Speech by the General
Mr. Crockett reviews the changing role of central banks
Manager of the Bank for International Settlements, Mr. Andrew Crockett, at the Money Macro and
Finance Annual Conference held in Durham on 11/9/97.
The BIS Annual Report for 1996-97 observes, with characteristic understatement:
"The last 25 years have been an eventful time for central banking". The period since the breakdown
of the Bretton Woods system has, indeed, seen enormous changes in the economic and financial
environment, and a major evolution in the objectives, indicators and instruments of central bank
policy. My objective this afternoon will be to review these changes, and to identify some of the
common factors that lie behind them.
The changes in the environment have been of both a macro-economic and a structural
character. Macro-economically, the move to floating exchange rates in the early 1970s was followed
by a period of substandard economic performance. In the industrial world high inflation rates
co-existed with disappointing growth. In the developing world, a borrowing spree was followed by a
debt crisis. Not until the last few years have monetary authorities been successful in restoring a more
satisfactory degree of price stability, and still the task is not complete. There have also been dramatic
changes in financial structure. The process of liberalisation and innovation has led to a globalisation
of finance and a quantum increase in intermediation. Coupled with an explosive growth in ever more
complex financial instruments, this has presented new opportunities to financial intermediaries, but
also created new sources of systemic risk.
The changing environment has both influenced and been influenced by an evolution
in the way central banks carry out their role of preserving monetary and financial stability. In the field
of monetary stability, attempts to exploit the Phillips curve trade-off produced almost wholly negative
results and led to a widespread consensus that the primary objective of monetary policy must be price
stability. The intermediate targets of monetary policy objectives have also evolved, with the earlier
emphasis on monetary aggregates giving way to exchange rate anchors in some countries and explicit
or implicit inflation targets in others. At the level of tactics, market management techniques, which
were formerly quite diverse, have tended to coalesce around the use of repurchase operations as a
means of controlling very short-term interest rates.
The other main function of central banks, that of preserving financial system stability,
has acquired considerably more prominence as a result of financial liberalisation, which has led to the
greatest spate of banking sector difficulties since the interwar period. The focus of central banks'
approach to maintaining systemic stability has evolved from field-of-activity regulation to a greater
stress on capital adequacy, and is still in the process of change. Meanwhile, a number of countries are
rethinking the institutional structure of supervision, with some placing responsibility for day-to-day
regulation with specialised supervisory agencies and assigning to the central bank the broad, though
less well-defined responsibility for systemic stability.
Throughout these changes, a constant feature has been central banks' search for
effective means of implementing policy in an environment where economic agents can use new
instruments and markets to arbitrage their way around restrictions and controls. The desire to avoid
distorting incentives and exacerbating moral hazard has been a guiding principle in this search. The
authorities have sought anchors for policy that are compatible with profit-seeking behaviour by
private agents in an increasingly competitive market. It is this search that will be the underlying
theme of this lecture.
I will begin by noting some of the driving forces behind the changes that have taken
place in the financial industry, and how they have manifested themselves. The key consequence for
policy, I will argue, is that markets have become more thus increasing the scope for
complete,
arbitrage by private agents, and decreasing the scope for the monetary authorities to use direct
controls to achieve policy objectives. In the next part of my remarks, I will review how approaches to
monetary policy have evolved over the past 25 years, in respect of ultimate goals, intermediate targets
and policy instruments. After this, I will consider how financial stability has grown as a policy
concern, and how the way in which supervision is viewed has evolved. Finally, I will have a few
words to say about the international monetary system.
I. The Changing Financial Environment
The driving forces behind the transformation in the financial environment that has
occurred in the past twenty to thirty years have been innovation and liberalisation. Technological
advances have dramatically lowered the cost of gathering and processing information, while new
financial instruments have increased the range of transactions economic agents can undertake.
Liberalisation has paved the way for the expansion and restructuring of the financial industry. It has
been driven both by the ascendancy of the free market philosophy and by the difficulty of
maintaining controls in the face of innovation.
The combined effects of innovation and liberalisation have been dramatic.
