Manuel Sánchez González: Financial crises - prevention, correction and
monetary policy
Speech by Mr Manuel Sánchez González, Deputy Governor of the Bank of Mexico, at the
Cato Institute 28th Annual Monetary Conference, Washington DC, 18 November 2010.
* * *
The opinions expressed herein are entirely my own and do not necessarily reflect those of the Bank of Mexico.
The financial crisis that surfaced in 2007 has stressed the need to identify the ultimate
sources of the incentives that were behind the preceding credit and housing bubbles. To
lower the likelihood of future financial collapses, prudent economic policies as well as an
adequate regulatory and supervisory framework for financial institutions are required.
Monetary policy, in turn, should be directed towards price stability, which is a central bank's
best contribution not only to long-term economic growth, but also to financial stability.
Bubbles and recurrent crises
Since the late 1990s, the United States and other advanced countries exhibited rapid rises in
housing prices that were supported by sizeable leverage taken on by households and firms.
A credit bubble evolved, along with a housing bubble, as banks and other financial
intermediaries facilitated borrowing by relaxing mortgage product standards. In some
countries, notably the United States, credit expansion was fueled by substantial use of loan
securitization and credit derivatives.
The eventual bursting of the housing and credit bubbles resulted in global turmoil with severe
consequences in terms of financial instability and a drop in income. Through contagion, this
burden was shared by many countries that did not create any autonomous asset bubbles.
The most affected nations were those that
hold close investment and trade ties with the
United States, as was the case of Mexico. The widespread negative impact of the
meltdown has justifiably called the attention of policy makers to finding ways to pursue
financial stability and avoiding future collapses.
To be realistic, the scope of such an objective should be properly bounded. Financial
bubbles, characterized by substantial rises in asset prices departing from previous trends
that are suddenly interrupted by a sharp fall, have been common in economic history. While
volatility in stock, currency and commodities prices are the norm, occasionally bubbles
emerge in many assets, including housing.1
Bubbles are formed because many people believe that the price of the underlying asset will
continue to rise into the indefinite future and that they can sell the asset before a change in
fortunes occurs. Long durations of bubbles may reflect information asymmetries and costs
associated with arbitrage in the form of short-sale constraints. In market economies, asset
price fluctuations and bubbles could be interpreted as unavoidable and even beneficial as
they become the means of rewarding good choices and punishing bad decisions.
One macroeconomic risk of asset price collapses is the possibility of a growth slowdown or a
recession. The empirical evidence of the effects of price falls in stock and currency markets
is somewhat mixed. However, the likely negative real consequences of housing bursts
appear to be clearer. Statistical analyses reveal that housing prices are strongly pro-cyclical
and that they are leading indicators of recessions and expansions.2
A second, potentially more serious cause of concern over large housing price fluctuations is
that they have frequently ended in banking crises. These episodes may involve problems of
liquidity and insolvency of certain financial institutions to the extent that the functioning of the
economy becomes impaired, for instance, if they produce a generalized panic and loss of
confidence.3
A target of smooth asset price behavior is hardly attainable through economic policy, given
the intrinsic uncertainty involved in financial transactions and the imperfect information policy
makers have at hand. More important, however, is the fact that such an objective is probably
undesirable as it amounts to controlling risk and returns, thereby creating moral hazard and
inhibiting innovation and growth.
What does constitute a sound policy goal is building conditions to ensure the continuous
functioning of the basic financial system, particularly the banking system, without which the
economy cannot work. This focus, which operationally requires a delimitation of what a basic
system is, gives content to the objective of financial stability and crisis prevention.
Preventing financial crises
The global crisis reflected excessive risk taking and high leverage on the part of economic
agents and financial institutions. A basic postulate of economics is that people respond to
incentives. Hence, to reduce the probability of another financial collapse, it is necessary to
learn from experience by identifying the ultimate sources of the incentives that led to the
crisis. By this, I mean the environment that economic agents face in making decisions. Given
this setting, private actions can be regarded as results, not as root causes of problems.
Examples of the former in the crisis are the high bonuses paid to bankers for placing
securitized loans and the poor credit evaluation of these instruments made by rating
agencies.
There is a large body of literature discussing the possible origins of the financial debacle. Of
course, any list of factors is incomplete not only to explain the crisis but to enable anticipation
of future ones. Despite this obvious limitation, one can expect that correction of the identified
conditions for inadequate incentives will lower the probability of banking disasters.
