Stefan Ingves: The role of the central bank after the financial crisis - the
challenges ahead
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of the Basel
Committee on Banking Supervision, to the Swedish Economics Association, Stockholm,
12 June 2013.
* * *
The last five years have been an extraordinary period for the global economy, with crisis
management and major fluctuations in growth and economic development. For politicians
and authorities in many countries, it has been - and still is - a complex world that is hard to
navigate. Five years after the financial crisis broke out, many countries are still in the process
of cleaning up after it. It can be ascertained that financial crises are expensive,
timeconsuming processes, and that far too little has been done previously to prevent them from
occurring.
The financial crisis has made it clear that the monetary policy framework needs to be
developed so that it takes greater account of the importance of financial stability. While the
crisis was indeed not caused by monetary policy, a lesson nevertheless learned is that price
stability does not suffice to ensure financial stability and a stable development in the real
economy.
The financial crisis has also brought to light deficiencies in financial stability policy, in that
microprudential policy does not guarantee financial stability. Hence, financial stability policy
must also be developed. It needs a clearer mandate as well as tools for managing systemic
risks. In response to this, macroprudential policy is now emerging as a new policy area.
Finally, the financial crisis has shown that monetary policy and financial stability policy must
be coordinated to an even greater extent than before. There is thus a great international
consensus that the roles and responsibilities of the central banks and other authorities are in
need of review. Today, I intend to discuss how I view the future role of the Riksbank. I will
focus on the interaction between monetary policy and financial stability policy and the new
policy area macroprudential policy.
The central bank's tasks and objectives may come into conflict with each other
In most countries, the central bank has a responsibility for price stability, while at the same
time supporting a sustainable economic development. In practice, this involves stabilising
inflation and some measure of resource utilisation. In addition, the central banks usually have
a responsibility for financial stability.
This means that the central banks often face various conflicting objectives or trade-offs. For
instance, it can be a case of striking a balance between achieving the inflation target and a
sustainable level of resource utilisation when inflation and resource utilisation are moving in
different directions. When productivity increases, inflation usually falls while resource
utilisation rises. So, in the short term, it is not possible to simultaneously stabilise inflation
around its target, and resource utilisation around its sustainable or long-term level.
It can also be a trade-off between a stable financial system and a sustainable level of
resource utilisation. Overly stringent regulation normally leads to more expensive financial
services, which affects resource utilisation. The stringent regulation of financial markets in
the 1960s and 1970s gave us a relatively stable financial system, but at the expense of
efficiency. On the other hand, deregulation brought about developments on financial markets
which created a "seemingly efficient" system, but which gave rise to major risks to stability.
The development over recent years has shown just how closely interlinked the tasks of the
central banks are. For example, the emergence of a situation of financial instability also has
repercussions for both inflation and resource utilisation. This illustrates that it is not possible
to conduct monetary policy and financial stability policy completely separately.
Differences in time horizons give rise to trade-offs
We can also describe the central banks' conflicting objectives in terms of different time
horizons. For monetary policy, the time horizon is usually two to three years, which is
reasonable in light of how the business cycle usually varies. However, we know from
experience that financial imbalances and risks in the financial system are built up over a
much longer period of time, which can include several business cycles. These longer periods
are usually described in terms of so-called financial cycles. There is no established method
of measuring the financial cycle, but lending rates, credit terms and asset prices are common
indicators.1
So, the financial cycle has its up- and downturns just like the regular business cycle, but is
often more protracted. In the upward phase, obtaining financing is easy and cheap, while it is
harder and more expensive in the downward phase. Sometimes, the upturn in the financial
cycle results in a financial crisis, but not always.
The difference in the time horizon between the regular business cycle and the financial cycle
gives rise to conflicting objectives for the central bank. When the cycles head in different
directions, there may be a trade-off between price stability and resource utilisation in the
short term, and financial stability in the longer term.
If a financial crisis actually occurs it will of course have repercussions on both inflation and
resource utilization. The trade-off is particularly severe if the central bank only has the policy
rate at its disposal.
