Jaime Caruana: Concluding remarks - conference on "Central Banks in the
21st Century"
Speech by Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel Committee
on Banking Supervision, at the conference on "Central Banks in the 21st Century", hosted by the Bank
of Spain, Madrid, 9 June 2006.
* * *
It is my pleasure to participate in this concluding session of the conference and to be accompanied at
this table by Pedro Solbes. I hope you found the presentations and discussions inspiring and
motivating. I certainly did. We are now witnessing some profound changes in the way our societies
organise their economic relationships, and these naturally pose new challenges to central banks,
regarding both their role of monetary policymakers and their responsibility to preserve and foster safer
and more efficient financial systems.
Over the last two days we have discussed some of the underlying forces of change and their
implications for the design of sound monetary policy and financial architecture, including the question
of how best to arrange payment and security settlement systems. Let me briefly elaborate on some of
the issues raised at the conference which I found particularly interesting. I will first reflect on the
difficult question of how monetary and financial stability relate to each other and then move to some
particular issues of special interest for a currency area, such as Economic and Monetary Union (EMU).
Monetary and financial stability
The global financial system has developed at an unprecedented pace in the last two or three decades.
During this time, many countries have undergone significant processes of financial liberalisation that
have contributed to deeper and wider markets, in terms of both the number of participants and the
assets traded on them. In the international sphere, financial liberalisation has led to a growing number
of countries gaining access to global capital markets and to a stepping up of the economic and
financial links among different regions. Technological progress has also played an important role. The
ability of market participants to obtain and process vast amounts of information almost instantaneously
and to conduct complex transactions at low cost has grown enormously.
In short, all these changes have significantly increased the possibilities for risk-sharing among
economic agents. And, as such, there is ample consensus that this process of financial deepening
brings tangible benefits for businesses, households and governments alike. There is little doubt either
that this phenomenon will continue its course over the foreseeable future.
In parallel to the changes on the financial landscape, we have also witnessed a remarkable
performance by our monetary policy frameworks in terms of attaining and maintaining low and stable
inflation, with noticeable effects on economic welfare. I believe that those achievements are largely
permanent. I further consider that, as stressed by Alan Blinder in the introduction to his insightful
paper, the debate over some of the core principles for sound monetary policy practice seems to be
resolved for now. For example, there is currently substantial agreement, both among academics and
monetary authorities, on the need to provide central banks with sufficient formal and effective
institutional independence, the superiority of interest-rate operational targets over quantitative
instruments, and the pursuit of low inflation as the main objective for monetary policy.
Both trends - towards deeper and more integrated financial markets, at one end, and towards
monetary policies clearly determined to deliver price stability, at the other - are important factors
behind the sound macroeconomic performance recorded practically worldwide over the last decade.
Notwithstanding this positive view on the recent past, central banks must deploy their best efforts
improving their monetary policy and regulatory and supervisory arrangements - to preserve and
consolidate the attainments I mentioned, since various significant risks and challenges lie ahead. As
stressed by Frederic Mishkin, the final success of the processes of financial liberalisation and
globalisation in developing economies hinges crucially on the ability of both policymakers and the
private sector to properly respond to a rapidly changing environment. No doubt, the spirit of this
proposition applies likewise to developed countries.
An increasingly liberalised and globalised financial system necessitates a reconsideration of some key
inputs in our current monetary strategies. The greater relevance of markets and their evolving nature
requires an ongoing assessment of the different monetary policy transmission mechanisms. This area,
while critical to successful monetary policy decision-making, still remains shrouded in considerable
uncertainty. Undoubtedly, the emergence of new financial assets and financial intermediaries poses
fresh questions here.
Furthermore, the magnitude of the financial funds flowing across different countries at the present time
and the uncertainty surrounding the sustainability and the possible effects of an eventual correction of
the so-called global imbalances means that central banks worldwide must take a much broader and
complex set of indicators into consideration when formulating their policies. Moreover, we are probably
at a juncture that can be best described as one of "Knightian uncertainty", in that some of the risks we
are facing, and the hypothetical consequences following their realisation, are essentially
immeasurable. Consequently, good monetary policymaking requires not only a continuous
reassessment of market conditions and expectations, but also forecasts and projections flexible
enough to encompass a wide set of scenarios.
I share the view set out yesterday by Jean-Claude Trichet that a sound communication strategy takes
on special importance in the current environment, as well. Anchoring expectations about future
inflation is a valuable asset, and especially at times of financial and real turbulence. Fluent
communication with market participants and the general public is also of great help in preserving
credibility, especially when circumstances lead to relatively persistent temporary departures from what
is sometimes called a "neutral" monetary policy stance, as some of our central banks have faced in
recent times, or when specific factors push inflation rates above what the monetary authorities
normally consider as satisfactory.