For expedience, the causes of the turmoil can be classified into cyclical and structural. In the
first group two contributing factors stand out. One refers to the low interest rates that
prevailed in the years prior to the global crisis. Authors are divided in stressing, as the main
source of this phenomenon, either an expansionary monetary policy reflected in short-term
policy interest rates, or capital inflows from emerging markets to developed countries that
affected long-term interest rates.4
There is much debate on the significance of the possible deviation of United States monetary
policy from the "correct" Taylor rule during 2002-2005. However, many empirical studies
conclude that policy interest rates that were negative in real terms and deviated from
traditional Taylor rules in the advanced economies did contribute to the gestation of the
crisis. The verified channels include an increase in housing investment and prices, a stimulus
to borrowing, greater risk taking by economic agents and banks, an increase in bank
leverage, and the loosening of lending standards. On the other hand, statistical evidence of a
separate contribution of capital inflows to the crisis appears less conclusive.5
The other factor of cyclical conditions encompasses policies aimed at promoting the
expansion of lending, through fiscal subsidies for borrowers, credit targets for banks, and
government guarantees on loans - for example, to make housing more "affordable" for
lowincome people. In the United States, government-sponsored enterprises promoted massive
securitization of subprime loans, something which was crucial in the gestation of the bubbles.
A central lesson here is that economic policy should not become a source of problems.
Expansionary monetary policy beyond optimal rules for a prolonged period of time and
policies for artificially promoting credit expansion should be avoided, among other reasons,
because they produce inadequate incentives.
Moreover, the structural factors behind the crisis refer to a poor regulatory and supervisory
framework for intermediaries. Regulation is justified to counter externalities such as the ones
experienced in the crisis. The prevailing regulatory rules probably contributed to the high
leverage and large maturity mismatch taken on by banks and other financial institutions
which ended in widespread counterparty mistrust, liquidity shortages, and contagion to
other markets. To a large extent, the undue exposure to risk was possible because
banks took much investment off their balance sheets.
One possible source of weakness stems from capitalization and liquidity standards that were
not effective enough to avert the crisis. A preventive, stronger set of requirements in terms of
levels and composition, with "sufficiently" broad scope, is necessary to generate responsible
behavior in the financial system. In principle, more stringent capitalization requirements
would induce shareholders of institutions to monitor more carefully the risk positions adopted
by their managers. Also, stricter liquidity standards would allow banks to handle stress
situations associated with tightened funding sources and increased deposit withdrawals with
more flexibility. Obviously, these restrictions may have an impact on the availability and price
of credit. Yet, the increased social benefits are expected to surpass the costs.
For capitalization, the definition of capital should be narrowed to include only truly
lossabsorbing items such as common equity. Ideally, one would like differentiate with different
weights not only the type of asset in general but the specifics of such assets - for example, a
mortgage for a low-risk customer should not absorb the same capital as one for a high-risk
customer. In practice, however, this procedure might be cumbersome and most importantly,
it would be largely dependent on judgment, despite the sophistication of any model. Hence, it
is probably better to seek high standards of capital relative to non-risk-weighted assets
including off-balance-sheet exposures; i.e., the total leverage ratio. Also, buffers for bad
times and contingent debt conversions into equity for tail risk situations are highly desirable.6
As for liquidity, although extreme versions of null maturity mismatch between the assets and
liabilities of banks have proven historically impractical, a more flexible and modern version of
Simons' (1948) full-reserve banking for retail deposits supporting the payment system should
not be excluded a priori.7
The agreement reached by the Basel Committee in September 2010, known as Basel III, that
established higher capital standards including two new capital buffers ("conservation" and
"countercyclical") to be introduced gradually, and a Tier 1 leverage ratio to be analyzed
further, is a step in the right direction. Nevertheless, the new requirements may still prove
insufficient to prevent crises, given their relatively low target values, and the inclusion of
components of lesser quality than common equity in Tier 1 capital. Overcoming these
limitations is of the utmost importance considering the poor record of the Basel Core
Principles for banking supervision in preventing financial problems in the past.8
However, the regulatory weakness that more likely led to excessive risk taking in this crisis
was the ambiguous government safety net held out to investors and institutions. This
included the explicit limited guarantees on deposits but most importantly, the realized
assumption that, when problems arise, the government can
extend this protection to other
investments and rescue financially significant institutions.
In particular, the "too big to fail" policy is a well-known source of moral hazard that leads to
the unpleasant outcome of promoting risk taking with private rewards and socially shared
costs. The only solution to dealing with this problem is to abolish the policy. This would imply
forgoing the bailout capacity of the authorities, perhaps through a legal stricture, and treating
all institutions alike in terms of standards and liquidation procedures. In the case of a failure,
shareholders and unsecured creditors should fully absorb all costs.
