Thomas J Jordan: A changing role for central banks?
Speech by Mr Thomas J Jordan, Vice Chairman of the Governing Board of the Swiss
National Bank, at the Welcome Event Master of Banking and Finance, St. Gallen,
22 September 2010.
* * *
I would like to thank Dr. Claudia Strub and Till Ebner for their valuable support in drafting this speech.
Introduction
The economic cost of financial crises is enormous. The recent crisis highlighted the extent of
systemic risk and thus the overriding importance of a stable financial system. It also
demonstrated the inadequacy of the instruments and measures used until now to ensure
financial stability. More effective measures are needed to check and prevent systemic risk.
The key question is how should - or can - this be achieved in the future?
In my talk today I would like to address this question by focusing on the role of central banks.
Specifically, I will endeavour to answer the following question: To what extent will the lessons
learned from this crisis affect or even alter the future role and tasks of central banks? I intend
to examine this from three perspectives:
In the first part of my talk, I will examine the extent to which central banks need to undertake
a fundamental review of their instruments and objectives in the light of recent events. In
particular, there is a need to analyse the effectiveness of the monetary policy strategies and
instruments used to date, especially in periods of crisis.
In my view, monetary policy measures and instruments alone are inadequate for the task of
effectively checking and preventing systemic crises. In the second part of my talk, I shall
therefore focus on the regulatory response to deal with potential instabilities within the
financial system. One possible response to the inadequacies highlighted by the crisis would
be to strengthen macroprudential supervision and regulation. In this case, the interaction
between these measures and monetary policy would have to be borne in mind. Thirdly,
institutional aspects play a key role in the restructuring of the regulatory environment. I will
outline these briefly in the final part of my talk.
Monetary policy after the crisis
Let me start by reviewing the objectives and instruments of central banks in the light of
recent events. Comparing today's world with the situation a few decades ago, it becomes
evident that much has changed. Deregulation of the financial markets has increased and
globalisation has progressed extremely fast - in the real economy as well. The brisk level of
trading made a significant contribution to the long-lasting worldwide upswing in recent years.
This was supported by the credible policies pursued by central banks, which increasingly
prioritised the goal of price stability, thus contributing to a global reduction in the level and
volatility of inflation. The battle against high inflation appeared to have been won. Overall,
this led to firm expectations of low inflation and a dramatic drop in risk premia in virtually all
areas of the financial markets.
However, the successful battle against inflation and the related reduction in macroeconomic
volatility - also known as the "Great Moderation" - were not able to prevent serious
instabilities within the globalised financial system.
Alongside its evident benefits, the "Great Moderation" thus seems to have produced a
number of damaging by-products. In combination with low real interest rates, financial
innovations and liberalised capital markets provided enormous credit-creation potential.
Together with a reduced perception of risk, this fostered a rapid rise in asset prices which
ultimately led to excesses and imbalances in some markets. Through contagion effects, the
bursting of a credit and asset price bubble can bring the entire global financial system to the
brink of collapse within a very short period of time. In view of the interaction with the real
economy, this also has serious implications for the world economy and global growth. This
raises a number of questions about the future role of central banks. Can and should
monetary policy be used to actively counter the development of imbalances or financial
bubbles? Does it make sense to use monetary policy instruments for this? Will the new
instruments used during the crisis also play a more important role in monetary policy in the
future?
To answer these questions, I would like to look specifically at two aspects. First, I will
examine the measures used by central banks during the crisis and briefly outline the
possibilities and limitations on their future use in monetary policy. Then I will consider
whether monetary policy should step up its focus on the goal of financial stability.
With regard to measures taken during the crisis, I can say straight away that the
effectiveness of monetary policy instruments was clearly demonstrated. We were able to
safeguard price stability and cushion the negative impact on the real economy. However,
vigorous interest rate cuts were not sufficient on their own - neither in Switzerland nor in
other countries. The liquidity situation on the money markets initially remained extremely
tense. In many cases, interest rates rapidly dropped to zero. The chief monetary policy
instrument could thus no longer be used. Central banks around the world therefore adopted
so-called unconventional measures. These included direct intervention in the financial
markets by buying assets, such as long-dated government bonds, debt securities issued by
private borrowers and foreign exchange. Another measure was the temporary expansion of
liquidity provision to banks beyond the "normal" level - for example, through repo
transactions with unusually long maturities of up to one year.
