Malcolm Edey: The financial stability role of central bank
Address by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of
Australia, to the Thomson Reuters' Australian Regulatory Summit, Sydney, 1 May 2013.
* * *
I have chosen as my subject today the financial stability role of central banks.
One of the consequences of the recent financial crisis has been a rediscovery, or at least a
renewed appreciation, of that role. If we think back to the pre-crisis period, it seems fair to
say that most of the public attention given to central banking was focused on the
conventional monetary policy function - that is, the regular adjustment of interest rates for
inflation control.
Without in any way diminishing the importance of that function, it is certainly the case that the
financial stability role of central banks has increased in prominence since the crisis. We can
see that in several ways. Central banks played a crucial part in the initial crisis response by
providing emergency liquidity support to institutions and markets under strain. In many cases
they held direct regulatory responsibilities for dealing with troubled institutions, or else
cooperated closely with the agencies exercising those powers. And they have played a key
advisory role in helping to shape the post-crisis regulatory environment around the world.
During this period, governments in a number of jurisdictions have taken steps to strengthen
the financial stability mandates of their central banks and in some cases have given them
additional regulatory powers to that end.
One commentator has gone so far as to say that the financial stability role of central banks
has been rediscovered with a vengeance 1. I want to explore today what that might mean in
practice.
The first point to make is that the financial stability role of central banks is not new. In his
2
book The Evolution of Central Banks Charles Goodhart argues that financial stability was
an original core function of central banks, arising from their unique position as lenders of last
resort to the banking system.
It is worth focusing briefly on the economic rationale for that role. It derives from the nature of
banking itself. Banks are intermediaries that engage in credit evaluation and maturity
transformation in order to link borrowers and lenders. In doing so they perform a function that
has become vital to the modern economy, but the history of banking shows that, without
proper supporting arrangements, the system can be vulnerable to instability. One source of
instability that became evident as banking systems developed was their vulnerability to runs
and panics. Put simply, even a sound bank could be put at risk if it were forced to liquidate its
assets in a panic, and the best defence against that was to give them access to a central
source of liquidity 3. Central banks evolved, or were established by governments, to meet
that need.
Historically this role had important synergies with other central banking functions, and with
other aspects of what we now call financial stability policy. Under the gold standard, the
lender of last resort (and the related liquidity management) functions were closely intertwined
with the price stability objective. The gold standard was seen as a general discipline against
inflation or deflation. Central banking actions to preserve the gold standard were therefore
seen as both promoting price stability and also promoting the capacity of banks to meet their
obligations - in other words, financial stability.
Part of that general role involved managing monetary systems in a way that would reduce
the risk of panic and instability in the first place. But it also meant applying Bagehot's famous
principle that central banks should lend freely, at a penalty rate and on good collateral, in the
event that a crisis occurred. The liquidity management role of central banks also led naturally
to their engagement in other areas of financial stability policy, including exercising a degree
of oversight of the banks that they were lending to.
Obviously the world now is very different from what it was in Bagehot's day. We no longer
have a gold standard, and financial systems are much more complex than they were then.
But I began with that background in order to emphasise an important point of historical
continuity. Central banks retain a key role as liquidity providers and managers today, and
these functions continue to have important synergies with other aspects of financial stability
policy.
How then should we think about financial stability policy in the modern environment, and how
should we think about the central bank's role in particular? I want to provide some general
thoughts on that question while acknowledging that this is not an area for simple answers.
When economists talk about policy frameworks in a given field, they like to think in terms of a
taxonomy that has (at least) the following main elements:
• First, the objectives - what is the policy aiming to achieve?
• Second, the instruments - what are the tools available for achieving them?
• Third, the strategy - what are the logical processes linking the instruments to
objectives?
• And finally, governance - who are the decision makers, and how are they held
accountable?
In the case of the monetary policy function of central banks these questions have been well
studied, and there is by now a well-established consensus as to what constitutes a best
practice framework, at least in general outline. It could be summarised as follows:
• The objective is inflation control, possibly defined as a numerical target and possibly
broadened to incorporate some element of business cycle stabilisation.
• The policy instrument (in conventional circumstances) is the short-term interest
rate4.
• The strategy could be modelled as something like what economists refer to as a
'forward-looking Taylor rule'. This essentially says that the interest rate is adjusted to
lean against fluctuations in output and inflation, in order to exert a stabilising
influence on both.
