Tarisa Watanagase: The road ahead for central banks - meeting new
challenges to financial stability
Luncheon talk by Dr Tarisa Watanagase, Governor of the Bank of Thailand, at the Foreign
Correspondents Club of Thailand, Bangkok, 20 July 2010.
* * *
Distinguished FCCT Members and Guests,
Ladies and Gentlemen,
First of all, I would like to thank the FCCT Board for inviting me to deliver this luncheon talk
as part of the Club's newly established Speaker's Lunch Series. To this, I am honored as
well as delighted to be back. It was exactly two years ago when I was here for the Club's
dinner program in July 2008, and let me tell you that I very much enjoyed our Q&A session
then. I certainly look forward to participating in such a lively exchange again this afternoon.
The topic of my talk today is "The Road Ahead for Central Banks: Meeting New Challenges
to Financial Stability," in which I will share with you my views on the roles of central banks
regarding the maintenance of financial stability, with particular reference to those at the Bank
of Thailand during the past few years and going forward. This talk will be divided into three
parts. The first part will be about the changing global view on financial stability policies as a
result of the recent global financial crisis. The second part will be a summary of what the
Bank of Thailand has done with regard to the maintenance of Thailand's financial stability.
The final part will be a discussion about the challenges ahead.
Ladies and Gentlemen,
Since my previous FCCT address, things have changed dramatically. Two years ago, the
main policy issue surrounding the economy was the sharp acceleration in inflation due to
drastic increases in oil prices. Two months after my talk, starting with the fall of Lehman
Brothers, the world went into the deepest recession never seen since the Great Depression.
Thailand was not spared, as the Thai economy last year experienced negative growth for the
first time since the 1997 crisis. In tandem with the slowdown of the global economy, oil prices
collapsed and inflation was no longer an issue. Over the past two years, policy focus would
be on how to restore the stability of the global and individual country's financial systems and
how to prevent such a systemic crisis from happening in the future. In other words, the
spotlight has turned from price stability to financial system stability, or in short, financial
stability.1
The global financial crisis has a significant impact on central banks' thinking of economic and
financial stability policies in three major areas. First, it is now widely accepted that monetary
policy also needs to take care of financial stability concerns. The pursuit of price stability
alone is not enough to ensure a smooth progress of the economy. Second, traditional
"micro" prudential regulation which aims to limit the distress of individual financial institutions
is not enough to ensure that the financial system as a whole will be able to cope with large
systemic shocks. There is the need for regulation that takes care of interactions between
financial institutions, markets, and the real economy. The latter is known as macroprudential
policy, a new buzzword that you may have heard of or will be hearing increasingly more often
in the future.
The third policy rethinking concerns the separation of banking regulation and supervision
from central banks. Before the crisis, an increasing number of countries had adopted a
model where a central bank only takes care of monetary policy and a separate independent
authority takes care of regulation and supervision of financial institutions. That model, which
promises superior performance in terms of financial stability maintenance, is now in question.
Let me elaborate on these three issues in a bit more detail. In the realm of monetary policy,
the conventional wisdom before the crisis, based on the long-standing success of former Fed
Chairman Alan Greenspan, was that monetary policy should stay away from direct financial
stability responsibility, particularly the management of asset price bubbles, and let the
financial markets take care of themselves. And if things go wrong, policymakers can always
clean up the mess after a bubble has burst by cutting interest rate aggressively.
As we all know, the severity and the costs of this global financial crisis have very much
discredited the so-called Greenspan Doctrine. Talk of risks to financial stability has now been
mentioned frequently in several central banks' monetary policy statements. Equally
important, signs of financial imbalances have become parts of a watch list for many central
banks. These developments stood in sharp contrast to the pre-crisis orthodoxy where
financial stability would factor into monetary policy decisions only to the extent that it affected
growth and inflation.
The changing consensus on monetary policy does not mean that central banks will be using
interest rates aggressively to fight off asset price misalignments and financial imbalances,
however. By all means, interest rate policy is probably too blunt to be a "corrective" tool for
financial stability given that, to materially impact asset prices, a substantial increase in the
interest rate is required. Using the policy interest rate to actively steer asset prices would
therefore have adverse consequences on the economy as a whole. Instead, the post-crisis
consensus emphasizes the use of monetary policy as a "preventive" tool for financial
stability, that is, not to allow monetary policy to sow the seed of asset price bubbles. An
important lesson from this crisis is that an over-extended period of low interest rates can
distort risk perception, leading to excessive risk taking and costly financial imbalances.