To counter possible externalities coming from the failure of any institution, a variable
surcharge on capital may be imposed based on an index of significant variables such as size
and interconnectedness. Clear rules of liquidity provision for solvent institutions on the part of
the lender of last resort as well as expedient resolution mechanisms including living wills and
efficient bankruptcy laws for insolvent ones, are essential elements of a stronger regulatory
framework.
The need for corrective measures
The preventive approach just outlined should help promote financial stability. Presumably,
the deeper the changes are, the less likely the financial system will face severe problems in
the future. Unfortunately, these measures cannot guarantee the elimination of crises.
In addition to the long history of recurrent financial calamities which by itself is a challenging
precedent, there are other reasons for not holding overly optimistic expectations. Among
others, the list of possible causes of crises is surely longer than the one previously
analyzed; the implementation of the recommended guidelines could be deficient; and
unless rules are sufficiently broad and supervision is really effective, there are always
ways to circumvent them.
From this standpoint, it is necessary for authorities to stay vigilant in order to react in a timely
way to early warnings of a possible financial crisis. This is clearly a daunting task, as
policymakers face obvious limitations. Authorities hardly have knowledge that is superior to
that of market participants, and typically most economic agents do not recognize bubbles as
they develop, which is one condition for the persistence of bubbles. Widespread
underestimation of risks was certainly the case in the global crisis. Although some authors,
such as Kasriel (2004) and Rajan (2005), warned of increased risks before the problems
arose, their admonitions were widely ignored.
The fact that most authorities miscalculated the risks in the crisis is worrisome. The inability
to detect incipient problems and the time it takes for any economic policy to exert effects
restrict the scope for corrective measures, where lags can even make them
counterproductive.9
In addition, even if detection were not a problem, authorities may be unwilling to implement
policies to counter a likely imminent crisis. This may reflect capture by the regulated entities,
which tend to evaluate most growth developments favorably, including unsustainable credit
expansions. Alternatively, reluctance to act preemptively may result from the authorities'
preference to react only after a bubble collapses. In monetary policy, this position
articulated by former Federal Reserve Chairman Alan Greenspan, came to be known as
the "Greenspan put."10
In any case, the debacle proved that the "hands-off" approach to dealing with pre-crisis
symptoms was too costly in terms of posterior instability and the unprecedented measures
implemented to offset the effects of the resulting turmoil. In particular, the extraordinary
actions undertaken post mortem pose significant challenges for the conduct of monetary and
fiscal policies in the future. Hence, in light of the described limitations, the need to intervene
in the form of corrective measures should be viewed as a "second best" solution to problems,
to be used only to overcome deficiencies in the preventive approach.
To make this requirement operational, a systemic risk supervisor needs to be defined which
would be in charge of assessing evolving risks based on well-defined methodologies. It is
preferable for prescriptions to be made in accordance with contingent rules announced in
advance to the public. The authorities' role can be complemented with the advice of
independent experts.11
At this point, the obvious question is which tools should be used to react to indicators of
Assuming
crisis. that no undue expansionary monetary or financial policies prevail, the
appropriate instruments should strengthen the regulatory and supervisory framework. Within
this area, it is reasonable to favor those measures that maximize effectiveness with the least
possible distortions. The menu of tools includes higher capital and liquidity requirements,
lower loan-to-value ratios, limits to lending concentrations, and stricter loan origination
standards.
The role of the central bank
In addition to the previous conditions, three issues seem to dominate the debate about the
ways in which central banks can contribute to financial stability. The first is the idea that
monetary policy should attempt to directly control financial booms that may lead to a crisis.
Given the relationship between relevant interest rates and asset prices, the proponents of
such a strategy argue that central banks can raise their policy interest rate to "prick" asset
bubbles.
It is widely known that monetary policy affects the general level of prices, at least in the long
run, and that it may influence output only transitorily. The transmission mechanism of
monetary policy to relevant variables, which is a subject of continuous empirical research,
may include several channels, one of which is asset prices. Hence, to the extent that asset
prices provide relevant information about the future state of the economy, central banks take
them into account in setting interest rates. However, its aggregate effects make monetary
policy ill suited for directly abating bubbles.
Among the disadvantages is the possibility that this attempt may easily enter into conflict with
other goals already entrusted to policy makers. For example, the interest rate increase
necessary to "lean against" a bubble may be so large as to exert a negative effect on output.
The possible conflict in the pursuit of the goals, in turn, may lead to a lack of accountability,
since deviations from one goal could be justified in terms of the pursuit of the other. More
importantly, perhaps, is the fact that using monetary policy to contain asset bubbles can be
interpreted as a commitment to smoothing out asset price fluctuations, thereby dampening
market signals and creating moral hazard.