• And the governance structure should involve the government setting the objective
and an independent central bank controlling the policy instrument, subject to
appropriate accountability.
Obviously this summary glosses over a vast amount of detail, but in concept at least the
framework is reasonably well studied and well accepted.
For financial stability policy, the position is much more complex.
The objective might be defined as something like avoid financial instability, or perhaps
slightly more scientifically, keep the risk of system-wide financial disruption acceptably low.
These things of course can't be readily quantified, at least at the level of the system as a
whole. There is no simple measure of system-wide financial risk, and the concept certainly
can't be expressed as a numerical target in the way that can be done for the inflation
objective. That doesn't mean, however, that the task is hopeless. We are better, I think, at
identifying particular sources of risk, like excessive leverage, poor credit standards, or
leveraged asset booms, than we are at aggregating them or quantifying their likely systemic
impacts. We do know financial instability when we see it, and we have a good idea of the
kinds of behaviour that can contribute to it. The objective, then, is to manage these risks to
an acceptable level.
The second element is the set of policy instruments. Here again, the position is much more
complicated than it is for the inflation targeting framework. The potential instruments of
financial stability policy are many and varied. One component I have already mentioned: the
central bank's role in liquidity management. Other instruments include the range of regulatory
requirements that influence risk taking in the financial sector, like capital and liquidity
standards. These are what might be termed 'structural' prudential instruments aimed at
promoting a generally robust financial system. In addition there is a growing interest in the
potential use of 'macro-prudential' tools in a time-varying and targeted way to respond to
risks as they evolve. Examples that feature in international debate include things like
maximum loan-to-valuation ratios that might be targeted at cycles in property lending, or the
counter-cyclical capital buffer incorporated in the Basel III standards, aimed at general credit
cycles. In addition to all this must be added the capacity of prudential supervisors to
influence and respond to banks' risk taking without the use of prescriptive rules. In Australia's
case I think we have been well served by APRA taking a pro-active approach on this front to
ensure that risks in the banking sector have been well understood and well managed. I think
of this as a policy 'instrument' in my general schematic outline, but it is not one that can be
easily quantified or formalised.
The third element of my outline is the strategy. How are the instruments deployed to meet
the objective?
It should be clear from what I have said so far that the policy strategy in this area can never
be as tightly defined or modelled as it might be in the monetary policy sphere 5. No one
would seriously think of trying to use the equivalent of a Taylor rule to summarise financial
stability policy. But clearly the policy approach needs to include at least the following
components:
• Appropriate management of system liquidity, including a framework for providing
emergency liquidity in a crisis.
• Capital regulation to ensure well capitalised banks.
• Supervision to promote sound loan lending standards and guard against imprudent
risk taking in the banking sector.
• Sound risk controls for other systemically important institutions, including providers
of critical financial infrastructure.
• Robust crisis resolution frameworks.
• Ongoing monitoring and analysis of systemic risks, including in asset and credit
markets; and
• Appropriate coordination among the key policy makers.
Central banks and supervisors have been working to strengthen all of these elements since
the crisis. Internationally, there are clear benefits to collective effort in a number of these
areas. In the area of bank regulation, for example, countries have a mutual interest in the
development of common minimum standards to promote resilience for the global system as a
whole. The Basel III package of capital and liquidity standards represents a major outcome of
that cooperative effort 6.
That brief outline might be thought of as capturing some important commonalities in the way
various countries are approaching financial stability policy in the wake of the crisis. But there
are also some significant differences in national approaches, especially in an organisational
sense.
That brings me to the fourth element of my outline, which is that of governance or, put
simply: who controls the instruments?
I have already made the point that one part of the instrument set - the management of
financial system liquidity, or the last resort lending function - is inherently a function of the
central bank. Internationally, one of the areas of recent debate has been on the extent to
which this and other central banking functions should be combined with prudential regulation,
or whether they are best kept separate. And, if they are not combined, how can they best be
coordinated, given the synergies between them?
In current international practice there are a variety of different approaches to this question.