These measures were taken for two reasons. First, they permit further monetary easing if the
desired stabilisation of prices and the economy cannot be achieved through cutting interest
rates alone. Second, unconventional measures can be justified by the central banks' role as
lender of last resort. Its role, in other words, of providing emergency funding for financial
institutions that are facing short-term liquidity bottlenecks. The aim of these unconventional
measures is to restore the functioning of market forces as quickly as possible and ultimately
to restore market confidence in the financial system. Two main lessons can be learnt from
the vigorous response by central banks. It showed that zero interest rates on no account
mean that central banks have exhausted their set of monetary policy instruments. Through
quantitative and credit easing measures, the central banks have effective instruments that
can be used to reduce risk premia, alleviate liquidity bottlenecks and prevent deflation.
Moreover, their role as lender of last resort has taken on a new dimension. Previously, this
role was confined to providing funds to bridge temporary liquidity bottlenecks at a particular
bank. At the height of the crisis, however, the priority was to secure the liquidity of entire
markets. The central banks demonstrated that they can fulfil this function to a previously
unforeseen extent. In short, they demonstrated their ability to respond to a systemic crisis.
Nevertheless, we need to be cautious when considering whether such measures should be
included in a central bank's conventional set of instruments in the future. These
unconventional measures proved useful for direct crisis management. However, so far we
have little practical experience of monetary policy management at zero interest rates,
especially over a prolonged period of time. It is clear that the instruments used come at a
price. In the longer term, for instance, they could create new instabilities and distortions on
the financial markets. Similarly, such an enormous increase in liquidity could lead to a
build-up of significant inflationary potential. So it is too early to conclusively assess the
impact of the measures taken. In general, though, they should be reserved principally for
crisis management. Looking beyond the reactive crisis management, the aftermath of the
crisis has brought an old question back into the limelight: To what extent should central
banks proactively hinder the development of imbalances on the financial markets, rather than
simply adopting an ex post "mopping up" role. More specifically: should central banks try to
counter market excesses by steering interest rates in order to prevent a potential collapse of
the financial system and the resultant costly implications for the real economy? This is a
complex issue and answering it would go well beyond the scope of this talk. However, it is
very topical and tends to recur constantly in the public policy debate. I would therefore like to
give you my view on this issue.
For a long time now, central bankers and economists have been examining the extent to
which changes in asset prices should be taken into account in monetary policy. For example,
this could mean that the central bank would raise interest rates if there was a risk that an
emerging credit bubble could destabilise the system. The debate is fraught with difficulties,
and though it started some time ago, research is still in its infancy. I will therefore merely
outline the possible problems and challenges that could arise. To make my position clear: I
am convinced that a strategy geared to medium and long-term price stability is vital for
effective implementation of monetary policy. After all, the economic benefits of stable prices
are undisputed. High and volatile inflation rates are detrimental to productivity and growth.
Uncertainty about future price trends leads to inefficient investment and consumer spending
decisions. That does not mean, however, that financial stability should be ignored completely
in monetary policy considerations. Nevertheless, taking greater account of financial
imbalances presents a number of practical difficulties. An initial problem is that a single
instrument - namely the interest rate - would be expected to achieve two objectives
and
simultaneously: price stability financial stability. That does not seem to be a problem at
first sight, because usually the two support each other, especially when taking a long-term
view. Credible action to ensure price stability fosters a sense of security and market
confidence, which in turn play a key role in ensuring financial stability. Similarly, a stable
financial system is a key prerequisite for price stability. The recent financial crisis provided
impressive negative evidence to confirm this rule. The bursting of a financial bubble can
easily trigger a deflationary trend.
So far, so good. However, a second glance reveals potential conflicts between these two
objectives in certain situations. For example, a positive supply shock - as a result of
technological progress, for instance - could keep inflationary pressure low for a prolonged
period. Expansionary monetary policy conditions could therefore be maintained. But if we
look at financial stability, this situation entails the risk of a boom-bust cycle, which would
require a tightening of monetary policy. A similar problem is conceivable if the economic
outlook is so poor that raising interest rates would be inappropriate because of the risk of
deflation. However, maintaining low interest rates would pave the way for potential
imbalances, which - from the point of view of financial stability - would actually have to be
countered by raising interest rates. Such situations make it clear that a single instrument
cannot simultaneously achieve two objectives.
