Elizabeth A Duke: Central bank cooperation in times of crisis
Speech by Ms Elizabeth A Duke, Member of the Board of Governors of the Federal Reserve
System, at the Center for Latin American Monetary Studies 60th Anniversary Conference,
Mexico City, 20 July 2012.
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It is a pleasure to participate in this commemorative conference on the occasion of the
60th anniversary of the Center for Latin American Monetary Studies (CEMLA). Since its
establishment in 1952, CEMLA has achieved a great deal on both the policy and research
fronts to promote our understanding of monetary and banking issues in Latin America and
the Caribbean.
The topic I have been asked to speak about today, "Central Bank Cooperation in Times of
Crisis," is very important. As we know, central banks typically work individually to achieve
objectives for their domestic economies. In the case of the Federal Reserve, monetary policy
is conducted to achieve our statutory objectives of maximum employment and price stability.
And, of course, fostering a stable financial system is key to attaining these goals. But the
experience of the past few years has illustrated - first with the global financial crisis and
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more recently with the strains in Europe that cooperation and coordination among central
banks around the world may be necessary at critical junctures to achieve these domestic
objectives.
In my remarks today, I will describe the evolution of the Federal Reserve's policies during
and after the global recession and show how many of those policies were undertaken in
coordination with, or in parallel to, similar actions by other central banks. I will start with the
monetary policy responses of the Federal Reserve and other central banks during the
financial crisis. I will then discuss the efforts that the Federal Reserve has made, often in
cooperation with other central banks and international partners, to help enhance financial
stability. Finally, I will focus on the challenges facing Latin American central banks, whose
economies and financial systems were affected by the crisis itself, and by the responses of
other central banks to the crisis.0F1
Federal Reserve policies and coordination with other central banks
Although the financial crisis that emerged in the summer of 2007 initially manifested itself as
a sharp deterioration in U.S. mortgage markets, the roots of the problem ran deeper. Indeed,
the consequences of a credit boom combined with excessive leverage, mispricing of risk,
and deficiencies in risk management became increasingly apparent. And given the
international extent of these vulnerabilities and interconnections, the crisis quickly became
global. Central banks around the world responded forcefully.
From the outset, the Federal Reserve vigorously used its traditional toolkit for managing
short-term interest rates. The Federal Reserve reduced the target federal funds rate from
5-1/4 percent in August 2007 to a range of 0 to 1/4 percent by the end of 2008. International
coordination on policy rate decisions is rare, but in October 2008, the Federal Reserve
announced a reduction in its policy rate jointly with five other major central banks: the Bank
of Canada, the Bank of England, the European Central Bank, the Swedish Riksbank, and the
Swiss National Bank. With clear signs of simultaneous economic slowing in many countries,
this coordinated action sent a strong positive signal to financial markets about policymakers'
collective intent to mitigate the effects of the crisis on their economies. Although not through
directly coordinated actions, other central banks, including those in Latin America, were also
reducing policy rates.
The stresses in financial markets and liquidity shortages were severe. So, in addition to
cutting policy rates, the Federal Reserve took measures designed to provide liquidity first to
banks and later to other financial institutions. A third set of measures involved the provision
of liquidity to address pressures in commercial paper markets and at money market funds.
These liquidity programs were largely unwound when financial markets improved.
As the Federal Reserve and other central banks worked to address liquidity shortages in
their own markets, it became clear that, as a result of globalization, firms were experiencing
funding shortages not only in domestic currencies, but in foreign currencies as well. In
particular, dollar funding shortages appeared not just in the United States but in countries
around the world, which, in turn, exacerbated pressures in U.S. funding markets. The
Federal Reserve already was providing liquidity to foreign financial firms operating in the
United States through its discount window and other facilities. To further address pressures
in dollar funding markets and support the flow of credit to U.S. families and businesses, the
Federal Reserve ultimately approved bilateral currency swap arrangements with 14 foreign
central banks, including two Latin American central banks.1F2 Under these swap arrangements,
in exchange for their own currencies, foreign central banks obtained dollars from the Federal
Reserve to lend to financial institutions in their jurisdictions. These swap arrangements pose
essentially no risk to the Federal Reserve: They are unwound (with a fee paid by the central
bank drawing on the swap arrangement to the Federal Reserve) at the exact same exchange
rate that applied to the original transaction, they are conducted with major central banks with
track records of prudent decisionmaking, and they are secured by the foreign currency
provided by those central banks.
