Rodrigo Vergara: Macroeconomic and financial stability - challenges for
monetary policy
Opening remarks by Mr Rodrigo Vergara, Governor of the Central Bank of Chile, at the
XVI Annual Conference on "Central banking, analysis and economic policies" of the Central
Bank of Chile, Santiago de Chile, 15 November 2012.
* * *
I thank Sofia Bauducco, Gonzalo Castex, Maria Consuelo Edwards, Luis Oscar Herrera, Kevin Cowan, and
Claudio Raddatz for helpful comments.
Good morning. Welcome to the Central Bank of Chile's sixteenth annual conference on
Central Banking, Analysis and Economic Policies. This year's version is about
"Macroeconomic and Financial Stability: Challenges for monetary policy."
We are expecting two exciting days of learning and discussion on topics at the forefront of
academic and policy research on macroeconomic and financial stability. The interaction
between academics and policy makers fostered by this conference provides an important
opportunity to learn from each other and share views and experiences that will help us
improve our policy decisions and hopefully go home with new ideas for research.
Today and tomorrow we will reflect on the role of central banks in preventing and reacting to
financial exuberance and financial crises. The discussion will focus on two important policy
questions: first, did the conduct of conventional monetary policy before the crisis contribute to
shaping it? And second, how should monetary policy react to a crisis? In particular, we will
discuss the efficacy of conventional monetary and macro-prudential policy action in
ameliorating the effects of financial crises. With these two questions in mind, we will also
explore the consequences of financial crises on unemployment, household credit, and the
real economy, and will try to understand how markets operate in environments with
multidimensional private information. Our last session will be devoted to analyzing the effects
of unconventional policies in dealing with the impact of the recent financial crisis in Chile. I
am confident that valuable lessons will come out of these two days of discussion.
To begin, I would like to share my views and Chile's experience in four issues that are
currently in the policy debate and that will underlie the discussion we will be having over the
next two days. The first issue relates to the debate on financial stability as a macro policy
goal and which institutions should be responsible for it. I will then turn to the availability and
usefulness of policy instruments to pursue financial stability. I will also refer to two aspects of
our experience in conducting monetary policy during financial crises: our experience with
unconventional policies during the recent global financial crisis and our experience with
financial rescues in our own financial disaster in the early 1980s. In the latter case, I will also
touch briefly on the impact of rescues on the Central Bank ́s balance sheet.
1. Financial stability as a policy goal. The role of the central bank
The recent financial crisis challenged the paradigm that the stability of the financial system
could be preserved through a combination of micro regulation and macroeconomic stability.
Before the crisis, many countries focused financial regulation on the risks faced by individual
financial institutions (as indicated by Basel II), and macroeconomic policy on the preservation
of price stability. This approach may have worked well during calmed times, but it also may
have allowed hidden financial risks to build up unchecked. As a result, there is growing
consensus that the pursuance of macro financial stability has to be considered in its own
right, in a way that combines micro regulation with a systemic view of the financial system.
However, while there is consensus in the approach, there is still debate on what institutions
should be in charge of ensuring financial stability, and in particular, what should be the role of
central banks.
There are advantages in having central banks involved in preserving financial stability, but
these advantages do not necessarily mean that they have to be the sole institutions in
charge. Central banks have a systemic vision of the economy that allows them to visualize
links between different players of financial systems and their potential consequences for the
real economy. Also, as lenders of last resort, the preservation of financial stability is of
natural interest for central banks. Thus, even if not formally in charge, central banks should
and do care about financial stability.
But at the same time, there are important risks in having central banks in charge of financial
stability. First is the risk of diluting the mandate of the central bank and damaging its
credibility. Central banks have fought hard to establish credibility by focusing on measurable
goals, maintaining clear communications with the public, and being transparent and
accountable in achieving these goals. The focus on inflation, a simple observable variable
has helped. Having a central bank with multiple mandates creates risks of policy dilution and
conflicting goals. In contrast with inflation, or even employment, financial stability is a fuzzy
concept with many dimensions that are hard to encompass in a single indicator. Attempting
to do so risks ending with a narrow view of financial stability, but having a broader, less
precise definition of financial stability makes it hard to establish credibility and accountability
for achieving it. On a more pragmatic front, there are good reasons to have banking
supervision conducted outside the central bank (which I will not address now), and many
countries follow this institutional arrangement. This should be considered when thinking
about the involvement of the central bank in financial stability because it is desirable that
micro and macro aspects of financial regulation be well coordinated to avoid sending
conflicting messages to regulated entities.
