"Easy Money, Uneasy Finance"
On the relationship between monetary policy and financial stability
Speech by Klaas Knot at the Peterson Institute for International Economics
Washington, 24 September 2018
In his speech at the Peterson Institute in Washington, Klaas Knot states that a sound financial
system makes life much easier for central bankers. But the reverse is also true: a weak financial
system can cost monetary policymakers many sleepless nights. And secondly, he points out the
need for further improvements in the regulatory framework in the coming years.
1. Introduction
Ten years ago, the global financial system was on the brink of collapse.
Within just a couple of weeks, well-known and systemically important financial institutions either
failed or teetered on the abyss.
Activity in several key financial markets ground to a complete halt. Soon after, the global economy
would enter a very deep recession.
To remind you of the extreme circumstances of that time, let me show you the front page of the
Financial Times from ten years ago on 24 September 2008. The headlines were dominated by the
frenzied efforts of the US government and the Fed to deal with the fallout from the Lehman
Brothers collapse.
We all remember the unimaginable developments that happened in those weeks. And we all
remember the pain of the Great Recession that hit the global economy in the following years.
However, I also remember the global commitment and co-operation among policymakers. Deep
uncertainty was plaguing the authorities.
But a combination of extraordinary measures, including interventions, capital support and liquidity
injections, eventually succeeded in restoring financial stability.1 And an unprecedented monetary
stimulus was provided through a range of conventional and unconventional tools.
Ten years later, we now stand at a vital crossroads. The supervisory reform program has made
important progress. Monetary policies are now being normalized.
This afternoon I want to take stock of the current challenges. I would particularly like to focus on
the importance of a robust financial system for conducting monetary policy.
I want to convey two main messages.
First, a sound financial system makes life much easier for central bankers. It limits the effects of
financial shocks on the real economy;
it strengthens monetary transmission channels; and it reduces unintended consequences of
monetary policy actions. But the reverse is also true: a weak financial system can cost monetary
policymakers many sleepless nights.
Second, against the background of a monetary environment that is likely to remain accommodative
for some time, we therefore need to further strengthen the global financial system. And to do that,
we need to further improve the regulatory framework in the coming years. I will argue that the
financial system is in much better shape than a decade ago, but important risks still remain.
I will argue that international regulatory authorities firstly need to maintain strict micro- and
macroprudential regulation; secondly, must seek further improvements in policy implementation;
and thirdly, should adapt to risks shifted outside their perimeter.
2. Causes of the crisis and policy responses
Let me briefly recall the financial, economic and policy circumstances which allowed the global
financial crisis to develop.
Causes of the crisis
In the decades before the crisis, the global financial system changed profoundly. This was the result
of deregulation, increasing competitive pressures on banks and increasing financial globalization.
These trends have led to a greater role for market finance and a stronger interconnectedness within
the financial system.
During the same period, the macroeconomic environment underwent important structural changes.
This happened on the back of accelerating globalization, the emergence of new players like China,
and technological progress. Against this background, large global flows of savings and investments
pushed down long-term interest rates, in the United States and other advanced economies.2
Accommodative monetary policies further allowed for financial risk-taking. It has been argued that
the "Great Moderation" allowed a leverage build-up that ultimately threatened financial stability
and hence macroeconomic stability.3
In the regulatory policy sphere, a widespread trend towards deregulation loosened the reins on
risk-taking in the financial sector. Microprudential supervision was not well equipped to address
this increased risk-taking.
In addition, macroprudential orientation of regulatory policy addressing systemic risk was almost
completely absent at that time.
In this environment, misaligned incentives prompted widespread risk-taking in the financial
system. In combination with high economic growth, important imbalances developed. When the
crisis erupted, banks did not have sufficient capital to absorb losses and authorities were not
adequately prepared to handle failing banks. The imbalances spread almost instantaneously across
the global financial system, as a result of the interconnectedness of financial institutions and
markets.
