Luis M Linde: The changing role of central banks
Speech by Mr Luis M Linde, Governor of the Bank of Spain, at the 4th Future of Banking
Summit, organised by Economist Conferences, Paris, 26 February 2013.
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Ladies and Gentlemen,
It is an honour, and a pleasure, to address such a distinguished audience as is gathering
today in this conference. I would like to thank The Economist for giving me the opportunity to
analyse some of the changes affecting central banks policies.
I will organize my talk around the two main areas of Central Banking: monetary policy and
banking regulation.
Firstly, I will address the changing role of central banks in monetary policy, before the crisis
and after the crisis.
Up until August 2007 - before the global financial crisis -, the general mood prevailing
among academics and policymakers was that there existed a well-defined, so to say,
"science or model of monetary policy". There was a kind of consensus among central
bankers about most elements of monetary policy strategy; and monetary policy was
perceived as being highly successful in developed countries, with low inflation and low
variability of inflation and output.
According to this consensus, macroeconomic stability was achieved through rule-based
monetary policy, delegated to an independent central bank with an implicit or explicit inflation
target and with very little role for discretionary fiscal policy.
Conducting monetary policy was considered to be relatively straightforward: the central bank
controlled the short-term interest rate with effects on the real economy, mainly through three
channels: long-term interest rates, inflation expectations and asset prices.
The credit channel of monetary policy was deemed weak; and the banking sector was
ignored by most macroeconomic models used in Central Banks: banks were believed to work
well and most market failures were attributed to product and factor markets.
Financial markets were assumed to be efficient at distributing and pricing risk. Financial
innovation was welcomed as it promoted gains in efficiency and welfare, leaving a reduced
role for central banks on this area.
One of the main implications of this consensus was that price stability was considered to be
sufficient for macroeconomic stability. This led most Central Banks to limit themselves to a
predominantly micro-prudential approach to regulation and supervision, focused mainly on
the soundness of individual institutions. There was a certain neglect of the importance of the
stability of the system as a whole.
After the crisis
In 2007, and especially after September 2008, the world was hit by a global financial crisis
which not only produced the most severe worldwide economic contraction since the Great
Depression, but also put into question our confidence on the "science of monetary policy".
It is probably still premature to identify the new model that will emerge from the crisis. It is
clear that some of the old beliefs will remain more or less intact: for instance, the idea that
fiscal policy is limited as a stabilization tool.
There are, however, two areas where I see more changes.
First, the conduct of monetary policy, through the implementation of non-conventional
monetary policies; and, second, the monitoring of the efficiency of financial markets and the
banking sector, and their interaction with macroeconomic stability. Let me comment on these
two issues.
Non-conventional monetary policies
At the outset of the crisis, all central banks reacted using conventional monetary policies.
First, they reduced interest rates in a rather aggressive way to prevent the disinflationary
process from translating into deflation. The outcome of these decisions is that official rates in
the main developed economies (Euro area, United States, Japan and United Kingdom) stand
now at values very close to zero.
At the same time, faced with the freeze of interbank markets, the main central banks,
including the Fed and the ECB, had to take on, directly, the task of redistributing liquidity. In
the early stages, the Fed and the ECB provided a generous monetary base to meet the
gross needs of banks. The ECB used its flexible array of financial instruments, while the Fed
was forced to adapt its operational framework to introduce new forms of intervention.
However, when the crisis worsened after the Lehman Brothers crisis, it became necessary to
take stronger action. This required the use of new, non-conventional, monetary policy
measures.
According to the academic literature, when interest rates are close to zero, non-conventional
monetary policy may come in three different forms: first, management of agents expectations
through a commitment by central banks to keep interest rates low for a long period of time;
second, increasing the balance sheet of the central bank; and, third, changing the
composition of assets in the balance sheet of the central bank.
The FED, the Bank of Japan and the Bank of Canada, have made use of the first kind of
instruments aimed at managing expectations. Therefore, they have made announcements
about the future path of interest rates to affect the agents' expectations about long-term
rates.
However, the non-conventional monetary policies more widely used since 2008 have been of
the second and third kind, that is, the ones affecting the size and composition of the central
bank's balance sheet.
In the euro area, the ECB changed its liquidity tenders to a fixed-rate system, with unlimited
amount. In order to remove uncertainty, it increased their maturity up to three years. It also
set up a program to purchase covered bonds and introduced the Securities Market Program
and the Outright Market Transactions Program to ensure proper transmission of monetary
policy during the shocks of the sovereign debt crisis. The Securities Market Program was not
a quantitative easing instrument, since purchases were later sterilized. In the US, by
contrast, the Fed's asset purchases reached a significant scale with the successive rounds of
quantitative easing, aiming at lowering the cost of financing over the whole of the yield curve.
