Ravi Menon: Getting in all the cracks or targeting the cracks? Securing
financial stability in the post-crisis era
Opening remarks by Mr Ravi Menon, Managing Director of the Monetary Authority of
Singapore, at the Asian Monetary Policy Forum (AMPF), Singapore, 24 May 2014.
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Monetary policy at the crossroads
1 Professor Tan Chorh Chuan, President of the National University of Singapore,
distinguished guests, ladies and gentlemen, good morning, and welcome to the inaugural
Asian Monetary Policy Forum. Thank you all for coming.
2 I would like to particularly thank Steve Davis of Chicago Booth and Bernie Yeung of
NUS Business School. It was your vision and tireless effort that made this Forum possible.
You have assembled here a dazzling array of eminent economists and respected
practitioners to discuss and debate the most pressing questions in monetary policy today.
3 One of these questions must be: what role should monetary policy play to help secure
financial stability? For two decades before the Global Financial Crisis, central bankers
thought they had found the secret sauce of monetary policy. The recipe was simple - an
independent central bank, a single target (price stability) and a single instrument (the interest
rate). Monetary policy was directed at achieving price and output stability, with the central
bank's reaction function well-characterised by the Taylor rule on an ex-post basis.
4 The recipe worked brilliantly. Sustained price stability and steady economic growth
were the order of the day. The result was the Great Moderation. Indeed, monetary policy was
getting boring.
5 Monetary policy was unencumbered by financial stability considerations. To be fair,
central bankers were not unconcerned about financial stability. But financial stability was
seen as the preserve of prudential regulation and supervision. Academic thinking reinforced
policy practice: the macroeconomic models central banks relied on did not map clear
linkages between financial and real variables.
6 Economists warned that it was difficult to identify a financial bubble. How does one tell
if the value of an asset reflected economic fundamentals or speculative fever? So, when
faced with potential financial vulnerabilities, it was deemed better to clean up after a bubble
had actually burst than to try to lean against suspected bubbles.
7 But beneath the still waters of macroeconomic stability, deadly financial whirlpools
were forming. Financial imbalances built up steadily in the advanced economies from the
mid-1990s to mid-2000s and culminated in the Global Financial Crisis of 2008/2009. The
Crisis sent financial systems into a tailspin and plunged economies into recession. The cost
of cleaning up after the bubble had burst proved extremely high. The "clean versus lean"
debate has been re-ignited, and within the "lean" camp there are differences over how to
lean. Monetary policy has become interesting again.
Financial stability: what we know and what we don't know
8 Following the Crisis, there has been growing consensus that it is important for central
banks to pay more attention to financial stability. We know now that macroeconomic stability
does not guarantee financial stability. Nor does prudential supervision of individual
institutions guarantee financial stability at the systemic level.
9 We also have a much better appreciation of how credit cycles have strong implications
for financial stability.
• Moritz Schularick and Alan Taylor describe financial crises as "credit booms gone
wrong".1 Risks to financial stability stem from both the pace of credit creation as well
as the level of credit.
• Claudio Borio and Piti Disyatat argue that the amplitude of financial cycles, such as
for credit, exceeds that of business cycles due to what he calls "excess elasticity" of
the financial system. Cross-border financial flows amplify domestic credit booms and
domestic monetary policy fails to constrain the credit creation process adequately.
• Frederic Mishkin warns how the bursting of credit-fuelled asset price bubbles can
lead to episodes of financial instability that are particularly damaging for the
economy.
10 These findings help us better understand the conditions that led to the Global Financial
Crisis. And the concerns remain valid in the post-Crisis environment. Central banks have
kept policy rates low for long, and purchased assets in large quantities further out along the
yield curve.
Even though the United States is already "tapering" its asset purchases, global
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financial conditions remain extremely loose.
There are signs of growing risk-taking: in the form of leveraged loans, covenant-lite
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corporate bonds, and narrowing spreads on sub-investment grade paper.
• The risks to financial stability are nowhere near pre-Crisis levels, but they bear close
watching. We must not repeat the mistakes of the past.
11 But there is as yet no consensus on how to secure financial stability and, in particular,
what role, if any should be played by monetary policy.
12 There are three broad approaches to these questions.
The first is to stick to the status quo. Monetary policy remains focused on price
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stability and no recourse is made to macroprudential policy beyond the use of
capital buffers to pre-empt insolvencies.