These patterns are not specific to the global financial crisis, as economic historians have
documented.4 Typically, financial crises are preceded by booms where factors like high growth,
innovation and increased risk taking interact.
In a very recent paper Ben Bernanke introduces yet another element:
the excessive reliance of financial institutions on short-term wholesale funding.5 This new element
explains why the global financial crisis was more extreme, and why it had more severe effects on
the real economy.
Policy responses
When the crisis erupted we needed new policy toolkits.
In the last ten years, therefore, a comprehensive reform program has been developed, under the
leadership of the G20, the Financial Stability Board, and the Basel Committee of Banking
Supervision.
The reforms have made financial institutions better equipped to deal with future shocks. Thanks to
these reforms, banks hold significantly more capital, which is more readily and easily available to
absorb losses. Banks also have stronger liquidity positions and have strengthened their governance
and risk management. Prudential policies increasingly include a macroprudential orientation with a
2
For a recent analysis of this mechanism, see B. Bernanke (2015) Why are interest rates so low, part 3: The global savings glut.
Wednesday. Brookings Blog, 1 April 2015.
3
See e.g. G. Stevens (2012) Challenges for central banking. Address to the Bank of Thailand's 70th Anniversary and 3rd Policy
Forum, Bangkok, 12 December; C. Borio (2014) Monetary policy and financial stability: what role in prevention and recovery?
BIS Working Papers No 440.
4
See e.g. Ò. Jordà, M. Schularick, A.M. Taylor and F. Ward (2018) Global Financial Cycles and Risk Premiums. NBER Working
Paper No. 24677. For an analysis of these elements in the first financial crisis of the modern era, see R. Frehen, W. Goetzmann,
and G. Rouwenhorst. (2009) New Evidence on the First Financial Bubble. NBER Working Paper No. 15332.
5
B. Bernanke (2018) The real effects of the financial crisis. BPEA Conference Draft, Fall.
stronger focus on financial stability. Risks originating in the shadow banking sector are better
appreciated, and over-the-counter markets have become more robust and transparent. In addition,
resolution management has emerged as a new toolkit to reduce too-big-to-fail distortions.
And it became clear that traditional monetary policy responses were not sufficient to deal with the
Great Recession. As policy rates were cut to their effective lower bound, further monetary
accommodation was achieved through unconventional tools such as forward guidance, longer-term
refinancing operations and asset purchases.
With the help of these new tools, monetary policy contributed to fixing a dysfunctional monetary
transmission mechanism, supporting the recovery and averting deflation risk.6
3. A framework for assessing monetary policy and financial stability
Today, the financial system is more resilient and the global economy is enjoying a period of strong
economic growth. However, important challenges remain for both monetary and regulatory
policymakers.
A framework I consider very useful for guiding policy actions is based on the following three key
elements7:
Firstly, the necessity of policies. Do circumstances require action by authorities?
Secondly, the effectiveness of the instrument. Can the proposed policies achieve the intended
objectives?
And thirdly, the possible unintended consequences of interventions.
In my view, both monetary and regulatory policies need to be based on such criteria as guideposts
for policymaking.
4. Financial stability and the monetary policy triangle
Let me apply this framework to monetary policy first, and focus on the interplay with financial
stability. My main point here is that a sound financial system makes life easier for monetary
policymakers.
Let me elaborate.
6
See e.g. J. Yellen (2017). The Goals of Monetary Policy and How We Pursue Them. Remarks at the Commonwealth Club, San
Francisco, California, 18 January; M. Draghi (2017). Accompanying the economic recovery. Introductory speech at the ECB Forum
on Central Banking, Sintra, 27 June; K. Knot (2017) Modesty in times of uncertainty. Speech at the Business Economists' Annual
Dinner, London, 29 November 2017.
7
For a lucid analysis along these lines, see W. Dudley (2013) Why Financial Stability is a Necessary Prerequisite for an Effective
Monetary Policy. Remarks at the Andrew Crockett Memorial Lecture, Bank for International Settlements 2013 Annual General
Meeting, Basel, Switzerland, 23 June 2013.