Moreover, alignment of market expectations with the central bank's own targets, through fluent and
transparent communication, allows monetary policy to exert a stronger influence along the entire yield
curve. Yet notice that this latter channel becomes most relevant if central bankers approach markets
from the sort of leadership position emphasised by Professor Blinder. I agree with him on this
important point: central bankers should continuously monitor markets and should extract from them as
much information as possible. But they must not put themselves under the thumb of what is
sometimes capricious and short-sighted market sentiment.
In any event, one of the most robust lessons we can extract from the recent period of global monetary
and output growth stability is that low inflation may well be consistent with episodes of high financial
volatility. Cases of financial stress have been recorded both in industrialised and in emerging market
economies over the last few years without noticeable inflationary pressure. Even in countries whose
financial system has proved more resilient, financial cycles have become wider and more volatile.
Indeed, a long period of monetary stability coupled with low interest rates, as has been the case for
some years now, may arguably be conducive to certain types of imbalances in asset markets. In such
an environment the poor returns on low-risk investments and the softening of lending standards may
lead investors to take on increasingly riskier projects. As economic agents underestimate the total
risks of their positions, the volume of investment in financial -and, in some cases, also real estate-
markets rises at a strong pace, and with it, asset prices and the overall level of credit, perhaps, with
both being further fuelled through the feedback mechanism operating between collateral value and
credit capacity. In that situation, there is a risk that a sharp asset price reversal might have a sizeable
impact on the stability of the whole system. Therefore, an otherwise beneficial context of price stability
and low financing costs might sometimes sow the seeds for the emergence of financial imbalances.
This latter, somewhat ironic conclusion has spurred a recent debate on the role to be assigned to
monetary policy as an instrument of use in correcting financial and real estate market excesses.
Should central banks react to asset prices over and above their direct effects on purely monetary
goals, such as inflation? The answers vary depending mainly on the confidence that one places in the
ability of central banks to detect price misalignments early and to undo them without causing major
damage to the economy.
I tend to think that while in normal conditions monetary policy should react only to changes in
economic variables insofar as they bear some influence on inflation dynamics, there are exceptional
circumstances in which policymakers have enough signals to conclude that the economy, as a whole,
is facing significant risks, thus warranting a more pre-emptive policy approach. This pragmatic view is
consistent with the idea that monetary policy decisions should be based not only on the most likely
scenarios but also on other, less probable ones which, however, may have far-reaching implications
for the entire system should they materialise. Certainly, an abrupt asset price correction pertains to
this class of low-probability event that may ultimately entail significant costs for a country's welfare.
More importantly, to place this approach to monetary policy in its right place, it is critical to recognise
that some of the risks inherent in the financial sphere should first be the subject of an appropriate
prudential framework. It is no exaggeration to say that any concern about unbalanced market
developments is, at core, a concern about a problem of inappropriate risk management. This
statement applies to the case in which, due to over-optimism or short-sighted behaviour, market
participants fail to appreciate the true risk of their investment or lending strategies. Yet even if their
behaviour can be thought as being fully rational from an individual perspective, nothing ensures that
the final outcome will not convey important risks at a systemic level that are not properly internalised
by single agents. As a result, a portion of the marked volatility and procyclicality of some key financial
variables, like asset prices and credit, may be understood as a reflection of individual and collective
risk misjudgement.
Hence, there is much to be gained in terms of greater resilience and efficiency of the financial system
through the design of regulatory and supervisory frameworks aimed at combating the factors that
underlie a poor assessment of risks at their root. In this sense, a sound prudential framework should
provide financial institutions with the right incentives to properly assess and monitor the risks of their
investment and lending policies, incorporating them accordingly into their pricing decisions. Increased
awareness of risks, and how these evolve along the business cycle, favours earlier reactions to
changing conditions and smoother adjustments in the flow of credit, thus reducing the likelihood of
episodes of abrupt liquidity and credit contraction.
The New Capital Accord, known as Basel II, is an example of a prudential framework that makes the
foregoing principles I have outlined its centrepiece, since it seeks to strengthen the stability of the
international banking system by promoting the implementation of more robust and comprehensive risk
management practices. It does so mainly by establishing a more precise and sensitive system to link
banks' real risks and the minimum regulatory capital requirements, and by imposing higher levels of
transparency in banks' financial reporting, hence fostering closer scrutiny by market participants.
