
pro-cyclical and in which liquidity and solvency are intertwined. In this context, when
in a financial crisis, it is crucial to cross-check, at every moment, information on the
evolution of banks balance sheet and data on money market functioning in order to
assess the risks to financial stability. Such an assessment enables to adapt, as far
as needed, the refinancing policy of the central bank, in order to alleviate tensions in
the market; those tension being a threat both to financial stability and to the
effectiveness of the transmission of monetary policy.
- Second, with regard to monetary policy, let me reiterate that one must carefully
distinguish between the monetary policy stance on the one hand, which should
remain focused on the macroeconomic objective of price stability in the medium
term, and the refinancing conditions of the banking system on the other hand, that
may have to be adapted in times of financial turmoil. Moreover, a solid anchoring of
inflation expectations seems to me particularly crucial in a period of economic and
financial uncertainty.
- Last but not least, in my view, regulatory issues related to the increase of financial
innovation over the recent period of rapid market growth should now be a matter of
primary concern. Moreover, the return of greater market discipline, closer monitoring
of risks by market participants and quite simply the use of commonsense principles,
such as acknowledging that there is no such thing as low risk/high return assets, are
in my view prerequisites for a return of confidence to the markets.