In the Swedish economy, we currently have a low inflation rate and relatively weak resource
utilisation, while at the same time credit volumes have been increasing relatively sharply for a
long time. There is therefore a trade-off between price stability and normal resource
utilisation in the short term, and financial stability in the slightly longer term. For a central
bank with only the policy rate at its disposal it is a case of balancing a poorer inflation and
resource utilisation outcome in the short term against uncertain but very severe outcomes in
the longer term. In such a situation, more expansive monetary policy can provide better
fulfilment of inflation and resource utilisation objectives in the short term. However, more
expansive monetary policy can also increase the risk of a financial crisis, and thus of very
severe outcomes in the longer term.
The way central banks work is changing
The financial crisis has led to a change in how central banks should approach the trade-off
between price stability and financial stability. Before the crisis, the general perception was
that the policy rate should be used to achieve price stability and to support the economic
development. If a crisis nevertheless occurred, cleaning up afterwards would be relatively
painless. With this approach, it was fairly simple to manage the trade-off between the
objectives of monetary policy in the short term, and risks to financial stability in the slightly
longer term, because the trade-off was negligible.
Recently, the pendulum has swung over to the view that monetary policy should lean against
the wind to a greater extent, and take greater account of financial stability.2 In the autumn of
2007, I took part in a panel debate in Jackson Hole, and indicated then that it is better to
attempt to prevent the risk of a financial crisis than to clean up afterwards. The main
argument as I see it - now as it was then - is that cleaning up is extremely costly and takes a
long time. Experiences in Sweden from the crisis of the 1990s are an example of just how
painful it can be. Because, reducing major debts often takes a long time, and during that time
possibilities of stimulating demand through monetary policy are limited. It doesn't matter
much if the debts are in the private sector, i.e. among households and companies, or in the
public sector. In both cases, a trend build-up of debt in relation to income is always
unsustainable in the long term.
A question is then how central banks more tangibly can lean against the wind. The policy
rate is a tool that can be used. We therefore need to develop the monetary policy framework
so that it takes greater account of financial stability. At the same time, financial stability policy
is changing, and a new policy area, macroprudential policy, is emerging which also aims to
lean against the wind. Hence, we are facing two changes in the areas of responsibility of
central banks, both of which create new possibilities to manage the trade-offs between price
stability, resource utilisation and financial stability. I will start to discuss monetary policy and
then move on to macroprudential policy.
The monetary policy framework is in need of review
As I have mentioned, monetary policy of the 1990s and up to the financial crisis was viewed
as successful by many. It was considered that this played an important role in both the
relatively low and stable inflation, and the relatively stable GDP growth during those years.
During the global financial crisis, it came to light, however, that major financial imbalances
had been built up despite the seeming stability of many macroeconomic indicators. An
important lesson from the financial crisis is therefore that low and stable inflation does not
always guarantee financial stability or sustainable economic growth.
The huge costs of the financial crisis to the real economy have led central banks around the
world to start thinking about the current monetary policy framework. The challenge ahead is
to create a framework which continues to safeguard stable prices, but which at the same
time is consistent with a sustainable development in the financial system. Financial
circumstances therefore need to be accounted for in the monetary policy decision-making.
Taking account of financial factors in monetary policy decisions
Different approaches can be used to formally take greater account of financial stability in
monetary policy decisions. For instance, how much a change in the policy rate affects the
probability of a financial crisis can be calculated. The trade-off is subsequently performed
between objective fulfilment in terms of inflation and resource utilisation during the forecast
period, and the risk of very poor objective fulfilment further ahead due to a financial crisis. A
consequence of this approach is that it has to be based on longer time horizons than
currently since the build-up of financial imbalances occurs over longer periods of
time. Norges Bank has chosen a different approach in which an explicit term is incorporated
into the loss function of the monetary authority. The purpose of this term is to capture that, in
addition to the price stability and sustainable resource utilisation targets, financial stability
should also be accounted for.
Whatever approach chosen, in order to give financial stability a greater role in the monetary
policy decisions, the use of financial variables as indicators in monetary policy
decisionmaking will increase.