Beyond the reorientation of monetary policy, the post-crisis consensus advocates the use of
macroprudential policy as the first line of defense against the buildups of financial
imbalances. In comparison to interest rate measures, macroprudential policy can address
sector-specific financial stability concerns more directly without excessive side effects on the
overall economy.
Macroprudential policy differs from traditional prudential regulation in that it adopts a
systemwide or systemic perspective. The idea behind macroprudential policy is that while financial
institutions may be individually safe, collectively they may be at risk due to herd behaviors
and their interconnections. Here, the U.S. subprime crisis serves as a case in point.
Regulators thought banks were safe because they had off-loaded their subprime credit risk
exposures through securitization and unknowingly allowed the market to grow out of hand.
From a system-wide perspective, the risk did not go anywhere as banks, in search for good
yields during the low interest rate environment, invested in securitized assets issued by other
banks. The situation was further exacerbated by the complex interconnections among U.S.
financial institutions whereby the failure of one institution greatly increased the probability of
failure of others.
To maximize its effectiveness, macroprudential policy should cover all types of financial
institutions that make up a financial system, not just banks, but also the likes of securities
companies, insurance companies, and hedge funds, to name a few. This is because modern
financial systems are complex and intertwined. In fact, one root cause of the global financial
crisis can be traced to loose regulation of the so-called shadow banking system in the U.S.
One key purpose of macroprudential policy is to limit excessive exuberance that could come
about during "good times," for example, by requiring financial institutions to hold extra capital
or by putting a cap on how much they can lend during an economic upswing. An implicit
message behind this is that these policies will not only help strengthen the financial system's
resilience, but also moderate financial institutions' actions from being too optimistic during an
economic upturn or too pessimistic during an economic downturn - the behavior known as
"procyclicality" of the financial system that exacerbates the business cycle. All in all, it is
envisioned that the combination of monetary policy and macroprudential policy will effectively
safeguard financial stability and hence macro stability at large.
On institutional arrangements, the global financial crisis clearly shows that the independent
regulator model does not live up to its promise. Some countries would have been better off in
dealing with this crisis had the regulatory power remained with the central banks. The most
notable example here is perhaps in the UK where the government will abolish the Financial
Services Authority (FSA) and transfer its regulatory responsibility back to the Bank of
England.
While the UK may be an extreme case, a growing consensus has emerged that central
banks should play a key role in preserving the overall stability and smooth functioning of the
financial system. In this respect, having supervisory authority over systemically important
financial institutions, such as commercial banks, would make the central bank's job a little
easier. Clearly, having monetary policy, lender of last resort function, and macroprudential
policy under the same roof allows for better policy coordination.
Ladies and Gentlemen,
Against the backdrop of the changing policy philosophy in the global central banking
community, let me now turn to the second part of my talk which is what the Bank of Thailand
has been doing in the past few years with regard to the maintenance of financial stability.
Through the 1997 Asian financial crisis, we learnt firsthand the importance of financial
stability to the real economy as well as the need to preserve it. Indeed, that the Thai
economy recovered rapidly from the global financial crisis this time can be attributed in part
to policies that put a strong emphasis on the health of the financial system.
In July 2004, upon an assessment that the booming economy may result in the buildup of
certain financial imbalances, the Monetary Policy Committee made the monitoring of "factors
contributing to financial imbalances" a permanent part of its assessment and policy
formulation process. As part of this macro-financial risk surveillance, signs of financial
imbalances in seven key areas are regularly monitored: the property market, the stock
market, the banking sector, the non-financial corporate sector, household-sector balance
sheet, government finance and public debt, and the external sector, with the goal of
establishing an early warning system for potential threats to financial stability, especially if
the underlying imbalances are related to monetary policy actions.