Australia of course is a jurisdiction that has an integrated prudential regulator separate from
the central bank. Other examples of that structure are Canada and Japan. The United States
and Europe have complex arrangements that fall somewhere in the middle. The UK has just
completed a transfer of the prudential regulation function back into the central bank after
separating them in the late 1990s. Indonesia is in the process of shifting in the opposite
direction. So clearly there are a variety of different organisational models. In many cases,
including Australia, central banks have a general mandate to use their powers to promote
financial stability, even if they are not the primary bank supervisor.
A key consideration in all of this is the obvious synergy between central banking activities,
prudential regulation, and crisis management and resolution responsibilities. The position of
central banks in financial markets is likely to give them early visibility of many types of
financial stress, and their position as the system liquidity provider gives them an essential
role in crisis management. For these and other reasons there is a clear need for ongoing
coordination of these various roles. But coordination is not necessarily best achieved by
organisational unity. Arguments can be advanced for a range of different institutional
structures, and it is perhaps not surprising that countries have come to differing conclusions,
depending in part on their own histories and their experiences during the crisis.
With that general background, I want to conclude with some observations about how we
organise these things in Australia 7. In particular, to come back to my original focal point, I
want to ask what is the role of the Reserve Bank in Australia's financial stability
arrangements.
It is sometimes said in answering that question that the Bank is the macro-prudential
authority in Australia and APRA is the micro-prudential authority. The implication is that the
Bank looks at stability from the point of view of the system while APRA looks only at the
individual institutions. I think that is at best an oversimplification and is an unhelpful way to
look at the two institutional roles. It presupposes that it is possible to focus on the system as
a whole without taking an interest in the individual components; or, conversely, that an
agency can sensibly look at the parts without being interested in how they interact with the
whole 8.
The difference between the two roles, I suggest, is best understood in terms of their powers
and responsibilities rather than their objectives. APRA has powers and responsibilities that
relate mainly to individual institutions, but its legislative mandate includes stability of the
system, and it can adjust its prudential settings to address system-wide concerns. The Bank
has a broad financial stability mandate, existing in conjunction with other macroeconomic
objectives and attached to a very different set of powers.
In a legal sense the Bank is authorised to provide financial services to the government and to
the financial system, and has significant powers to engage in financial activities in the public
interest. As I have said, those powers enable the Bank to act as lender of last resort and
liquidity manager for the financial system in addition to its better-known role in conducting
monetary policy.
When bank supervisory powers were shifted from the Reserve Bank to APRA under the
1998 Wallis reforms, the Bank's general mandate to use its powers to promote financial
stability was reaffirmed. This was more recently emphasised by the incorporation of
reference to the financial stability mandate into the Statement on the Conduct of Monetary
Policy in 2010. The Wallis reforms and subsequent legislative changes also gave the Bank
significant regulatory powers in relation to the resilience of the payments system and of
financial market infrastructure.
In summary, then, the Reserve Bank and APRA have different powers but overlapping and
complementary objectives in relation to financial stability.
It goes without saying that the two institutions have a strong appreciation of the need to work
closely together and to coordinate with the other key agencies, especially ASIC and the
Australian Treasury. There are a number of mechanisms, both formal and informal, for
achieving this. At the peak level the four agencies form the Council of Financial Regulators,
chaired by the Reserve Bank Governor. Numerous other coordinating arrangements exist at
the staff level. Although the Council is a body without formal powers, it has played an
important role in a number of different ways, including information sharing, helping to develop
the overall post-crisis response and in making coordinated recommendations to the
government. Internationally I find that there is a lot of interest in the Australian coordination
arrangements, and it is interesting to observe that a number of other jurisdictions have
moved to develop financial stability council structures of their own in the wake of the crisis.
To recap briefly, I have tried to outline what I see as the main elements of financial stability
policy, to explain why the central bank has a key part in it, arising from its role as system
liquidity manager, and to highlight the need for coordination between the central bank and
other agencies, especially the prudential regulator.
All of that falls well short of a general theory of financial stability, unavoidably so because I
don't think such a theory is achievable. Nonetheless, I think the arrangements that I've just
described have generally served Australia well. During the recent period of global financial
stress, our banking system and our crisis management arrangements have proved more
resilient than most.
In the end, of course, what counts is not the way financial stability policies are allocated to
particular agencies but the quality of their implementation. And that of course remains the
focus for the Reserve Bank, as well as for the wider body of financial regulators in Australia
and abroad.