Geographical barriers have largely disappeared, leading to the emergence of an increasingly
integrated global capital market with a sizable group of multinational financial intermediaries
operating in all the major centres. Distinctions among different classes of financial intermediary have
become blurred, with the relaxation of regulatory restraints, the growth of conglomerate structures,
and the increasing ease with which institutions can transform the risk characteristics of their
portfolios through the use of derivatives. Another significant development has been the securitisation
of assets and the institutionalisation of savings. Together, these trends have greatly increased the
volume of tradable financial assets, and the amount of transactions passing through financial markets
and settled in clearing systems.
The significance for central banks of these developments in the financial environment
is that they have made markets more that is, they have greatly increased the ability of
complete,
market participants to exchange assets and income flows over time, space, and market instrument.
Portfolio management is far less constrained than before by lack of access to liabilities or claims with
desired pay-off characteristics. This has profound effects for central bank activity, both in the
formulation and implementation of monetary policy, and in the preservation of financial stability.
At the macro-economic level, markets can now discipline policies far more quickly
and effectively than in the past. Bad policies, or indeed any policies that are unsustainable in the face
of profit-maximising behaviour by private agents, will quickly have to be reversed. This means that
the authorities always have to consider, in framing economic policies, whether they are credible and
how the market will react to them. It is very hard, for example, to spring an inflationary "surprise"
that has a positive effect on output; or to set an exchange rate objective that is inconsistent with the
underlying stance of macro-economic policies.
Concerning financial stability, more complete markets mean that competition
squeezes out rents created by restricted franchises. Financial institutions have less of a cushion of
protected profits and are therefore more vulnerable to losses caused by mismanagement or
misfortune. This has inevitably increased the emphasis given to the role of the authorities as the
ultimate guarantor of financial stability. At the same time, it has reduced the effectiveness of
regulation that is not based on market incentives. Financial institutions have a broad menu of
techniques that enable them to get around regulations that are intended to increase safety, but are
burdensome to the institutions to which they apply.
II. Monetary Policy
(a) Objectives
In the aftermath of the collapse of the Bretton Woods system (and for the United
States for some time before that), monetary policy was designed to secure the best trade-off between
output growth and inflation. The intellectual basis of policy was the Phillips curve. Eventually,
however, the stagflation that marked the 1970s caused both the objective of policy and its
implementation to be reassessed.
Today, there is a widespread consensus among central bankers, and economists more
generally, that price stability should be the overriding goal of monetary policy. The rational
expectations literature, and the lessons of experience, suggest that there is no exploitable trade-off
between output and inflation in anything other than the very short run. Moreover, inflation leads to
distortions and uncertainties that impair economic performance. Worse, the short-run relationship
between inflation and output growth seems to be asymmetric: the output sacrifice needed to get
inflation down may be greater than the output gain when inflation is allowed to rise. Taken together,
these considerations mean that the best service monetary policy can render for the real economy is to
keep inflation credibly at low levels.
In fact, policy has been remarkably successful in recent years in bringing inflation
down in virtually all industrial countries. So much so, that a number of issues are now coming to the
fore that were previously considered as of second-order importance. These questions include: how to
avoid bias in the measurement of inflation; whether inflation should be zero or some low positive
number; whether the authorities' objective should be expressed in terms of inflation or the price level;
and how quickly one should return to the stated objective after a disturbance.
It is hard to dispute that measurement bias in inflation should be corrected, if possible.
That is easier said than done, however. Some biases can be relatively easily removed, such as that
arising from infrequent re-weighting of the consumption basket. Others are more difficult to deal
with, such as adjusting adequately for quality changes. And some are very difficult to correct, such as
properly incorporating new goods and services. Still, with some heroic assumptions it should be
possible to arrive at a serviceable estimate. The Boskin Commission in the United States has put the
bias at just over 1%; in other countries, the bias is thought to be no more than half that.