Measuring financial stability is often difficult
To measure the extent of financial stability requires a broad approach which can often
resemble detective work. The stability report which we publish twice a year is an example of
the type of comprehensive analysis that is needed. It describes a series of indicators, for
example credit growth, risk premiums, and the development on various asset markets. From
this year, we have also introduced an annual report of our assessment of Sweden's financial
infrastructure. Taken together these indicators often give a good picture of the financial
situation. Hence, the extent of financial stability cannot be summarised in a single, simple
financial variable.
This type of measurement problem is in fact also apparent in the inflation rate and the
resource utilisation. The formal inflation target for the Riksbank is measured using CPI, but
we also use various measures of underlying inflation. In order to measure resource
utilisation, we look at a series of different measures such as the GDP gap, unemployment
gap and the employment gap. For inflation and resource utilisation, we have long learned to
use different measures even though we know they are inherently uncertain. Applying that
experience will be useful when it now comes to evaluating different measures of financial
stability.
Financial stability cannot be assessed by relying on various indicators alone, though. The
reasons for the development must also be understood. It can be compared to the reasoning
of central banks in assessing inflation. An increase in inflation does not in itself constitute a
reason for increasing the policy rate. Appropriate monetary policy depends on the reason for
the change. If the rise is due to price pressure from increased demand, the monetary policy
will not be the same as it would have been had the rise been due to lower productivity.
Similarly, rapid credit growth is not necessarily always a sign of lending being unsustainable
and posing a threat to financial stability.
A hot topic on that subject is how much house prices and the debt build-up of households
should weigh in monetary policy assessment. In general, central banks do not have targets
either for house prices or household debt. A rapid surge in house prices or rising lending
may, however, signal an imminent financial crisis which could affect future inflation and
resource utilisation. Hence, under certain circumstances, also taking account of house prices
and household indebtedness in monetary policy decisions is necessary. The extent to which
this should be done is, of course, a matter of judgement affected by several factors. For
instance, it depends on the other variables currently being taken into account, and the
shocks expected ahead. The housing market is also an important part of the monetary policy
transmission mechanism. The house prices thus also contribute important information about
which shocks are driving the economic development.
On the whole, I do not believe that the flexible inflation target policy conducted by the
Riksbank since the mid-1990s, with price stability as the overriding target, needs changing.
However, monetary policy must to a greater extent lean against the wind and take greater
account of financial stability.
Macroprudential policy provides financial stability policy with a new focus
The emergence of macroprudential policy as a new policy area involves a far-reaching
change in the preventive work of financial stability policy.3 Macroprudential policy is about
limiting systemic risks from a systemic perspective. It is about analysing the links between
the various agents in the financial system and the relationship over time between the
financial system and the macro economy. Macroprudential policy affects the resilience of the
financial system, but one (more or less pronounced) effect of this is also that lending rates
are affected, which is of consequence to the trade-off between price stability and financial
stability. To highlight this in more detail, I will provide a general picture of how I view
macroprudential policy. As a starting point, I will take the interest rate which households and
companies pay for loans ( ). Put rather simply, this can be defined as the central bank's
tilending
policy rate plus an interest rate margin ( ):

t
i  i  .
tlending t t
The interest rate margin depends on the banks' compensation for administrative expenses
and capital and funding costs, risk premiums and the banks' profit margin. Credit terms such
as the loan-to-value ratio and amortisation requirements are not directly visible in the interest
rate encountered by borrowers, but in order to illustrate their effect at an aggregate level,
they can be restated into interest rate terms. In order to obtain a simple formula, I therefore
include the credit terms in the "interest rate margin".
Interest rate margins and credit terms tend to vary over time with the financial cycle. When
the future outlook is bright and financial agents, households and companies alike are
optimistic, risk premiums are usually low, which leads to lower lending rates and generous
credit terms. This contributes to a rise in credit growth and asset prices. When outlook
deteriorates, banks' lending becomes riskier, or is at least perceived as such, which can be
noticed in higher risk premiums and tougher credit terms. The banks, quite simply, become
more restrictive in their lending in bad times and we will have a downturn in the financial
cycle.