The success of these swap lines in alleviating funding pressures and reducing interbank
borrowing rates is a testament to the benefits of central bank cooperation. Moreover, in
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addition to easing funding shortages, these swaps also helped to allay market fears they
had a preventive as well as a curative role. For example, four of the central banks that
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participated in these arrangements Brazil, Canada, New Zealand, and Singapore did not
end up drawing on the facilities, but it is generally believed that the existence of the lines
helped prevent stresses that could have otherwise developed. As the financial crisis receded,
the swap lines were closed in February 2010. However, swap lines with several foreign
central banks were reopened in response to financial strains that developed in Europe.2F3
In many countries, policy rates fell to nearly zero. With substantial economic slack remaining,
these central banks faced the challenge of finding ways to further ease monetary policy. The
Federal Reserve expanded its balance sheet through the purchase of longer-term Treasury
securities, agency debt, and agency mortgage-backed securities. The idea was to put
downward pressure on longer-term yields to spur demand and also to encourage some
portfolio rebalancing toward riskier assets and loans to the private sector. More recently, the
Federal Open Market Committee decided to extend the average maturity of its holdings of
securities by selling shorter-maturity Treasury securities and buying longer-maturity Treasury
securities. This maturity extension program created additional downward pressure on
long-term rates without expanding the size of the Federal Reserve's balance sheet.
In addition to using conventional monetary policy and balance sheet tools to provide
monetary accommodation, communication is an important tool used by central banks to
enhance the effectiveness of policy. At the conclusion of each meeting, the Federal Open
Market Committee issues a statement of policy actions taken and the rationale for those
actions. Detailed minutes are published three weeks later, and lightly edited transcripts are
made public with a five-year lag. In 2011, the Chairman began holding press conferences on
a roughly quarterly basis to discuss economic projections submitted by participants and
actions taken at the meeting. In August 2011, the Committee statement included forward
guidance that economic conditions are likely to warrant exceptionally low levels of the federal
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funds rate at least through mid-2013 a date that was later extended to late 2014 which
put further downward pressure on longer-term interest rates. In January 2012, the Committee
released a statement of its longer-run goals and policy strategy. At that same meeting, the
Committee also began including participant projections of the appropriate path of the federal
funds rate in the Summary of Economic Projections. The Committee continues to discuss
ways in which communication can be used to enhance policy.
While these policy moves of the Federal Reserve were not coordinated with other central
banks, other central banks shared these challenges and responded in broadly similar ways
to expand their balance sheets. For example, the Bank of England and the Bank of Japan
also used large-scale purchases of medium- and long-term government securities to provide
stimulus. In addition, several other foreign central banks, including the Bank of Canada and
the Bank of Japan, also more actively used forward guidance about the path of policy rates.
Finally, the common challenges and problems of the past few years reinforced the
importance of open discussion among the world's central banks. Central bank leaders draw
on collective experience through discussion in such diverse international forums as the Bank
for International Settlements (BIS), Group of Twenty (G-20), and CEMLA. CEMLA is an
excellent example of what can be achieved by central bank cooperation through such means
as courses and seminars, international meetings, technical assistance, publication of
research studies, and exchange programs.
Cooperation in areas of supervision and regulation
Central banks around the globe have focused not just on responding to the crisis, but also on
working to minimize the risk of future crises by improving the soundness and stability of the
financial sector. Indeed, the global financial crisis has underscored the importance of the
financial stability objective of central banks. Given the global nature of financial markets and
large financial institutions, coordination and cooperation among central banks and bank
supervisors and regulators more generally is crucial in achieving this goal. Let me provide a
few examples of such efforts.
First, the crisis highlighted shortcomings in capital and liquidity requirements. Central banks
with bank supervisory responsibilities have been heavily involved in designing and promoting
international frameworks to address these shortcomings. The Federal Reserve has
supported the Basel Committee's adoption of improved capital requirements that include
raising risk-weightings for traded assets, improving the quality of loss-absorbing capital
through a new minimum common equity ratio standard, creating a capital conservation
buffer, and introducing an international leverage ratio requirement. The Federal Reserve has
also supported the Basel Committee's work on quantitative liquidity requirements and its
work on capital surcharges for banks of global systemic importance.