In light of the challenges involved, monetary policy should focus on the primary objective of
pursuing price stability. Given that credit and housing bubbles are relevant to the extent that
they may weaken the financial system, it is better to use the aforementioned regulatory and
supervisory tools to target the source of the problems, such as loose credit standards or
excessive bank leverage.
A second issue concerns what is referred to by some authors as a "new central bank
paradigm." In this view, it is claimed that central banks failed to detect the signs of the crisis
and to implement measures to prevent it because their focus on price stability was too
narrow. Accordingly, part of the problem was the use of incomplete economic models that do
not incorporate crucial aspects of the financial sector. The solution to this weakness is then
seen as a modification to the central banks' mandate so that it includes financial stability in
addition to price stability and, in some countries, full employment, making central banks
accountable for all of these goals. It is also advised that augmented economic models should
be built to guide policy decisions.
Although suggestions to improve performance are always helpful, including those regarding
methodological shortcomings, the intended paradigm revision should be viewed with caution.
Most central banks already have legal obligations related to financial stability, so a mere
change to statutes would not necessarily make much difference.12
Moreover, monetary decision making is only partly based on models, as it considers all
relevant available information and combines this with judgment. Of course, it is always wise
to refine econometric frameworks to include significant relationships. However, by their
nature, models are simplifications of reality, so of necessity they omit many factors. Simple
criteria such as the Taylor rule are powerful not because they incorporate everything but
because they serve as a robust guide to monitoring central banks' commitment to price
stability.
Furthermore, the contribution of price stability to financial stability should not be
underestimated. The worldwide conquest of inflation has been an outstanding achievement
which has substantially increased social welfare and eliminated a common source of banking
crises, especially in emerging economies, such as that witnessed in Mexico in the
mid1990s. Price stability is a necessary condition for avoiding undue banking collapses. This,
however, does not preclude the need for central banks to be involved in crucial specific
responsibilities aimed at promoting financial stability, applying their expertise in cooperation
with other authorities.
The third issue centers on the implications of the unprecedented expansionary monetary
stance adopted by the central banks of the developed countries, particularly the United
States, in the sequel to the crisis. In addition to the complications from eventually
implementing effective exit strategies once inflation risks emerge, this stance have induced
investors to search for higher yield, in the process assuming more risk.
The resulting capital movements have tended to inflate the prices of certain assets, including
the currencies of emerging market economies. Even though the migration of funds could
soon prove to be transitory, since 2009 the governments of various countries have been
implementing measures intended to avert the appreciation of their currencies. These actions
include some varieties of capital controls and central bank interventions in foreign
exchange markets. However, capital controls may lessen investor confidence in these
economies, generate black markets, and inhibit the entry of capital necessary for
innovation and productivity improvements. Currency interventions, in turn, are hardly
effective and tend to impose financial losses on the central bank. Furthermore, the most
important threat generated by these actions is a widespread movement toward
protectionism that could hamper the sustained recovery of the world economy. Thus, it is
preferable to completely avoid these measures.
Conclusion
The global crisis has revealed the importance of establishing conditions to ensure the
continuous functioning of the financial system. To lower the likelihood of financial collapses,
an indispensable prerequisite is for economic policy never to become a source of problems.
Additionally, a preventive, rules-based approach to the regulatory and supervisory framework
of financial institutions is a prerequisite for generating adequate incentives.
The crisis confirmed that the "hands-off" approach in dealing with early warnings of risks was
too costly in terms of the eventual instability that ensued and the unprecedented policy
measures later undertaken, which now imply future restrictions. Corrective intervention
measures should be viewed as a "second best" solution, to be used only to overcome
deficiencies in the preventive regulatory approach.
Finally, monetary policy is ill suited for directly abating bubbles. Given that bubbles are
relevant to the extent that they may weaken the financial system, it is better to use
regulatory and supervisory tools to target the source of problems. Moreover, the scope of
a new central bank paradigm should be viewed with caution, especially if it implies the
underestimation of the contribution of price stability to financial stability. Also, the risks
associated with the unprecedented monetary measures undertaken by the central banks
of developed nations to offset the consequences of the crisis include the threat of
protectionism, something that should by all means be avoided.
References
Adrian, Tobias and Hyun S. Shin (2009) "Money, Liquidity and Monetary Policy", American
Economic Review, Papers and Proceedings, 99(2), pp. 600-605.
Assmann, Christian, Jens Boysen-Hogrefe and Nils Jannsen. (2009) "Costs of Housing
Crises: International Evidence", Kiel Working Paper 1524, Kiel, Germany.