So, why should central banks take account of fluctuations in interest rate margins and credit
terms? Well, because there is a series of so-called external effects associated with financial
activity which lead to the banks (and other financial agents) intensifying these fluctuations.
The majority of the external effects are due to the fact that the social costs of financial
instability are greater than the costs borne by the banks.
Put simply, financial stability can be equated to stable interest rate margins and credit terms
over time.4 In other words, interest rate margins which are not too low in good times or too
high in bad times, and credit terms which are not too generous in good times or too
restrictive in bad times. Lending and the building up buffers among both lenders and
borrowers then stabilises over time. I would like to emphasise that this is a highly simplified
description of financial stability, which to a certain extent disregards the structural aspects of
systemic risk such as resilience and risks in financial infrastructure on the one hand, and
such factors that trigger financial crises on the other. However, even the simplified picture
gives important insights.
The new tools being developed and the old tools which can be used for a new purpose are
crucial to the success of macroprudential policy. Allow me therefore to discuss
macroprudential policy tools and how they are intended to function.
Macroprudential policy tools and how they fit in with monetary policy
Typical macroprudential policy tools are capital and liquidity requirements chiefly focused on
banks and the supply of credit. However, it's also about measures to limit demand, such as
the mortgage cap, or the regulation of exposures and haircuts with the purpose of limiting the
contagion risk in the financial infrastructure. The various tools can be divided into static and
time-varying tools. Using my simple lending rate formula, I will illustrate how, in different
ways, these tools affect lending rates and credit terms. That is, after all, partly their purpose.
However, this also has consequences for monetary policy.
z
The static tools can be illustrated by adding a variable ( ) denoting how regulation affects
interest rate margins and credit terms in the simple definition of the lending rate:
i  i  (z) .
tlending t t
The primary purpose of static regulation is to adapt resilience according to the structural
factors which give rise to systemic risk, such as the size, concentration and degree of
maturity transformation of the banks. The introduction of static regulation involves a one-time
shift in the interest rate margin. Monetary policy may need to take account of this. Monetary
policy must naturally also take account of the extent to which the measure affects the risks of
financial instability ahead.
However, variations in the view of risk-taking and credit growth also involve variations in
systemic risk over time. A time-varying macroprudential policy tool is therefore also needed.
This is also a way of attempting to make the regulation slightly cheaper, i.e. managing the
balance between stability and efficiency. An example of time-varying regulation is the
countercyclical capital buffer. It aims to induce banks and other financial institutions to build
up capital buffers in good times, which they can then reduce in bad times. However, such
time-varying regulation also contributes to stability by increasing the costs of borrowing when
credit growth and other financial variables suggest that systemic risk has increased, and
reducing the interest rate margin in financial crisis situations when the buffer can be used.
We can illustrate the time-varying part by adding a time index also for the regulation
variable ( z ):
i  i  () z .
tlending t t t
If time-varying regulation is introduced, the variations of the interest rate margin will be
different over time, which can affect the monetary policy transmission mechanism. At the
same time, a central bank must, irrespective of macroprudential policy, understand how the
financial sector determines various financial prices in order to understand how monetary
policy affects the economy through the lending rate.
