Jean-Pierre Landau: The role of central banks - lessons
Remarks by Mr Jean-Pierre Landau, Deputy Governor of the Bank of France, at the
VIth International Symposium of the Banque de France on "Which regulation for global
imbalances?", Paris, 4 March 2011.
* * *
I am going to talk about the relationship between monetary policy and financial stability. This
topic is abundantly debated. I will take, however, a modest approach and deal only with
some operational aspects. These are, nevertheless, crucial since the essence of modern
Central Banks is their operational independence. It is therefore relevant to ask how it might
be affected or impacted by the search for greater financial stability.
The starting point is that financial frictions matter. They matter both for financial stability,
which is obvious, and for the transmission of monetary policy, a point which should have
been obvious but was somehow forgotten. Prior to the crisis, most of our macro models
tended to represent the transmission mechanisms through a simple, immaculate,
intertemporal substitution effect whereby changes in policy rates would induce expenditures
shifting across time. Money and financial institutions play almost no role in that mechanism,
as credit was implicitly supposed to respond only to interest rate movements.
What do the words "financial frictions" exactly mean? I will interpret those terms as
encompassing the conjunction of maturity transformation and leverage which drives the
expansion or contraction of financial institutions' balance sheets, thus the overall equilibrium
in credit markets, including securitized markets.
Those dynamics obviously have a direct impact on financial stability. Financial fragility comes
out of excessive leverage and maturity transformation, fueling asset price increases. And,
conversely, liquidity shocks and deleveraging are the symptoms and channels behind
financial crises.
As importantly, and less recognized until recently, those dynamics also have a major impact
on the transmission mechanism of monetary policy. The functioning of the credit channel, but
also the interest rate channel depend on financial intermediaries being able to fund
themselves and arbitrage across different market segments, instruments and maturities.
Dysfunctional credit markets were a major reason why Central Banks embarked into
exceptional liquidity provision, credit easing and asset purchases.
One important point, here, is that the same dynamics affect both financial stability, on the
one hand, and monetary transmission channels, on the other. Now, presumably, any macro
prudential policy would try and influence the evolution of maturity transformation and
leverage. By doing so, however, it would also have a monetary impact. And, conversely,
changing the monetary stance, by moving policy rates, also may have an influence on
financial stability.
The relative strength of those influences is not empirically known. Those of us who would
use monetary policy with a financial stability objective implicitly assume that leverage and
maturity transformation are very sensitive to interest rates. I am not sure this is true. At the
very least, during the crisis, we have seen deleveraging proceeding at an accelerated pace,
although interest rates have been brought down - and this is the reason why there has been
a zero lower bound problem. I suspect that, symmetrically, interest rate hikes would have
been powerless to stop the incredible build up in leverage prior to the crisis.
This is the very reason why we need additional - macro prudential - tools to deal with
financial instability. But this analysis also shows that macro prudential and monetary tools are
not independent. So we have to give up the ideal vision of a world where two objectives -
price and financial stability - would be pursued with two independent set of instruments. The
reality is somehow messier and this has important consequences. Operating two different
policies with two sets of interacting instruments is definitely a challenge. Once we move away
from the pure "Tinbergen" world, preserving the operational independence of monetary policy
may require particular attention.
Add to this that mandates and accountability regimes are very different for price and financial
stability. Central Banks are independent, but macro prudential authorities are not. In all major
jurisdictions, Governments, and Parliaments, are deeply involved in the organization and
management of macro prudential supervision. Likewise, while price stability mandates are
precisely defined and often quantified, financial stability mandates are specified in very broad
terms. There are good reasons for this situation. In devising and implementing macro
supervision, authorities are facing delicate trade-offs between efficiency and stability in the
financial system. Deep social choices are involved, which, arguably, can differ across
countries and periods of time. Also, as recent experience has shown, financial stability may
ultimately involve fiscal commitments.
Finally, and most importantly in my view, we lack the analytical framework upon which both a
financial stability mandate and operational independence could be validly and legitimately
anchored. Central Bank independence has closely followed theoretical breakthroughs, in the
1970s, in our understanding of inflation dynamics. It was made possible because societies
reached a common - and easily communicable - agreement on the lack of trade-offs
involved, on the long run, between inflation and growth. That robust, and commonly shared
analytical background on what monetary policy could - and could not - achieve was
essential in establishing the primacy of price stability and the legitimacy of independence in
monetary policy making. We are very far away from such a theoretical agreement on the
causes of financial instability, on the real trade-offs between efficiency and stability in
finance, on the role of innovation and, finally, on the origins and detection of asset and credit
bubbles. It would therefore be illusory, and dangerous, to expect that a precise mandate for
financial stability could be defined, let alone quantified, in a foreseeable future.
The situation is therefore somehow confusing and this raises important challenges for the
future. At the risk of oversimplifying, Central Banks associated with - or responsible for -
financial stability may find themselves with:

two separate missions: price and financial stability

two different accountability regimes: full independence for monetary policy;
coordination or subordination mode for financial stability

two interacting sets of instruments: interest rates and macro prudential tools (a
situation made even more complicated when unconventional monetary policies are
implemented)
The potential for confusion is real. It is not difficult to imagine situations where actions that
Central Banks take on pure monetary policy grounds are nevertheless contested in the name
of financial stability. To some extent, this has always been a possibility. The difference, now,
is that institutional frameworks exist through which - implicit or explicit - challenges to
Central Banks operational independence can materialize.
It might be tempting to conclude, then, that Central Banks should stay away from financial
stability and concentrate exclusively on ensuring price stability. This, unfortunately, is
impossible, if only for reasons that Charles Goodhart has well explained in a previous paper:
ultimately, Central Banking is about providing liquidity and liquidity provision is an essential
and central component of financial stability.
What can we conclude?

First, central banking is not only about monetary policy but also involves an
essential component of financial stability. This seems to me a broad consensus
coming out of the crisis.

Second, monetary policy is about setting interest rates, but also involves observing
and analyzing leverage and liquidity. Monetary aggregates as well as the volume
and modalities of maturity transformation reveal very useful information on the
transmission mechanism. This is actually the conventional wisdom within the
Eurosystem, through the use of the second pillar. Although less acceptable outside
the euro area, I conjecture that the lessons of the crisis will trigger some rethinking
here and there.
 Finally, the debate on whether monetary policy should also aim at financial stability
must give more consideration to the awkward interaction between instruments and
the diversity of accountability regimes. Both create the potential for additional
confusion about the ultimate objectives of each policy. It seems to me that most of
the discussions are conducted under the implicit assumption that price stability will
be as easy to maintain in the next decade as it was in the past. So, there would not
be much to lose in "diverting" some of the power and credibility of monetary policy to
seeking financial stability. It is very clear that this assumption is severely tested,
perhaps sooner than we thought. It will be important, in this environment, to maintain
clarity of purpose and robustness in institutional arrangements in order to limit the
risk of weakening the benefits of Central Bank independence, which were so hardly
won over the last decades.