• In the second approach, monetary policy explicitly takes account of financial
stability in addition to price stability.
• Under the third approach, monetary policy remains focused on price stability, while
financial stability is secured with the help of macroprudential policy.
13 I will keep my remarks on the first approach brief as it is well-known and is still the
dominant practice in most central banks today, especially in the advanced economies. Under
this inflation targeting approach, monetary policy will not try to respond to credit cycles or
asset bubbles unless they have a demonstrable impact on inflation outcomes.
• As Lars Svensson puts it, flexible inflation targeting "remains the best-practice
monetary policy before, during, and after the financial crisis".
• John Taylor, who will address us this evening, provides a more rule-based
characterisation of this approach through the Taylor rule.
• He finds that if monetary policy in the US had been appropriately configured to
macroeconomic outcomes in the 2000s, the housing boom would have ended in
2003 instead of 2006 and that mortgage debt levels would not have risen so high.
14 Let me now take up the second and third approaches in more detail.
Monetary policy: getting in all the cracks
15 The intellectual underpinning for the second approach is based on the insight that
monetary policy has the potential to affect financial stability through the "risk-taking
channel".2
• Jeremy Stein puts it succinctly - "Monetary policy is fundamentally in the business
of altering risk premiums".
16 Loose monetary policy can heighten vulnerabilities in the financial system by altering
both the perception of risk and the tolerance for risk.
• In conventional monetary policy, lower policy rates boost incomes and profits, and
enhance asset and collateral values. This reduces banks' estimated probability of
defaults and losses, leading to greater leverage and risk-taking.
• In unconventional monetary policy, large scale asset purchases by central banks
depress returns along the entire yield curve. This provides asset managers the
incentive to take on more risk, often in a herd-like fashion.
17 When interest rates are below the natural rate at which desired investment and savings
equilibrate, banks will continue to expand credit. When economic agents are determined to
take risks, they will find ways to circumvent measures that central banks and regulators have
put in place. Non-monetary tools like macroprudential policy will therefore not adequately
address the root problem caused by interest rates that are too low.
18 Under these circumstances, only monetary policy can "get in all of the cracks" to plug
the vulnerabilities. An increase in short-term interest rates will trigger a more realistic
evaluation of asset and collateral values, income flows, and thus risks. This will curtail the
extent of leverage created by banks and capital markets and keep asset managers from
crowding into risky assets. The effects of monetary policy are all-pervasive, and cannot be
easily circumvented.
19 This approach, if formalised, amounts to augmenting the Taylor rule with an additional
term to capture deviations in financial variables from their equilibrium levels.3 If financial
market imbalances are growing, ceteris paribus, monetary policy should be tightened, even if
it causes further deviations in output from potential in the short term. This approach does not
preclude the need for robust financial regulation and supervision. But the key is to get the
price of money right, to encourage a more realistic perception and tolerance of risks.
20 While no central bank currently implements monetary policy in this way, the concept
behind the approach may not be as abstract as it seems. I know from my conversations with
central bankers that they do not ignore financial stability considerations when setting
monetary policy.
Why "getting in all of the cracks" may not always work
21 Relying solely on monetary policy to secure financial stability may not always be
sufficient. Let me offer three reasons why.
• First, monetary policy could be constrained by its traditional mandate: price and
output stability.
• Second, monetary policy could be constrained by global financial factors.
Third, monetary policy may get in all the cracks, but it may not be able to fill some of
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them.
I will touch on each of these considerations in turn, drawing from the Asian experience in
recent years.
22 First, it is possible that there is a conflict between the objectives of price stability and
financial stability in the short term. Financial cycles have longer frequencies than business
cycles, and the two cycles tend to diverge. The interest rate appropriate for price and output
stability may therefore not be consistent with financial stability. This has been the case in
Asia in recent years.
23 When Asian economies recovered fairly quickly from the Global Financial Crisis, their
central banks raised interest rates. This was, by a happy coincidence, congruent with the
need to stem rapid credit growth that was being fuelled by improved economic prospects
domestically and easy monetary conditions globally.
24 But subsequently, economic activity in Asia started slowing down, following the
Eurozone debt crisis and other domestic shocks. It became untenable for Asian central
banks to raise interest rates further. However, risk-seeking capital flows continued washing
into the region, inducing further increases in credit and asset prices. The business cycle and
financial cycle began to diverge.