Bernanke, Ben S. (2005) "The Global Saving Glut and the U.S. Current Account Deficit",
Sandridge Lecture, Virginia Association of Economics, Richmond Virginia, March 10.
Bernanke, Ben S. (2010) "Monetary Policy and the Housing Bubble", presented at the Annual
Meeting of the American Economic Association, Atlanta, Georgia.
Bleaney, Michael and Liliana Castilleja-Vargas (2009) "Real Exchange Rates, Valuation
Open Economies
Effects and Growth in Emerging Markets", Review, Vol. 20, No. 5,
pp. 631-643.
Bracke, Thierry and Michael Fidora (2008) "Global Liquidity Glut or Global Savings Glut",
ECB Working Paper Series, No. 911, Frankfurt am Main, Germany.
Čihák, Martin (2006) "Central Banks and Financial Stability: A Survey of Financial Stability
Reports", presented at the IMF Seminar on Current Developments in Monetary and Financial
Law, Washington, D.C., October 23-27.
Demirgüç-Kunt, Asli and Enrica Detragiache (2010) "Basel Core Principles and Bank Risk:
Does Compliance Matter?", IMF Working Paper, No. 81, Washington, D.C.
Eickmeier, Sandra and Boris Hofmann (2010) "Monetary Policy, Housing Booms and
Financial (Im)Balances", ECB Central Bank Working Paper Series No. 1178, April.
Garber, Peter M. (2001) Famous First Bubbles: Fundamentals of Early Manias, Cambridge,
Massachusetts: MIT Press.
Greenspan, Alan (1999) "Testimony before the Committee on Banking and Financial
Services", U.S. House of Representatives, Washington, D.C., July 22.
Kasriel Paul L. (2004) "Collateral Damage from a U.S. Housing Bust", Positive Economic
Commentary, The Northern Trust Company, July 30.
Kindleberger, Charles P. and Robert Aliber (2005) Manias, Panics and Crashes: A History of
Financial Crises, Hoboken, New Jersey: John Wiley & Sons.
King, Mervyn (2010) "Banking: From Bagehot to Basel, and Back Again", presented at The
Second Bagehot Lecture Buttonwood Gathering, New York City.
Kotlikoff, Laurence J. (2010) Jimmy Stewart Is Dead, Hoboken, New Jersey: John Wiley &
Sons.
Leamer, Edward E. (2007) "Housing is the Business Cycle" in Federal Reserve Bank of
Kansas City Housing, Housing Finance and Monetary Policy, pp. 149-233, Kansas City.
Maddaloni, Angela and José-Luis Peydró (2010) "Bank Risk-Taking, Securitization,
Supervision and Low Interest Rates: Evidence from the Euro and the U.S. Lending
Standards", ECB Central Bank Working Paper Series, No. 1248, October.
Mishkin, Frederic S. and Eugene N. White (2002) "US Stock Market Crashes and their
Aftermath: Implications for Monetary Policy" in William B. Hunter, George G. Kaufman and
Michael Pomerleano (eds.) Asset Price Bubbles: The Implications for Monetary, Regulatory
and International Policies, Cambridge, Massachusetts: MIT Press.
Obstfeld, Maurice and Keneth Rogoff (2009) "Global Imbalances and the Financial Crisis:
Products of Common Causes", presented at the Federal Reserve Bank of San Francisco
Asia Economic Policy Conference, Santa Barbara, California, October 18-20.
Rajan, Raghuram G. (2005) "Has Financial Development Made the World Riskier?" in
Federal Reserve Bank of Kansas City The Greenspan Era: Lessons for the Future,
pp. 313-369, Kansas City.
Reinhart, Carmen and Kenneth Rogoff (2009) This Time Is Different: Eight Centuries of
Financial Folly, Princeton, New Jersey: Princeton University Press.
Simons, Henry C. (1948) A Positive Program for Laissez Faire: Some Proposals for a Liberal
Economic Policy, in his Economic Policy for a Free Society, pp. 62-65, Chicago, Illinois: The
University of Chicago Press.
Squam Lake Working Group on Financial Regulation (2009) "An Expedited Resolution
Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities" Council on Foreign
Relations Working Paper, April.
Tarullo, Daniel K. (2010) "Involving Markets and the Public in Financial Regulation"
presented at the Council of Institutional Investors Meeting, Washington, D.C., April 13.
Taylor, John B. (2007) "Housing and Monetary Policy" in Federal Reserve Bank of Kansas
City Housing, Housing Finance and Monetary Policy, pp. 463-476, Kansas City.