A further problem is that a bubble is not easy to identify. Expecting us to be able to tell in
advance whether damaging price imbalances are building up within certain asset classes is
not realistic. First, that would require us to be better than market forces in assessing the
fundamentally justified value of a specific asset. Second, it is not easy to clearly identify
which variables are to be used as indicators of imbalances.
A third problem is that we do not yet have any sound knowledge of the timing, effectiveness
and required scope of the monetary policy response that would be necessary to counter
financial imbalances. Since asset prices are typically far more volatile than real economic
variables and general price levels, substantial changes in interest rates could be required to
check financial imbalances, and this could have serious side-effects on the goal of
maintaining price stability.
As you can see, there are many questions that have not yet been clarified. The problems I
have mentioned make it clear that central banks would rapidly reach their limits if they were
simply to add a further goal alongside price stability without new instruments to deal with it.
The more objectives an instrument is expected to achieve, the greater the risk of wrong
decisions and conflicting objectives.
However, as I have already said, these problems do not mean that financial stability should
be ignored completely in monetary policy decisions. Asset prices and other variables such as
credit growth must be included as indicators when assessing the situation and the outlook for
inflation. They are already included in the practical implementation of today's monetary policy
strategy. Yet care must be taken when interpreting such "instability variables" because they
provide only limited information about future economic trends. To sum up, monetary policy
can make an important contribution to financial stability. However, the set of monetary policy
instruments is unsuitable for excluding all imbalances in all circumstances. Accordingly,
instruments that have a direct effect are needed to counter the emergence of (global)
financial instabilities. A key lesson of the crisis is that there is scope to strengthen what is
known as macroprudential supervision and regulation. This should be seen as
complementary to monetary policy, to aid attainment of the twin goals of price stability and
financial stability. Allow me to explain this in more detail.
A framework for macroprudential supervision and regulation
Put simply, macroprudential supervision and regulation is concerned with the stability of the
entire financial system, rather than that of individual institutions, which is the domain of
microprudential supervision and regulation.
Macroprudential supervision and regulation involves examining systemic risks that arise from
the interaction between individual banks or the risk that the default of a single bank
- because of its size or market share - could jeopardise certain functions that are vital for the
economy, such as payment transactions or lending business. For example, one solution that
could significantly reduce such problems would be progressive capital adequacy
requirements. In other words, the greater a bank's systemic importance, the more equity it
would be required to hold. If capital adequacy requirements rise in step with systemic
importance, banks have an incentive to stay smaller and thus less systemically important.
Capital reserves for systemically important banks in excess of a minimum level could also act
as a kind of "automatic stabiliser". Reserves built up in "good times" allow banks to absorb
losses in "bad times" without having to cease normal business operations. Another central
aspect of macroprudential supervision and regulation takes account of the build-up of
systemic risks over time, and especially the procyclical effects in the financial sector.
Discretionary action could be taken to cushion the growth of such risks over time - for
instance, by imposing an obligation to build up additional capital in phases of excessive
credit growth, in other words a countercyclical capital buffer. A key aspect here is that such
measures help prevent possible imbalances within the financial system. Another way of
achieving the required countercyclical effect is, for example, imposing direct restrictions on
loan-to-value ratios if there are signs that a bubble could be forming in certain markets, such
as the mortgage market.
The difficulties of applying macroprudential supervision and regulation should not be
underestimated, however. First and foremost, experience of discretionary instruments is still
fairly limited. For example, there is not yet any conclusive research showing which indicators
could be used to reliably identify systemic risks. Moreover, it is not easy to assess the point
beyond which credit growth should be regarded as excessive. Furthermore, the interaction
between macroprudential and monetary policy instruments could make implementation more
difficult. In particular, monetary policy transmission channels could be affected. The impact of
a change in interest rates on lending could vary depending on the level of a bank's capital
buffer. Therefore, in order to develop reliable indicators for systemic risk, to analyse the
interaction and feedback between macroprudential and monetary policy instruments, and to
carefully evaluate the effective measures, we need clear mandates, enough time and
additional expertise.
So what is the role of central banks in establishing such a macroprudential framework?