Credit markets are often not entirely homogeneous, but consist of several different segments
or sectors. The development within different sectors can vary tremendously. Although many
other factors affecting the lending rate and other credit terms are of an aggregate nature,
sector-specific factors are often important too. It is therefore important to have a
macroprudential policy tool focusing on individual sectors. This is not least important in
attempting to reduce the costs of leaning into the wind. If for instance lending to households
is weak while lending to companies is strong, and we only have a broad tool such as the
policy rate or the countercyclical capital requirements, it will be hard to achieve a policy rate
or interest rate margin which is optimal for both sectors. Sector-specific capital requirements
would enable increasing the interest rate margin only for the corporate sector, thus avoiding
a contraction for households. We can illustrate sector-specific tools by adding an index (S)
for sector-specific tools:
lending
i  i  ( z )
tS , t tS , tS ,
It might be assumed that macroprudential policy ought to reduce the need for monetary
policy to lean into the wind. This is true to a certain extent. Macroprudential policy is
important in offloading monetary policy. If the macroprudential policy tools can increase the
interest rate margin, the policy rate can be put at a lower level than would otherwise have
been possible without an increase in credit growth. Monetary policy can thereby stimulate a
faster economic recovery through other channels, like the exchange rate channel, without
risking the financial stability. However, in practice there is a limit to how much prices on
different credit markets can be affected through regulation, and how much lending rates can
thus diverge from the monetary policy rate. If the divergence is too wide, incentives to
circumvent the regulations are also great, i.e. conducting regulation arbitrage. Throughout
history, we have seen countless examples of regulation arbitrage undermining the efficiency
of financial regulation. This was the case in Sweden not least in the 1970s and 1980s, when
the combination of a loan cap and a negative real interest rate gave rise to great incentives
for regulation arbitrage, which led to the emergence of a "grey" credit market.
Macroprudential and microprudential policy also need to be coordinated
Macroprudential policy is also linked to other policy areas, not least to microprudential policy.
Unlike macroprudential policy, which focuses on stability in the financial system as a whole,
microprudential policy focuses on the stability of individual financial institutions and on
consumer protection. Decisions in microprudential and macroprudential policy thus differ;
they derive from different motives and are based on different types of analysis.
To a certain extent, however, the tools for microprudential and macroprudential policy can
complement each other. Microprudential policy establishes certain minimum requirements
aimed at ensuring that individual institutions are sufficiently resilient to the risks they
encounter. On top of these are then placed the macroprudential requirements, which aim to
counteract risks at systemic level and which can also be time-varying. Often, the same tools
are used for both purposes, and in this case it is fairly clear that the tools can complement
each other. However there are also situations where microprudential and macroprudential
policy can come into conflict with each other. A typical example is a financial crisis situation
in which a macroprudential policy authority wishes to reduce the capital buffers of banks in
order to stimulate lending while, from a microprudential perspective, it would instead be
desirable to see the banks strengthening their balance sheets with more equity. So, there is
a need to coordinate these policy areas too. Also, the knowledge about individual institutions
generated in microprudential supervision work is important to understanding risk build-up at
systemic level.
Wind strength is also affected by other policy areas
Not only is there a strong link between monetary and macroprudential policy and a need to
coordinate macroprudential and microprudential supervision - the need to lean against the
wind is also affected by other policy areas. Fiscal policy has a significant influence on
borrowing and lending incentives. However, other policy areas can also come into play, such
as housing policy when it comes to household indebtedness. There is thus a limit to what can
be achieved by macroprudential policy, or monetary policy for that matter, which depends on
other policy areas.
The opportunities and limitations of macroprudential policy - the example of the
Swedish household sector
I will now be much more specific about the opportunities and limitations of macroprudential
policy by focusing on a concrete example. By now, it is well known that, for a number of
years, the Riksbank has seen substantial risks associated with household indebtedness.
Also, a number of external experts have indicated the housing market and private
indebtedness as a risk factor.5 In other words, this matter is highly suited to the discussion
about what macroprudential supervision can and cannot do or, if you like, how
macroprudential policy can contribute to managing the trade-off between price stability and
financial stability we are facing.
The countercyclical capital requirement would have been activated
One way of illustrating the possibilities of macroprudential policy to limit the risks ensuing
from the debt build-up of the household sector is to consider how the countercyclical capital
requirement would have been used if it had been in place. This requirement involves the
banks building up an extra capital buffer when aggregate lending is high. In a crisis, the
banks are then able to use this buffer to stimulate lending. Although this tool is not yet in
place, we can assess fairly well how it would have been used historically, thanks to the fact
that the Basel Committee has provided guidelines regarding when it is appropriate to activate
the requirement. The most important indicator in this assessment is the credit gap, which is a
measure of how much credit growth deviates from its long-term trend. The reason for the
credit gap having gained a key role in the assessment is that it has proven to be the indicator
that warns of an impending crisis best and sufficiently early. A pure mechanical application of
the credit gap can provide a certain guide to when the capital requirement would have been
activated (see figure 1).6
Figure 1.