Necessity
First, a sound and stable financial system will reduce the need for monetary policy actions aimed at
macroeconomic stabilization.
The global financial crisis and the ensuing Great Recession have shown that shocks emanating from
the financial system can have a devastating impact on the real economy. Similarly, a financial
system experiencing stress amplifies the effect of shocks originating in the real economy.
Both mechanisms then lead to larger deviations of output from potential, and inflation from target,
compared to an environment in which the financial system had remained stable. In turn, this would
call for more monetary policy interventions to stabilize output and inflation.
Effectiveness
Second, monetary policy is more effective when the financial system is sound.
Standard monetary policy determines marginal financing conditions in the short-term money
market. Its macroeconomic effects depend on several channels through which financial
intermediaries pass on these policy rate decisions to the real economy. Especially on my side of the
Atlantic, during the European debt crisis, these transmission channels became impaired.8
This severely restricted the ability of policy rate cuts that central banks had implemented to
stabilize the real economy. Central banks ultimately had to resort to unconventional monetary
policy tools, to restore the pass-through of lower policy rates to firms and households.9
A sound financial sector therefore enhances the effectiveness of monetary policy by improving the
functioning of the monetary transmission mechanism. It helps monetary policy achieve its
objectives with less effort, and reduces the likelihood that the effective lower bound is reached.
Unintended consequences
Third, the more sound a financial system, the less likely it is that monetary policy will have
unintended consequences. Conversely, the weaker a financial system, the more likely it is that
monetary policy actions will create unintended consequences.
8
A recent research paper by DNB economists illustrates this mechanism and shows that recapitalizing banks more quickly (as it
was done e.g. in the United States) strengthens the monetary transmission mechanism (M. Mink and S. Pool (2018) Credit supply
and monetary transmission after a banking crisis. Mimeo, DNB).
9
For an early theoretical analysis of this mechanism, see e.g. V. Cúrdia and M. Woodford (2011) The central-bank balance sheet
as an instrument of monetary policy. Journal of Monetary Economics, 58 (1). An overview of theoretical and empirical research
on how the GFC was transmitted to the real sector, the nature of financial frictions and their impact on the transmission of
monetary policy decisions can be found in M. Gertler and S. Gilchrist (2018). What Happened: Financial Factors in the Great
Recession, Journal of Economic Perspectives, 32(3).
These unintended consequences of monetary policy for financial stability can occur through
different channels.
A first and much debated mechanism is the risk-taking channel of monetary transmission.
According to this, monetary policy has a systematic impact on ex-ante risk-taking in the financial
sector, by setting the universal price of leverage10, affecting financial conditions and ultimately the
real economy.11 A prolonged period of loose monetary policy can contribute to the build-up of
financial imbalances. In this sense, persistently low interest rates since the turn of the century have
been perceived as contributing to the global financial crisis as well.12
A second mechanism through which persistently low rates affect financial soundness relates to the
reduced incentives for balance sheet repair. The more so if macro- and microprudential regulation
are insufficiently developed.13
This is most evident in a crisis situation, such as the one from which we have recently emerged in
the euro area, or the crisis in Japan in the 1990s. Monetary stimulus through conventional and
unconventional instruments, may help to avoid a collapse of the banking sector.
But it can come at the expense of reduced incentives for balance sheet repair by individual banks. It
can promote the evergreening of non-performing loans and even regulatory forbearance. In this
context, unconventional policy instruments are more intrusive than conventional monetary policy.
And they can create deeper market distortions that aggravate the risk of a misallocation of
resources and financial instability.
It is often argued that prudential and not monetary policies should be geared towards financial
stability risks. But I tend to agree with Charles Bean that "there are important qualifications to this
somewhat Panglossian view of the ability to maintain both price stability and financial stability by
14
assigning monetary policy to the former and macroprudential policy to the latter."