A more risk-sensitive capital framework tends to make banks more watchful of the actual risks of
lending policies focused on short-run targets, such as market share or portfolio size, which presumably
are important ingredients in periods of credit booms sustaining speculative activities. Furthermore,
greater transparency in the information provided by banks on their balance-sheet and risk position
must help alleviate the informational asymmetries among shareholders, lenders and borrowers that
arguably lie behind most episodes of financial distress.
Yet despite the recent advances in the design of a banking supranational prudential framework, much
remains to be done, especially with regard to other financial institutions and markets. From my
personal experience as governor of a central bank with supervisory and regulatory responsibilities,
member of the Governing Council of the European Central Bank (ECB) and member of the Basel
Committee on Banking Supervision, I strongly believe that there is much merit in central banks playing
an active role in the pursuit of prudential policies that rightly respond to the challenges posed by the
current process of intense financial deepening. I would agree that one specific institutional model is
unlikely to fit all. Moreover, the operational separation between prudential and monetary policies
should in any event be preserved. However, it is in the general interest of societies to take advantage
of the institutional strength and the valuable information and analytical expertise held by most central
banks in order to safeguard the soundness of financial systems.
Reflections on challenges in EMU
The challenges faced by a central bank are certainly not smaller if it has to conduct a single monetary
policy for a multinational currency area.
We have seen that in the new economic and financial landscape, central banks should explore ways
to fully internalise the close links between financial and macroeconomic stability. The Eurosystem is
well suited to take into account the existing synergies. The Treaty itself establishes price stability as a
primary objective while at the same time calling on the European System of Central Banks to
contribute to the smooth conduct of prudential policies and the proper operation of payment systems.
Nonetheless, central bank policies must deal with a heterogeneous economic scenario where national
economies retain distinctive features both in terms of exposure to specific shocks and as a
consequence of the different functioning of domestic policies and allocation mechanisms. Moreover,
while markets are increasingly integrated there are still frictions impeding sufficiently flexible flows of
products, capital and labour. Even in the financial services area, and although progress in developing
the single market is already evident, some transactions involving agents in several euro zone
countries are still penalised in comparison with purely domestic operations.
Against this background, the Eurosystem has had to face the challenges posed by economic
heterogeneity and imperfect integration in two ways. Firstly, by complementing the monitoring of
eurowide aggregate variables with the analysis of relevant national developments in order to identify the
policy that best helps ensure price stability in the euro area as a whole. Secondly, by promoting a
better integration of markets, particularly financial markets, in the euro area.
Regarding this latter issue, the role of payment systems is crucial. As we have heard this morning, the
Eurosystem is making a significant contribution by developing a wholesale payment system, known as
TARGET2, which will provide for safer and more efficient large-value payment flows within the euro
area. I would agree that more has to be done by the competent authorities to achieve higher
integration for retail payments and securities transactions. However, the Eurosystem, together with the
European Commission, is actively supporting the Single Euro Payments Area initiative and has
devoted much effort to promoting more efficient and safer securities settlement systems and to
facilitating the cross-border use of collateral.
In any event, I have the impression that in years to come the Eurosystem will have to strengthen
further both aspects of its policy approach. As EMU is not likely to become a much more homogenous
area in the foreseeable future, the need might be felt to pay more attention to key national economic
developments on the basis of the contribution by the National Central Banks, therefore making more
intensive use of the federal organisation of the European monetary authority. My feeling is that
country-specific analysis is proving increasingly informative for fully understanding the situation,
prospects and policy needs of the euro area as a whole.
Similarly, I would not be surprised if the ECB were to find it appropriate in the future to raise its profile
somewhat in defending a more integrated and liberalised market for financial services in Europe.
Conclusions
In sum, our economies are now experiencing some important changes, both with regard to how goods
and services are produced and traded, and the possibilities that agents face to organise their
economic decisions over time. Most of the underlying forces causing these changes must be judged
per
as largely beneficial se. Yet as occurs with any new situation, we face much uncertainty that
requires a comprehensive learning effort. As central bankers, we have learnt that price stability should
be deemed as a highly valuable but insufficient achievement to promote financial stability. We have
also gained some understanding as to why this is so, and, hence, on the need to take some steps
towards making the goals of monetary and financial stability compatible and sustainable. Admittedly,
our knowledge is still scarce in some important areas. However, as the interaction between the two
objectives is becoming more pronounced, the role of central banks is probably more complex but also
more relevant.