Time periods when countercyclical capital buffers should have been activated
based on historical measures of the credit gap (per cent).
3
2,5
2
1,5
1
0,5
0
81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11
Countercyclical buffer
Households
Non-financial corporations
Note: The calculations are based on a mechanical application of the credit gap approach.
We can see that the requirement would have been activated on two occasions. The first time
would have been a few years before the banking crisis of the 1990s, and the second time
around 2005, that is just before the global financial crisis. We can also see which lending
makes the credit gap grow by applying the approach separately to different sectors. The
driver of activation of the capital requirements in the 2000s is mainly the household sector.
So, during this period, the credit gap was not an early warning of the global financial crisis or
the recession in the Baltic countries. Instead, it warned of an unsustainable development in
Sweden, due primarily to credit growth in the Swedish household sector.
Targeted capital requirements and measures to strengthen the buffers of households
A number of measures have already been taken due to the increased indebtedness of
households. The Riksbank has taken account of the risks associated with household
indebtedness and the developments on the housing market in monetary policy.
Finansinspektionen recently decided to introduce a risk weight floor of 15 per cent for
Swedish mortgages, which can be seen as a sector-specific capital requirement. Measures
have also been taken more directly targeting the demand side of the mortgage market. In
October 2010, Finansinspektionen introduced a mortgage cap, restricting mortgaging a home
to a maximum of 85 per cent of its value. The Swedish Bankers' Association has also
established principles according to which new mortgages exceeding 75 per cent of the value
of the home should be amortised.
However, household indebtedness is still high in both a historical and an international
perspective, and more needs to be done. The 15 per cent risk weight floor is a welcome
initial step in partly compensating for the higher loan-to-value ratios of households in relation
to disposable income and lower amortisation levels, which could lead to high credit losses
ahead. In my opinion, however, risk weights for mortgages need to be raised even further.
Not least to better internalise the external effects associated with such lending - for example,
the risks to financial stability which may ensue from the drop in consumption of highly
indebted households in the event of a decline in house prices.
We also need measures which strengthen the buffers of households and contribute to
curbing credit growth in the household sector more permanently. It would be preferable if the
banks themselves took the responsibility for sounder lending practices. But, if this does not
happen soon enough, and forcefully enough, then the authorities must intervene.There are
many so-called quantitative regulations which can be used for this. The mortgage cap
introduced by Finansinspektionen can be adjusted, and limitations can be introduced on the
size of a loan in relation to the household's income. Another tool is introducing an
amortisation requirement, which directly reduces household indebtedness. I believe that, in
the current situation, separate amortisation requirements should be considered to
supplement the existing measures.
Stricter credit terms can also be achieved with so-called qualitative measures which affect
borrowing capacity. It would then be a matter of tightening banks' credit assessment
procedures, which can be done in several ways. For instance, a review can be performed of
the way the banks calculate borrowing capacity using discretionary income calculations, and
the scenarios a borrower can withstand. As part of their credit assessment procedures,
banks should also ensure that all mortgage customers can cope with amortising their
mortgages at a certain rate. One way of influencing amortisation behaviour could also be to
clearly inform customers about the long-term consequences of different rates of amortisation.
The government has commissioned Finansinspektionen to investigate the conditions for
placing requirements on banks to provide mortgage customers with tailored advice about
suitable rates of amortisation, which is a step in the right direction.
In terms of the possibilities of macroprudential policy, we can, with different types of capital
requirements, increase the banks' buffers and, with various supplementary measures,
increase the buffers of borrowers (households in this case). The higher buffer requirements
will affect the costs of borrowing, and could thus also contribute to curbing credit growth.
Because all of these measures ultimately affect the cost of borrowing in one way or another,
it might be appropriate to use a little of several tools rather than a lot of one, since different
tools affect various groups in society slightly differently. Also, the use of several tools can
reduce the possibilities of regulation arbitrage.
Macroprudential policy does not resolve the structural problems on the housing
market
It is important to empha