25 A second constraint on the effectiveness of monetary policy to deal with domestic
financial stresses is the prominent role played by international liquidity in fuelling these
stresses.
• Philip Lane has detailed the strong inter-linkages between global liquidity conditions,
international debt flows, and domestic credit conditions.
• Hélène Rey has observed that global liquidity conditions determined by advanced
economies' monetary policies, can, at times, override domestic monetary policy
even with exchange rate flexibility.
• Maurice Obstfeld, who will speak on this subject in a few minutes, takes a less
extreme view. He argues that monetary independence is still possible, but because
of the impact of financial globalisation, monetary policy carries a much bigger
burden in trying to achieve both financial stability and purely macro objectives.
26 Recent Asian experience is illustrative. The exuberance in Asian asset markets and
consequent build-up of financial risk in recent years has been exacerbated by the global
search for yield in a zero interest rate environment. Raising policy rates may not sufficiently
alter the level of risk-taking in these economies.
• In fact, paradoxically, a central bank that tightens monetary policy to stem financial
vulnerabilities could perversely attract more capital flows into the economy, resulting
in stronger credit growth and rising asset prices.
27 Third, it is not clear that monetary policy can fill all the cracks. Monetary policy flows
into all the cracks no doubt, but some cracks are just too big to fill.
28 Financial vulnerabilities are not evenly spread across the economy. They tend to be
concentrated in specific sectors and segments, such as in real estate. So, even when
monetary policy has configured overall liquidity and risk-taking settings appropriately, specific
pockets of financial market vulnerabilities, e.g. a property bubble, could remain.
29 Monetary policy is too blunt an instrument for addressing such specific risks to financial
stability, and it can cause significant collateral damage on the rest of the economy if it tries to
do so.
• During a property boom, compared to interest rates, expectations of price
appreciation may have a greater influence on current prices.
• Kenneth Kuttner and Illhyock Shim estimate that a 100 basis point increase in the
short-term interest rate would lower real annualised credit growth by less than
1 percentage point in the following quarter. Such a rate hike will also reduce real
housing price growth by only 1 percentage point.
• Using monetary policy to prick a property bubble may therefore require very sharp
increases in interest rates to be effective. But this may have unintended spillovers
on other parts of the economy.
Macroprudential policy: targeting the cracks
30 This brings us to the third approach to securing financial stability: using
macroprudential policy, while monetary policy continues to focus on price and output stability.
Macro-prudential policies can be more effective for "targeting the cracks" where specific
vulnerabilities are concentrated.
31 But what exactly are macroprudential policies? Given its recent rise to prominence, it is
still a nebulous concept with differing definitions. Let me offer my thoughts on what
macroprudential policy is and what it is not, from the perspective of Singapore, which has
been an early experimenter and practitioner in this area.
32 First, it is closely related to yet distinct from microprudential policy. Some have called
macroprudential policy "old wine in new bottles". Yes and no. Many of the tools are indeed
the same as the microprudential limits familiar to regulators: loan-to-value ratios,
debt-toincome ratios, debt service ratios, and so on.
33 But there are some key differences. When these prudential limits are used for
macroprudential purposes, the scope and impact are much larger. Let me give an example.
• A loan-to-value ratio of 80% for property loans, applied through the cycles, as we
have had in Singapore for many years, is a microprudential tool.
• But when we limit the loan-to-value ratio to 20% for a third property loan, as we have
done in Singapore recently, it becomes a macroprudential measure.
Macroprudential policy may well be old wine, but it is in much bigger bottles!
34 Second, unlike monetary policy which has a single instrument, macroprudential policy
requires a multi-dimensional approach. There is no single instrument that has a stable and
reliable relationship with financial stability or asset price stability.
35 Macroprudential policies encompass more than just counter-cyclical capital buffers.
Adjusting capital requirements in a counter-cyclical fashion or increasing the risk weights for
loans to vulnerable sectors cannot fill the cracks completely. In a boom market characterised
by keen competition among banks, higher capital charges do not translate into sufficiently
higher lending rates that can restrain demand.
• A cross-country study by the Basel Committee on Banking Supervision shows that a
1 percentage point increase in capital ratios results in a median rise in lending
spreads of only 13 basis points.