For these reasons, the institutional setting for monitoring and preserving financial stability will
likely vary across countries. But the natural interest of central banks in financial stability and
their advantages in providing a systemic view of the financial sector and the economy
suggest that they should be involved at some level. Whatever the institutional setting for
pursuing financial stability, it is important that it guarantees that the systemic aspects of
financial decisions are properly taken into consideration, that the institutions involved have
the necessary tools to prevent the formation of excessive risks in the financial system and
quickly act when they materialize, and that it ensures that these tools are used with a unified
view of the micro and macro aspects of financial regulation. Whether this is achieved by
having a single entity in charge of regulation or by having instances that facilitate the
coordination between the different entities in charge of it may be of second order importance
if such coordination works well.
In Chile, the Central Bank is expected to act as a lender of last resort to commercial banks
facing liquidity problems. We are also in charge of some aspects of financial regulation such
as retail payments; bank liquidity and market risk regulation, aggregate limits for pension
funds, and others.1 Furthermore, preserving an appropriate functioning of the payment
system is a goal established in our charter that is clearly related to the stability of the
financial sector.
So, we naturally care about financial stability, and accordingly we monitor systemic aspects
of the functioning of all participants in the financial sector, conduct regular surveys of market
participants, run an annual survey of the financial position of households, and produce a
twice-yearly financial stability report that is widely read by other regulators and market
participants, among other activities.
However, in Chile the supervision of different groups of financial institutions, and the legal
power and tools to enforce regulation are spread across several entities. For instance, the
banking sector is under the supervision of the Superintendence of Banks and Financial
Institutions (SBIF), mutual funds and insurance companies are regulated by the
Superintendence of Securities and Insurance (SVS), and pension funds, which are large
players in our financial system, are regulated by the Superintendence of Pensions (SP). In
this setting, the preservation of financial stability crucially relies on the capacity and ability of
all players involved, including us, to share our views and coordinate our actions. This is
currently done through routine interaction between us, and more formally through periodic
meetings in the Financial Stability Council, an entity created precisely to guarantee such
coordination.
2. Financial stability tools
Let me now turn to the discussion of what are the most appropriate tools to pursue financial
stability. Of course, this discussion draws from the previous one on whether the central bank
should be in charge of it. But let's forget about that for a second to tackle one of the main
aspects of this debate, which is whether a central bank that cares about financial stability
should use the policy rate as a tool. There are different views on this regard, both in
academic and policy circles that you probably know well. I am among the ones who think that
the interest rate is often too blunt a tool to deal with financial stability issues, especially when
they have clear sources that can be addressed more directly, since the policy rate affects
every sector of the economy.
Furthermore, under some circumstances the required movement in the policy rate for
financial stability purposes may be in conflict with the price stability mandate. Assuming that
such tradeoff is absent, that reasonable movements in the policy rate are expected to be
useful to deal with financial stability concerns, and that there are no better tools at hand, it
may be reasonable to rely on it as a tool for financial stability.
However, in many situations at least one of these conditions would not hold and other
options would prove more efficient. For instance, more often than not financial stability
concerns are related to specific segments of financial intermediation. Concerns about rapid
growth in credit to the housing sector can be tamed by changes in loan-to-value or
debt-toincome ratios, for example. Dynamic provisions related to general or specific forms of credit
may also help banks maintain a solid position through the financial cycle, and discretional
changes to reserve requirements may also help rein in rapid bank credit expansion. Of
course, all these measures are not cost free and their use must properly consider these
costs against specific financial stability concerns. For instance, increases in reserve
requirements affect only the banking sector, which may lead to disintermediation and
increased cost of credit for those with limited access to other sources.
In Chile many of these tools are under the control of the Superintendence of Banking and
Financial Institutions (SBIF). This makes the Financial Stability Council I just mentioned a
crucial instance for coordinating and implementing financial regulation with a systemic view.
3. Monetary policy in an environment of financial crisis
When using policy tools to prevent financial crisis is not enough and the financial system
becomes unstable, standard monetary policy tools might be impaired. Many central banks
target the overnight interbank rate, so the transmission of monetary policy relies on a working
financial system and its effectiveness may be significantly weakened in conditions of financial
distress. Furthermore, under extreme conditions, such as those experienced during the
recent financial crisis, standard monetary policy may reach its natural limit that is the
zerolower bound. Under these conditions, unconventional monetary policies may be the only
ones at hand for a central bank.
The experience of the United States and Europe with unconventional tools during recent
years is well known to all of you, so let me briefly describe our experience with them. It is
important to mention that the scale of our interventions was substantially smaller, since we
had to quickly undo many of our policy actions because of the fast recovery of the Chilean
economy after the recession of 2009. I hope our history will shed some light on those that
view the undoing of large interventions as a cause for concern.