Concerning the desirable of (properly measured) inflation, there seems to be a
level
consensus that a low positive number (1-3%) is better than zero.1 The reasons for this are both a
priori and empirical. When inflation averages zero over time, the price level must, by definition, be
falling for a significant part of the time (and a significant number of individual prices will be falling,
even if the general price level is flat). This creates two problems. Firstly, if wages and prices are
sticky downward, it may require a higher level of unemployment to stabilise the overall inflation rate
at zero than at some higher number.2 Secondly, since nominal interest rates cannot go below zero, it
will become impossible to engineer negative (or even very low) real interest rates to help recovery
from a recession. Such considerations have led most observers to favour a low but positive rate of
inflation. Those who prefer zero tend to point to the distortionary effects of the tax system,3 or to the
risk that any positive number can be revised up, as justifying the more ambitious target.
It is the fear of slippage that also motivates the suggestion to express the price
stability objective as a constant price (rather than a zero or constant rate of inflation). The idea is
level
that the impact of an inflationary (or deflationary) surprise in one period should be offset in the
succeeding period by a policy aiming at reversing the initial shock. In this way, the price level would
be constant through time, enhancing the credibility of monetary policy and facilitating the
development of very long-term contracts.
One obvious objection to the pursuit of a policy of literal price level stability, namely
that it would require deliberate deflation following any inflationary disturbance, can be overcome by
expressing the price objective in terms of a rising trend through time. Nevertheless, perhaps
surprisingly, there is still little support in central banking circles for expressing the inflation objective
in terms of the price level, rather than its first derivative. This may be because, if there is believed to
be an optimal inflation objective, whether zero or a low positive number, it seems odd to adjust it as a
result of past events.
The last element of objective setting for central banks is how quickly they should seek
to return to an inflation target once having been forced away from it. There seems to be an emerging
inter
consensus, reflected, alia, in statements by the Bank of England, that a period of 1-2 years is
appropriate, this being the time it takes for a change in monetary policy to have the bulk of its effect
in prices. To attempt a quicker restoration of price stability would risk overshooting, while to go
more slowly would tend to undermine credibility. It should be noted, however, that this
recommendation holds clearly only for minor departures from the objective. If the actual inflation rate
is a long way away from the desired rate, there is no consensus on whether gradual or shock therapy
is to be preferred. Much depends on the political circumstances, as well as on surrounding economic
policies (e.g. fiscal policy) that affect credibility.
(b) Anchors
Just as difficult as setting the objective of monetary policy has been settling on the
means for achieving it. A variety of approaches have been in vogue at various times in the past
twenty or thirty years.
has acquired a bad name because, at least in countries with
Pure discretion
nonindependent central banks, it is seen as a cloak for politically-motivated decisions. Such decisions
have sometimes been a crude attempt to buy votes by easing of monetary policy before elections, the
benefits of monetary relaxation coming relatively quickly and the costs of higher inflation emerging
only later. More frequently, however, they have involved an attempt to use a presumed
output/inflation trade-off to strengthen employment prospects; or an unwillingness to tighten
monetary policy until evidence of inflationary pressures was already apparent in the data. Whatever
the motivation, a fully discretionary policy has often lacked the strategic coherence to prevent
inflation accelerating.
became popular in a number of countries in the 1970s, on the
Monetary targeting
back of Milton Friedman's dictum that "inflation is always and everywhere a monetary
phenomenon".4 The powerful intuitive appeal of the money-inflation link was undoubtedly helpful in
mobilising support for a rigorous anti-inflation policy in the United States, United Kingdom and
elsewhere in the late 1970s and early 1980s. Nevertheless, one of the key requirements for such a
policy, namely a stable demand for some monetary aggregate, has not been adequately fulfilled in
recent years (at least in most countries). One by one, central banks that had adopted monetary targets
in the 1970s, dropped or downgraded them in the 1980s and 1990s. Nowadays only Germany and
Switzerland place strong reliance on monetary aggregate targeting, and even they apply such policies
with a significant measure of judgment.
has a long history. The gold standard involved stabilising
Exchange rate targeting
the domestic price level in terms of gold, and the Bretton Woods system linked national currencies to
the dollar. More recently, exchange rate anchors have been used effectively by a wide range of
countries. Their value in restoring discipline and credibility is hard to doubt. But they have two major
disadvantages that have become evident in recent years. Firstly, when capital markets are integrated,
any country adopting a strict exchange rate peg subordinates its monetary policy to that of the anchor
country. This works well when monetary policy requirements are in harmony; less well when there
are divergences, as the United Kingdom discovered in 1992. Secondly, if a country adopting a
currency peg fails to master domestic inflationary pressures, it may find that its balance of trade
deteriorates and eventually reaches a point of unsustainability. The decision to adjust or abandon an
unrealistic peg has proved to be one of the most difficult of economic policy decisions - in part
because so much has typically gone into seeking to achieve credibility through adherence to the peg.