10
See C. Borio and M. Drehmann (2011) Financial instability and macroeconomics: bridging the Gulf. Financial instability and
macroeconomics: bridging the gulf. In A, Demigüç-Kunt, D. Evanoff and G. Kaufman (eds.) The international financial crisis: Have
the rules of finance changed?, Singapore: World Scientific Publishing.
11
See Borio, C., and H. Zhu (2012). Capital Regulation, Risk-Taking and Monetary Policy: A Missing Link in the Transmission
Mechanism. Journal of Financial Stability; F. Smets (2014) Financial stability and monetary policy: How closely
interlinked?https://www.ijcb.org/journal/ijcb14q2a11.htm International Journal of Central Banking.
12
For an analysis of the role of low short-term interest rates in the GFC through their impact on risk-taking incentives, see J. Stein
(2013) Overheating in Credit Markets: Origins, Measurement, and Policy Responses. Speech at the Federal Reserve Bank of St.
Louis research symposium on "Restoring Household Financial Stability after the Great Recession: Why Household Balance Sheets
Matter", 7 February. For a careful discussion of the channels through which a low-for-long scenario could still engender material
risks to financial stability, see Committee on the Global Financial System (2018) Financial stability implications of a prolonged
period of low interest rates. CGFS Papers No 61.
13
The idea that low capitalization can induce risk shifting in response to shocks hitting bank balance sheets was developed in a
seminal study by M. Dewatripont and J. Tirole (1994) The Prudential Regulation of Banks, MIT Press. See also J. Tirole (1994) On
Banking and Intermediation. Joseph Schumpeter Lecture. European Economic Review.
14
C. Bean (2014). The future of monetary policy. Speech at the London School of Economics, London, 20 May 2014.
This implies that an effective prudential policy is a necessary but not a sufficient condition for
monetary policy to be effective in the medium to long run. Central banks must be conscious of
unintended consequences of a monetary strategy that keeps policy rates low for a long time.
Translating this to the current context, my main takeaway is that as long as inflation remains
subdued, central banks are likely to maintain an ample degree of monetary accommodation. But the
longer this accommodation is maintained, the more pressure will mount on financial regulators and
supervisors to be able to preserve financial stability.
5. Financial stability and the regulatory policy triangle
So what would this mean in practice, and how does it relate to the international regulatory agenda?
My key point here is that in an environment in which monetary policy is likely to remain
accommodative for some time, it is important that the agenda for regulatory reforms is pushed
ahead, along several dimensions.
Let me also elaborate here by referring to the same three elements: necessity, effectiveness and
possible unintended consequences.
Necessity
The first question is whether the regulatory reforms that have been adopted are still necessary. My
short answer here is Absolutely. And we actually need to strengthen our regulatory toolkit even
further.
As I mentioned before, the global financial crisis could develop in an environment with high growth
and increasing risk appetite, with low interest rates and abundant liquidity on the one hand, and on
the other hand the emergence of new risks, due to technological developments or innovation that
were not adequately captured by microprudential and macroprudential regulation.
The regulatory reforms taken in response to the crisis were thus needed to restore the balance in a
previously under-regulated sector. As of today, vulnerabilities in bank intermediation are much
smaller and bank resilience is stronger. However, some of the drivers of the crisis are still present.15
The total debt of households, firms and governments is now higher than ten years ago. Short and
long-term rates are still very low. And financial institutions and markets remain strongly
interconnected.
In this context, we should be wary of recent indications of diminishing momentum for regulation.
And there are even industry calls for rolling back some of the agreed reforms, to which I clearly
would not subscribe.
On top of that, I would like to highlight the need to further develop the macroprudential toolkit. The
current macroprudential tools are incomplete and - by design - limited in scope and impact.16
Almost all jurisdictions have established a macroprudential authority.
But there is still some difficulty to identify - and/or reluctance to actively develop -
macroprudential policies to address risks to the financial system as a whole.