Generally speaking, the traditional tasks of central banks are closely linked to various
aspects of systemic stability. A stable financial system is very important for the effective
implementation of monetary policy. But also in active crisis management, central banks bear
a major responsibility, as the recent financial crisis clearly demonstrated. The contribution of
central banks is therefore of great relevance in the analysis and regulation of systemic risk.
In particular, central banks will have a key role to play in macroprudential supervision and
regulation for the following reasons: Developing and structuring macroprudential measures
requires reliable analytical and forecasting skills - for instance, with regard to the overall
economy or specific market segments, such as real estate. Central banks have extensive
and soundly based knowledge of these fields. Moreover - as I have already pointed out -
macroprudential policy interacts closely with monetary policy. This implies that the
information advantage of central banks could be important in shaping macroprudential
measures. Central banks will therefore almost certainly have to play a major role in
implementing such instruments.
At the same time, the risks involved in overemphasising the role of central banks in
connection with such supervision and regulation also have to be borne in mind. Central
banks could find themselves facing increased political pressure that could jeopardise their
independence. If their credibility with regard to maintaining price stability were undermined,
this could have devastating implications for the effective implementation of monetary policy.
Institutional aspects
And now, in the final part of my speech, I would like to look at some institutional aspects. To
allow a more detailed analysis of systemic risks and how to keep them in check, we need a
macroprudential framework in which various instruments can be combined to optimal effect.
What is the best way of achieving this? Firstly, it is essential to recognise that ensuring
financial stability as a whole is generally dependent on the decisions made by a range of
different bodies. These need to act together in order to ensure financial stability. To create
the necessary basis for a functioning macroprudential framework, the exact institutional
set-up of the regulatory authorities is of the utmost importance. First and foremost,
objectives, mandates and responsibilities need to be clearly defined. In Switzerland, for
instance, FINMA - the Financial Market Supervisory Authority - is responsible for the
regulation and supervision of individual banks. The SNB, on the other hand, is required to
contribute to financial stability. With regard to Switzerland's two big banks, there is a clear
overlap between institutional and systemic risks. In this context, an exact definition of the
responsibilities of the SNB and FINMA is of central importance for optimal macroprudential
supervision and regulation. The revised Memorandum of Understanding between the SNB
and FINMA is an important step in this direction. Secondly, to ensure that the institutions
involved can optimally carry out the roles assigned to them, it is also important to give them
the right tools. In concrete terms, this means that the SNB would, for example, need to have
more extensive information about the stability of financial institutions - regarding their risk
exposure, interdependences, etc. - or it would require specific instruments enabling it to take
the right decisions when implementing macroprudential policy.
Thirdly, the crisis made it clear that closer international cooperation between regulatory
authorities is vital. Functioning international coordination mechanisms are required to counter
future crises earlier and more effectively. International cooperation is the only way to check
undesirable developments on the globalised financial markets.
Conclusion
Ladies and gentlemen, the stable economic growth and low inflation of the last two decades
could not prevent the emergence of vast imbalances in the global financial system, as the
financial and economic crisis clearly showed. Such massive economic shocks are bound to
have an impact on how central banks work. Nevertheless, ensuring price stability remains
our top priority.
The crisis made it evident that central banks have an effective set of instruments that can be
used to mitigate the negative impact of financial crises. The unconventional measures used
in this regard also proved to be effective. Yet despite these measures, the cost of the crisis
remains enormous. One central conclusion, therefore, is that more attention needs to be paid
to crisis prevention in order to improve the stability of financial systems. However, monetary
policy instruments are only suitable up to a point in countering the emergence of financial
imbalances. Hence, a different approach is needed. Strengthening macroprudential
supervision and regulation is one plausible option. Macroprudential policy takes account of
systemic risks in the financial sector through action geared to reducing such risks. As yet,
however, we have little experience of this type of supervision and regulation. It is therefore
vital that we act prudently and gradually when implementing any new measures, and that we
give ourselves adequate time. The first step is to define clear and realistic mandates and
objectives and to evaluate possible instruments. Collaboration between the various
authorities involved - both nationally and internationally - is also of crucial importance.
Overall, we need to create conditions that allow the timely application of suitable instruments
to counter emergent financial instabilities. These instruments would essentially supplement
our set of existing monetary policy instruments. Within such a framework, the SNB would be
able to make an optimum contribution to both objectives - price stability and financial
stability.