In response to the perceived shortcomings of monetary and exchange rate targets, and
of unconstrained discretion, attention has been given in recent years to inflation targeting and
as a means of strengthening the likelihood that price stability objectives will
central bank autonomy
be met. At first sight it might seem tautological to use an inflation target to achieve an inflation
objective. In fact, there is rather more to it, as the practice in the United Kingdom shows. The idea is
that a public commitment to an inflation target, coupled with the maximum of transparency in
describing the authorities' forecasts and decision-making process, enables a discretionary approach to
be applied with less risk that monetary policy decisions will be biased toward leniency. If, in
addition, the central bank is made fully independent to pursue a clearly-defined goal, political
interference will be avoided.
A growing list of countries have adopted the inflation targeting approach in recent
years, including Canada, New Zealand, Australia, the United Kingdom, Sweden and Finland. The
practical implementation of the approach has varied in a number of respects, including who sets the
target (government or central bank); whether it is expressed as a range or a fixed point; the price
index employed; the use of adjustment or "override" mechanisms, and so on. These differences,
however, are less significant than the common principle on which targets are based. So far, targets
have been rather successful, though the approach has yet to be tested under adverse conditions.
(c) Tactics
Just as there has been convergence in the goals and the strategy of monetary policy
implementation, so too there has been in matters of tactics. Twenty or thirty years ago, a variety of
operating tactics were used, including control of some measure of the monetary base; variations in
reserve requirements; discretionary discount window intervention; open market operations, at a
variety of maturities; direct lending controls; and moral suasion.
Nowadays, direct controls on lending have been abandoned in virtually all countries.
Reserve requirements have been reduced to very low levels, to avoid distorting patterns of
intermediation, thus making control of the monetary base an imprecise instrument. Use of the
discount window and bond market intervention have similarly fallen out of favour. Central banks
now generally use very short-term reversible transactions ("repos" and "reverse repos") to inject or
withdraw cash from the money market. The maturity of these transactions is typically either
overnight or for a few days.
Short-term money market operations enable central banks to maintain control over
overnight interest rates. Longer-term interest rates are then influenced by expectations of how central
banks are likely to adjust overnight rates in the face of economic developments. This, in turn, places a
premium on credibility and effective signalling of policy intentions.
The use of interest rates as the principal operating instrument does not mean, it should
be stressed, that the volume of money and credit is considered unimportant as a determinant of
inflationary trends. Rather, it reflects the view that "noise" in the demand for bank reserves is better
accommodated by some short-term flexibility in the growth of liquidity than by fluctuations in
overnight interest rates; and by the belief that judicious management of overnight interest rates will
enable the authorities to achieve the desired degree of control over credit volumes in the medium
term. At the same time, it is also part and parcel of the process that has led central banks to place
relatively more weight on prices (interest rates, exchange rates) than on quantities in the formulation
and implementation of policy. There are several reasons for this, ranging from the socio-political
climate to structural economic factors such as the development of financial markets.
II. Financial System Stability
Besides the achievement of price stability through the appropriate use of monetary
policy, the other major focus of central bank activity is the preservation of stability in the financial
system. As first articulated by Bagehot, this involves a willingness to act as a lender-of-last-resort to
the banking system, to counteract the possibility of a "run" developing on a solvent but illiquid
institution, and to avoid the risk of a contagious spread of financial distress. Central banks have
always had an important role in maintaining systemic stability, but it is only comparatively recently
that economists generally have become aware of the analytic issues involved.