Effectiveness
The second question is whether the regulatory reforms carried out thus far were effective.
Although the early signs of much stronger resilience in the core financial system are encouraging, it
is still relatively early to judge whether this has been enough. Too-big-to-fail incentives have surely
been reduced, but few would argue they have actually been eliminated.
The new rules in response to the crisis were also designed in a short time frame and many reforms
progressed in parallel. It is therefore a natural process that, after the initial implementation of such
a comprehensive set of reforms, policymakers now shift their focus to the phase of policy
evaluation. International standard setting bodies like the FSB have to continuously assess the
design and implementation of reforms to see whether regulation meets the objectives while
minimizing distortions. And this is what we are actually doing. It goes without saying that such
analyses should be evidence rather than sentiment based, and focused on better rather than less
regulation.
The global financial crisis has also shown that international co-operation is key in developing
effective regulatory policies. The global financial sector is closely integrated, and national or
regional developments create external effects that directly and indirectly affect financial stability in
other jurisdictions.17
Developing a common approach creates a level playing field between jurisdictions which prevents
regulatory arbitrage. The post-crisis reform agenda, but also the creation of a single supervisory
mechanism in Europe are important examples of successful international cooperation after the
crisis.
Unintended consequences
The third question relates to unintended consequences of regulatory reforms.
A main concern here is the potential of shifting risks outside the regulated sector as new rules come
in. As Charles Goodhart forcefully argued, prudential policy faces a "boundary problem":
...effective regulation can penalize financial intermediaries within the regulated sector compared to
those just outside, leading to substitution flows towards the unregulated.18
For example, when it comes to what we now call non-bank financial intermediation (formerly
known as shadow banking) the growth of total assets in recent years has been higher than in
traditional banking. It is true that since the crisis, efforts by the G20 and the FSB have resulted in
better insight into non-bank intermediation.
Yet there are still important questions about potential systemic risks originating from the
unregulated sector and how these risks could interact with those emanating from the regulated
sectors.
6. Conclusion
Let me conclude.
The global financial crisis was a sobering experience that presented an existential threat to financial
stability. The potential disruptive effects to the financial sector and the economy at large called for
exceptional measures.
In those turbulent times, the monetary, regulatory and supervisory response essentially followed
three guideposts. Firstly, authorities did what was needed. Secondly, they implemented policies
that were effective. And thirdly, they tried to mitigate unintended consequences.
We have come a long way. Financial stability has been restored and the financial system is now
more robust than a decade ago. However, the next ten years will undoubtedly present new
challenges.
History teaches that new vulnerabilities will emerge and the next financial crisis will eventually
occur. We cannot assume that financial regulation will always be able to fully prevent the next
crisis, because regulatory coverage is never complete and new risks can emerge from other
segments of the economy or its financial sector. Technological innovation will continue to change
the business models of banks and how they operate within the financial sector. New businesses will
emerge along the chain of value creation.
These fundamental changes can lead to disruptive innovation and new operational risks, such as
cybercrime. Such risks are outside the natural domain of regulatory authorities, but will become
increasingly important to financial stability.
Financial supervisors should therefore continue to expand their knowledge and enhance their risk
monitoring activities in those areas.
This underlines why we have to remain vigilant and continue to adhere to our strategy of pursuing
a sound financial system. It would support and enhance current monetary policies and contribute
to containing the unintended consequences. In addition, a well-regulated financial sector would
provide us with a much better starting point than prior to the global financial crisis.
Little I said is entirely new - yet I feel that these words should now be heard again. Let me illustrate
that with a 2001 quote from the late Andrew Crockett, whom we all know as one of the founding
fathers of the FSB:
"achieving the elusive twin goals of financial and monetary stability will require mutually
reinforcing anchors to be put in place in the two spheres. Moreover, it will require an enhanced
appreciation of the interdependence of policies in the two areas."19
And perhaps, instead of everything I have said today, these words alone would have sufficed.