Another example of international cooperation on the regulatory front is the Financial Stability
Board (FSB), which consists of key financial regulators around the world, including the
Federal Reserve. The FSB has identified a number of challenges that international
cooperation among central banks and financial regulators are helping to address. One such
challenge regards over-the-counter (OTC) derivatives. To reduce the systemic risk of
OTC derivatives, the G-20 leaders have agreed to require that standardized OTC derivatives
be cleared through a central counterparty. Another challenge is that of cross-border
resolutions, and the FSB has undertaken analytic work on how to improve the resolvability of
financial firms that have a substantial international presence. The FSB has also identified
and spurred cooperative work on gaps in financial data and on the so-called shadow banking
system.
As a bank supervisor, the Federal Reserve has cooperated with foreign bank supervisors
(including other central banks) through participation in supervisory colleges, which are
multilateral standing working groups of supervisors formed for the purpose of enhancing
effective consolidated supervision of an international banking organization. Supervisory
colleges enhance the information exchange and cooperation of home and host supervisors
to help them develop a better understanding of the risk profile of a banking organization.
Lastly, at the Federal Reserve we have also been working closely with other U.S. agencies in
the recently established Financial Stability Oversight Council on the implementation of the
financial stability reforms laid out in the Dodd-Frank Act. One key aspect of this act is the
focus on a "macroprudential approach" that pays attention to the financial system as a whole,
in addition to individual financial institutions and markets. The greater emphasis on
macroprudential tools has been widespread. Indeed, the Federal Reserve has participated in
analyses of macroprudential tools and policies undertaken with other G-20 central banks at
the BIS and with bank supervisors on the Basel Committee.
One of the reasons that coordination is required for supervision and regulation is the
substantial cross-border operations of many financial firms. The deleveraging of some global
financial institutions with a significant presence in Latin America and the potential effect on
economic performance serves as a stark reminder of the interlinkages of financial institutions
and economies. The deleveraging of these institutions also highlights the need to coordinate
across regulators and acts as a catalyst to spur greater action and information sharing.
Latin American central banks: crisis response and challenges
Earlier I mentioned how central banks around the world, including those in Latin America,
lowered policy rates in response to the global financial crisis. Although the crisis developed in
advanced economies, Latin American central banks, such as those in Brazil, Chile,
Colombia, and Mexico, cut policy rates in 2009 as their economies were being hit hard
through trade and financial linkages with advanced economies as well as through commodity
price channels. Their capacity to follow countercyclical policies was in striking contrast to
many previous times of stress, when policy rates could not be lowered for fear of frightening
off international investors. The fact that these Latin American economies were able to
respond by lowering policy rates and also by boosting fiscal support is a testament to the
decisive steps taken to strengthen macroeconomic policies and financial systems, including
improvements in the monetary frameworks under which their central banks operate.
Many Latin American economies staged quick and strong recoveries from the global
recession and subsequently started to raise policy rates to try to ward off overheating
pressures. Conversely, many advanced economies, with their prolonged soft recoveries,
needed to continue to follow expansionary monetary policies. Accordingly, as was also the
case in emerging Asia, the monetary policy stance of several central banks in Latin America,
such as Brazil and Chile, diverged from those of advanced economies. The resulting rise in
interest rate differentials, on top of the generally stronger growth in Latin America, helped to
fuel capital inflows, which, at times, have proved challenging for the policymakers of these
economies to manage. Of course, more recently, with intensification of the crisis in Europe,
some Latin American countries, most notably Brazil, have again lowered their policy rates in
response to concerns about slowing growth.
Even within Latin America, however, the experience of economies has not been uniform. In
particular, Mexico, with its stronger ties to the United States, was hit earlier and harder than
many other economies in the region. Even though Mexico's recovery in the second half of
2009 was strong, it had less momentum and considerable economic slack remained in the
country. As such, the Bank of Mexico did not consider it necessary to raise policy rates
during its recovery period, unlike many other Latin American central banks.
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These developments underscore an important point that while central banks may benefit
from coordination and cooperation, taking the same policy stance at the same time typically
will not be the best choice for all central banks. Accordingly, it is imperative for each central
bank to have monetary policy tools to appropriately address domestic objectives independent
of the actions of other central banks.
Conclusion
In this age of global financial integration, the Federal Reserve and other central banks often
must cooperate to achieve their individual mandates. This need for coordination has been
especially true during the recent crisis, when the actions of central banks working together
proved very helpful in easing financial strains and boosting confidence. Indeed, closer ties
and more-open lines of communication across central banks are some positive outcomes of
these difficult times. This spirit of cooperation should continue as our respective central
banks work to pursue monetary policies appropriate for our own economies while supporting
stable financial systems around the world.