Following the crisis of the 1930s, there was growing agreement, first in the United
States and later elsewhere, that the stability of the financial system should be based on two pillars:
firstly, explicit or implicit support to protect depositors at banking institutions; and secondly, a
structure of regulation that would reduce the risk of banks getting into trouble in the first place.
For the first twenty-five years or so of the post-war period, banking system stability
attracted relatively little attention. Economic conditions were favourable, which limited the scope for
troublesome bad-lending decisions. Just as important, restrictions on market access and regulation of
permitted activities enhanced franchise values and provided protection against losses.
Essentially, entry into banking was restricted, both by natural economies of scale and
by regulatory restraints. Competition within the banking industry was limited by tolerating cartel-type
practices and by rules, such as interest rate and credit expansion ceilings, that protected existing
firms. Such practices greatly reduced the probability of bank failure. The value of the banking
franchise made stockholders and managements unwilling to take risks with the continued viability of
firms under their control. And if serious losses did occur, rescue by other firms was likely, either in
order to acquire a valuable franchise, or as part of an implicit quid pro quo for the maintenance of
their own favoured status.
Two forces came to the fore in the 1970s and subsequently that made this regulatory
approach unsustainable. One was the growing influence of the free market philosophy, and the
accompanying dismantling of controls and restrictive practices. This affected the of
willingness
public authorities to limit competition in the name of stability. The other was the development of new
financial instruments that enabled market participants to replicate virtually any kind of contract,
regardless of regulatory restraints. This affected the ability of policy makers to influence financial
activity through regulatory controls. Interest ceilings on demand deposits were circumvented by the
development of NOW accounts; exchange controls spawned the development of Euro-currency
accounts; and the growth of derivatives markets provided transactors with a multiplicity of ways of
creating contracts with equivalent pay-off characteristics but different forms.
The breakdown and eventual abandonment of direct controls required renewed
attention to the issue of how to make the financial system resilient. The search was made more urgent
by the fact that banks' capital strength had (predictably enough) weakened during the period when
their protected franchise generated guaranteed profits. This weaker capital position was highlighted
by a number of episodes in the 1970s and early 1980s, notably the Third World debt crisis that
erupted in 1982.
The vulnerability of banking systems in industrial countries that was revealed by the
1980s debt crisis led to a renewed focus on as a means of
risk-based capital adequacy
strengthening systemic resilience. Bank regulators had, of course, always had rules for capital
holding by the institutions they supervised, but these were not harmonised across countries, and in
many jurisdictions, they were in the form of crude capital/asset ratios. What was different about the
regulatory approach developed in the 1980s is that it was founded on international agreement, and it
focused on the concept of capital as a cushion against risk.
The Basle Committee on Banking Supervision had been created in 1974, with the
initial task of identifying which country's supervisors should be responsible for the activities and
soundness of internationally active banks. In the mid-1980s the Committee turned its attention to the
development of capital standards for such banks. When finally promulgated in 1988, these standards
divided banks' assets into five risk categories, running from sovereign securities of industrial
countries (with a zero risk weight) to ordinary commercial credits (with a 100% risk weight).
Supervisors from G-10 countries agreed to see that internationally-active banks under their
jurisdiction held capital at least equivalent to 8% of risk weighted assets.
The Basle Capital Accord, which has subsequently been updated and amended, was a
substantial step forward for bank regulation. It meant that required levels of capital were more closely
related to the reasons for which banks hold capital, that is, to cover the risks in their portfolio. At a
practical level, it led to a marked strengthening of major banks' capital ratios, which had become
dangerously low.
But although the Basle Capital Accord took regulatory practice a significant way
towards the market, it did not take it the whole way. The limited number of risk categories obviously
(and deliberately) did not capture the full spectrum of creditworthiness. And the "building block"
approach to the calculation of risk did not allow for the risk-reducing (risk-enhancing) properties of
diversification (concentration).
Much recent thinking has focused on - using the
incentive-compatible regulation
market's own internal forces - as the most promising next step strengthening the financial system. It
is banks' shareholders and management that have the strongest interest to measure risk accurately (at
least if they expect to be around to bear the consequences of their actions). An internally generated
measure of risk should be better than one derived from formulaic risk-weights generated by
supervisors. There is, therefore, a strong case for supervisors to use the calculations developed by
firms themselves, at least if they can be satisfied that the risk assessment model is adequately robust.