On the regulatory side, fully aware of the implications of systemic risk, we have incorporated
macroprudential elements into our regulatory framework well before the concept became
popular in the wake of the global financial crisis. Although we did not use the term, some of
the prudential measures that we have deployed in the past few years were in the spirit of
macroprudential policy of enhancing the resilience of the financial system over the cycle and
of restraining the buildup of systemic risks. For example, in 2003, when we observed rising
high-end real estate prices along with strong mortgage lending, we imposed a ceiling on the
loan-to-value (LTV) ratio for residential property with the transaction price exceeding 10
million baht. Later in 2004, observing a significant credit card loan growth, we placed limits
on credit card borrowing by instituting a minimum income requirement, among others. More
recently in 2006, seeing that banks were strong enough, we asked them to further set aside
sizable provisions for loan losses in compliance with a new international accounting
standard. This had an adverse impact on banks' bottom line at the time, but the extra
provisioning would later provide cushions for Thai banks during last year's economic
downturn. Regarding all these instances, it should be noted that in choosing the specific
macroprudential measure to be used, the Bank of Thailand has exercised great caution in
terms of market friendliness, for a fine line exists between the balance of financial efficiency
and financial stability.
Here, I would like to note that having both monetary policy and regulatory responsibilities
together allows us to see the big picture when making policies, whether monetary or
macroprudential ones. This synergy has also enabled us to act quickly and decisively with an
informed judgment, which served us well during the global financial crisis. In Thailand, talk of
removing regulatory duties from the Bank of Thailand surfaced from time to time after the
1997 crisis, and I think we were fortunate that the government did not go through that path.
In addition, with regard to the purview of our regulation, the new Financial Institutions
Business Act (Section 5) allows room for the Bank of Thailand to regulate any unregulated
financial businesses that may have significant impacts on the economic and financial
systems. This means that, we will be able to take care of systemically important financial
firms outside current regulatory purview if the situation warrants.
Ladies and Gentleman,
Lastly, let me share with you what I see as major challenges for the maintenance of financial
stability in Thailand. While we may have a head start over many countries, we are not in
anyway complacent. In particular, three important challenges loom on the horizon.
the global economy, while doing much better than a year ago, still have many
First,
vulnerabilities which could give rise to the next round of global financial instability. Most
importantly, the public debt problems in certain European countries constitute a major risk
factor. At the other end of the spectrum, the growth and interest rate disparity between Asia
and advanced economies amidst the still abundant global liquidity from the unprecedented
monetary policy stimulus around the world could attract de-stabilizing capital inflows that will
put pressure on exchange rate, encourage a buildup of financial institutions' short-term debt,
and fuel bubbles in various sectors.
Second, in light of the possible buildups of financial imbalances, there is a need to further
enhance the ability to identify potential threats early on. For example, at least in its early
phase, bubbles are almost always associated with favourable economic fundamentals.
Effective monitoring of bubbles therefore calls for better data collection, market intelligence,
and risk analysis. While timely bubble identification remains very difficult, the good news is
that better identification techniques are being developed and will continue to improve.
Finally, there is a need to watch the developments in international regulatory reforms very
closely. It is true that a plethora of proposals have been discussed in the world stage, but
some may impose more costs than benefits to Thailand. After all, many regulatory pitfalls
that gave rise to the recent global financial crisis do not apply to us, for example, those
related to securitization. In addition, some proposals may be more stringent than necessary
given the nature of financial transactions in Thailand. For example, the currently proposed
leverage ratio requirement treats banks' letter of credit (L/C) the same as complex
derivatives, which will impose substantial
costs on Thailand's trade finance business. The challenge here is therefore to weigh
carefully the benefits, the costs, the necessity, and the appropriate timing for the adoption of
the new international standards so as to ensure that our financial system is not overburdened
by unnecessary rules. Again, this highlights the tradeoff between financial stability and
financial efficiency
Ladies and gentlemen,
In closing, let me reiterate that the Bank of Thailand gives great care to both price stability
and financial stability. The policy responses undertaken by the Bank over the past few years
have helped preserve the Thai financial system's resiliency which in turn contributed to the
economy's turnaround. Despite challenges in the period ahead, we will try our best to ensure
that Thailand's economic and financial stability continues to remain intact so as to support
the economy's sustainable long-term growth.
Thank you very much for your attention.