36 Dealing with the magnitude of financial cycles or bubble dynamics that economies
typically face from time to time requires some absolute prudential limits. In Singapore, we
have employed the following limits on property loans:
• Loan tenure cap of 35 years.
• Loan-to-value ratios of 80%, 50%, and 40% for the first, second, and third property
loans respectively, for tenures less than 30 years; for loan tenures more than
30 years, the loan-to-value ratios are 60%, 30%, and 20%.
• Total debt-service ratio of 60%, taking into account all debt obligations and using a
medium-term interest rate of 3.5% for residential properties. (Current mortgage rates
are generally below 2%.)
• Cap on banks' property-related exposures at 35% of their total exposures.
37 In fact, macroprudential policies need not even be limited to prudential tools at the
disposal of central banks or financial regulators. In the face of abundant global liquidity,
credit-based prudential measures may not constrain loan growth or asset price increases
sufficiently. Singapore has therefore also adopted fiscal measures such as stamp duties on
buyers and sellers of properties as part of the macroprudential toolkit.
• The seller's stamp duty ranges from 4% to 16%, while the buyer's stamp duty
ranges from 3% to 18%.
• These are essentially transactions taxes that aim to curb the speculative flipping of
properties.
38 Third, it is important to draw a distinction between macroprudential policies and capital
flow management measures. Capital flow measures are applied "at the gate" seeking to
regulate flows into and out of the economy; macroprudential measures are applied "inside
the house" targeted at sectors where financial vulnerabilities are building up.
• Capital flow measures are highly distortionary and pose long-term costs to the
economy. Clearly, such measures should not take the place of needed
macroeconomic adjustments.
Capital flow measures may be warranted under extreme circumstances to safeguard
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financial stability. But as the IMF puts it, their implementation should be "targeted,
transparent, and generally temporary".
39 Asian economies have deployed macroprudential policies to deal with financial
imbalances, to a greater extent than other economies. So far, the results have not been bad.
They have largely tempered the credit cycle and the pace of asset price increases, while
generally maintaining price and output stability.
A synthesis?
40 Let me bring together the main strands of my remarks. The view that central banks
ought to pay due consideration to financial stability is gathering momentum. I have described
two alternative approaches to the status quo to achieving this:
• The second approach incorporates financial stability considerations in the setting of
monetary policy; and
The third actively uses macroprudential policy to help secure financial stability.
•
41 Perhaps the differences between the two approaches are exaggerated. Both
approaches require the central bank to integrate monetary policy functions effectively with
prudential policies.
• In the second approach, strong supervisory and regulatory policies have to be in
place even as monetary policy adjusts the level of risk-taking in the economy.
• In the third approach, monetary policy must be appropriately calibrated to the
economy for macroprudential measures to effectively target specific areas of
imbalances.
42 In practice, the difference between the two approaches is likely to be one of degree
and emphasis rather than of fundamental principle. Central banks will choose the most
appropriate combination of the two approaches, taking into account the structure of their
economies and the nature of the threats to financial stability existing at any point in time.
43 And let us not forget the continued relevance of the traditional approach. Just because
central bankers had previously ignored financial stability considerations with costly
consequences, we must not overcompensate now by placing such an undue burden on
monetary policy to secure financial stability, that it becomes detrimental to price and output
stability.
44 We do not need to reinvent macroeconomics. Nor do we need to discard most of what
we know about monetary policy, built from decades of rigorous research and painful
experience. Much of that knowledge remains relevant. In thinking about the so-called new
normal, we should pay equal heed to what is new and what remains normal. No doubt, we
need to update our paradigms to meet new realities. But we do not need to overhaul them.
45 We should also bear in mind that the current situation is highly unusual. We must not
fall into the trap of believing that the innovative policy measures being taken now in response
to these unusual conditions represent the basis for a new paradigm in the future.
46 I suspect that when the dust has settled and more normal conditions return, monetary
policy regimes will not look drastically different from pre-Crisis days.
• I think more central banks will have an eye to financial stability considerations - at
least informally - when setting monetary policy.
• More central banks are also likely to have macroprudential policy toolkits at their
disposal, which they will use from time to time but perhaps not on the scale that has
been used in Asia in recent years.
• But in essence, monetary policy will remain largely focused on price and output
stability - as it should be.
47 Perhaps as T S Eliot puts it, the end of all our exploring is to arrive where we started
and know the place for the first time.
48 I wish you a successful conference. Thank you.
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