This is the approach that the Basle Committee in fact followed when the capital
accord was amended to include market risk in addition to credit risk. The difficulties of extending the
approach to credit risk are considerable, since a loan portfolio does not have a market value whose
variability can be tracked over a series of observations. Nevertheless, the concept is similar, and the
best financial firms are now beginning to apply a similar methodology to the calculation of credit risk
as they do to market risk.
Does this mean that decisions relating to prudential capital requirements can be left to
private institutions? Not quite. Although private institutions are, in principle, best placed to measure
the riskiness of their own portfolio, they are not necessarily the best judge of how much capital they
ought to hold. This is because when a public authority acts as a lender-of-last-resort, or ultimate
guarantor of systemic stability, that authority is providing part of the "capital" that the banking
system needs to safeguard stability. In the absence of regulatory rules, financial institutions would be
tempted to economise on capital holding, reasoning that the authorities would either come to their
assistance, or shoulder the consequences of systemic failure. So even if the task of
measuring risk
can be largely privatised, the task of deciding the appropriate level of capital holding may still
require a public policy judgment.
Important public policy decisions are also involved in dealing with financial
institutions which, for whatever reason, find themselves with an inadequate capital. Low levels of
capital can lead to the phenomenon of "gambling for resurrection" - banks pursuing risky strategies
in the knowledge that shareholders will get the benefit of good outcomes, while bad outcomes will
impose losses on third parties.
Thus far, I have discussed financial stability in terms of the health of the institutions
that go to make up the banking system. But there is another dimension that has received increasing
attention from central bankers over the past 10-15 years. It concerns the market infrastructure that
underpins financial transactions, and in particular the payment and settlement system. While this
might seem an unexciting subject to economists, it is in fact of great practical importance. At a
conservative estimate, more that $5 trillion per day passes through the settlement system, most of it
representing large-value financial transactions cleared by a relative handful of major clearing banks.
If one of these institutions became unable to meet its obligations in the clearing, the consequences
could be dramatic.
Because this is the case, it is worth taking a moment to understand the issues that
arise. Broadly speaking, there are two sets of problems. Easiest to understand are the problems facing
of payment and settlement systems - that is, those who trade in financial markets and then have
users
to use the systems to settle their deals. Almost every deal has two sides - one party pays, the other
party delivers whatever is being bought. For these users, the difficulty arises where there is no
mechanism to co-ordinate the two sides. The party paying is thus exposed to the risk that the
counterparty fails to deliver, and vice versa. In other words, there is often no mechanism to ensure
delivery-versus-payment. In securities markets this is by now a relatively familiar issue. More
recently, the need to tackle the similar problem which arises when settling foreign exchange deals has
come to be appreciated. In both cases the value of the deals being settled is so substantial that the
resulting settlement risks can be of a size to cause systemic concern.
The second set of problems concerns one particular category of system users -
namely banks, who also typically the payment and settlement systems. Until quite recently,
provide
the standard form of settlement was end-of-day net settlement. That is to say, all the payments and
receipts between banks were allowed to accumulate during the day, to be settled by a transfer of the
smaller, net amount at the end of the day. Banks liked this arrangement because it meant they could
hold smaller balances on their accounts at the central bank. But its systemic weakness was that it
usually required participants in the clearing to grant unsecured, uncontrolled and unlimited credit to
other participants during the period until final settlement occurs. It is quite common for the credit
thereby extended to a single counterparty to exceed a bank's entire capital. Implicitly, the participants
in the clearing are assuming that the central bank would be forced to come to the rescue if problems
arose.
Over the past few years, considerable effort has been devoted to alleviating these
sources of systemic risk, and solutions are now being implemented. Solutions to protect users of the
systems include introducing improved delivery versus payment mechanisms for securities markets
and the possible introduction of some new form of multi-currency settlement arrangement for foreign
exchange markets. Solutions to protect system providers include the introduction of tighter internal
controls within traditional end-of-day settlement systems or, in an increasing number of cases, the
replacement of such traditional systems by