Shortly after the collapse of Lehman Brothers, the Central Bank of Chile began reducing the
policy rate from an initial level of 7.25 percent until it reached the effective lower bound of 50
basis points in July 2009. The rate remained at that level for one year until June 2010. During
that period, the Central Bank also took unconventional measures aimed at providing liquidity
to the financial markets. For instance, we offered financial institutions access to a term
liquidity program (FLAP) at the monetary policy rate of 0.5 percent. During January 2010 we
reached a peak of 6.5 billion dollars on the liquidity program, equivalent to 40% of the
banking system's capital and reserves.2 Our exit strategy from this expansionary policy was
free from major difficulties. We started unwinding these special facilities in November 2009
by gradually shortening their term. As we finished dismantling our special programs we
slowly began increasing the monetary policy rate to a neutral range. The withdrawal of the
monetary stimulus at an appropriate pace allowed us to maintain inflation expectations at a
two year horizon close to our target of 3 percent.
Before moving on to the next topic, let me close this discussion by stressing that, while central
banks have been and will continue to be creative in using all available tools to achieve their
mandate, we must recognize the limits of conventional monetary policy in circumstances of
extreme financial distress. Conventional monetary policy alone is unlikely to be able to put
back the economy on the right track and its combination with other policies certainly increases
the chances of success.
4. Financial rescues and their Impact on a central bank's balance sheet
Please allow me now to finish with another topic where Chile's experience can contribute to
the international debate: the implementation of a financial bailout and the risks it imposes on
the operation of a central bank. In normal times, central banks conduct their operations
maintaining only the safest assets on their balance sheets, typically government bonds or
other low-risk assets. But in times of distress, acting as lender of last resort, central banks
may also accept lower quality, more risky assets, as collateral for liquidity provision or in
outright purchases aimed at rescuing banks, with the consequent risk to their balance
sheets. This has been indeed the case in several countries during the recent financial crisis.
The possibility that risk-taking by central banks may result in losses that affect their
reputation and operations has recently preoccupied policymakers, especially when pondering
about the possibility of a large rescue operation of troubled European banks by the ECB. The
concerns are both financial and operational. The financial soundness of a central bank, the
usual lender of last resort in a country, is an important firewall for trouble in the financial
system. While a central bank may count with the help of the sovereign, this channel may be
a source of concern when sovereign themselves are facing problems, and it also raises
some worries about the ability of the central bank to maintain its independence. There are
also those who argue that, since the liabilities of central banks can be arbitrarily created, the
financial position of a central bank shouldn't matter. But this argument forgets that doing so
may endanger the achievement of the inflation targets that many central banks have taken
as their operational goals, affecting their reputation and independence.
In 1982, as the debt crisis spread through Latin America, the Chilean financial system, which
had channeled substantial foreign-currency-denominated syndicated loans, became largely
insolvent. Under these conditions, the government engineered a massive rescue operation
through the central bank where several of the most important banks became nationalized
and others disappeared, after their assets were absorbed by other institutions. This
intervention prevented an even larger collapse of activity than the one we ended up
experiencing. The manner in which it was implemented, where shareholder equity was fully
diluted and institutions assumed a subordinated debt to the central bank that took a long time
to repay, helped maintain the rescue's moral hazard concerns at bay. This, together with new
regulation, resulted in a healthier financial system. However, an important cost of this
intervention is that the balance sheet of the Central Bank of Chile was severely stressed,
leading us to operate with negative capital until today. This negative capital is also a
consequence of the Central Bank's balance sheet composition, with international reserves in
foreign currency earning a much lower return than the interest we pay on our domestic
currency liabilities. In addition, an appreciation of our currency makes our capital more
negative, as we mark to market our international reserves.
The lesson from our country's experience in this regard is that we have been quite able to
operate with negative capital for the last several years, maintaining inflation under control
and preserving the working of the financial system. Thus, while operating with negative
capital is far from ideal, at the levels at which we have been operating, it is not cause for
undue alarm. It is possible to conduct monetary policy under these conditions, especially
when accompanied by an environment of good institutions and fiscal strength. Other well
respected central banks have been operating under similar conditions.
I cannot finish this presentation without thanking Sofia Bauducco, Lawrence Christiano, and
Claudio Raddatz for putting together the program of what promises to be an exciting
conference, and all of you for coming to participate and share in the discussion.
Thank you.
References
Céspedes, L., Javier García-Cicco and Diego Saravia. 2012. "Monetary Policy Responses to
the Global Financial Crisis: The Chilean Experience". Mimeo.
Compendio de Normas Financieras. Banco Central de Chile. Available at
http://www.bcentral.cl/normativa/normas-financieras/index.htm