These divergences in the use of non-conventional tools reflected not only the specific
characteristics of the respective financial systems - the banks predominant role in the euro
area compared with a greater importance of capital markets in Anglo Saxon countries - but
also the institutional framework and the differing perceptions and assessments of the risks
that may be assumed by central banks.
Thus, I would say that the Euro system's response has been more complex, adapting itself to
the difficulties that have arisen at the different stages of the euro area crisis, seeking to act
on the segments of the transmission monetary policy mechanism that were seen to be most
impaired. On the other hand, the US strategy involved some blurring of the boundary which
separates monetary policy from fiscal and financial stability policies. This entailed risks for
the monetary authority's independence that the ECB, as the central bank of 17 countries with
full sovereignty in other non-monetary policy areas, could not assume.
In short, the financial crisis compelled central banks to adopt, along with robust monetary
policy responses, exceptional measures and an unprecedented expansion in their balance
sheets. Their joint, coordinated action stopped the dangerous spiral of financial deterioration
and economic contraction in which the world economy found itself at the end of 2008 and in
the first few months of 2009.
However, whatever the changes in implementation, there is one main principle that remains.
I refer to the belief that monetary policy - conventional or not - cannot solve the ultimate
causes behind the loss in investors' confidence or the tensions in financial or banking
markets. In fact, its main role is to provide time to adopt the necessary measures to reform
and/or adjust.
Macroprudential policy
The other area in which I see more changes for the role of central banks is in the oversight of
efficiency of financial markets and their interaction with macroeconomic stability.
One of the main lessons of the crisis is that price stability, without financial stability, does not
guarantee macroeconomic stability. Therefore, there is an emerging consensus on the need
to develop a specific new area of economic policy, with a preventive focus and the explicit
objective of ensuring the stability of the financial system as a whole. This has been named
"macroprudential policy" and together with monetary policy, is bound to become one of the
main elements in the policy set in the foreseeable future.
Macroprudential policy is articulated around two dimensions.
The first one, looks at how risk is distributed in the financial system at a given point in time. It
requires instruments that impose tighter standards for individual institutions whose
contribution to system-wide risk is larger, the so called Global Systemically Important
Financial Institutions (G-SiFis), whose list was last updated by the Financial Stability Board
(FSB) in November 2012.
The second one, looks at how aggregate risk evolves over time. This requires the use of
instruments that contribute to moderate the typical pro-cyclicality of the financial system. I will
come to that later on, when commenting on the new Basel III capital framework.
Before this, allow me to mention the Spanish experience with the so-called "dynamic" or
"statistical provisions" which were introduced in 2000. This can be considered a pioneering
case of a macroprudential response. The tool proved to be useful in Spain during the
financial crisis in the two dimensions identified earlier: mitigating the build-up of risks - even
if to a limited extent - and providing capacity of loss absorption to the banks. But the Spanish
experience also showed that "dynamic provisions", although, in my opinion, well targeted and
designed, should have been complemented with other instruments.
In order to develop and implement this new policy, the main developed economies have
created new authorities in charge of macro-prudential supervision, such as the Financial
Stability Oversight Council in the United States or the Bank of England's Financial Policy
Committee. In France, in December 2012, the Government approved a draft Law on the
reform of the banking sector that, among other things, envisages the establishment of an
equivalent authority, the "Conseil de la Stabilité Finacière" (CSF). At the Bank of Spain we
are also currently looking at the way a Spanish Macroprudential Authority should be set up.
Changes in bank regulation
Ladies and Gentlemen, I would like to turn now to the changes that have occurred in the
regulatory field
The crisis we are still going through was triggered, on the one hand, by the extraordinary
loose monetary and financial conditions - and the expansion of credit - of the period
between 2000 and 2007. On the other hand, inadequate rules - result of two decades of
deregulation, and sometimes bad deregulation - compounded the problem and facilitated
high leverage.
The Basel capital ratios of the time were low or, in some cases, not applied. There was
excessive reliance on internal bank models. The way VaR models were defined by Basel and
applied by banks underestimated what we call tail risks, that is, risks associated to events
with low probability of occurrence but extremely high cost.
Therefore, there was a need for a regulatory response after the crisis. Since the main
elements of this response are well known, I will limit myself to a few remarks.
First, the response took a predictable pattern: the strengthening of capital requirements, both
as regards levels and quality of capital. Basel III is first of all about this.
Second, as already mentioned, the crisis highlighted the need to introduce a macroprudential
perspective in financial regulation. The new counter-cyclical capital buffer in Basel III is an
important step in this direction. However, the implementation of this instrument will not be
easy. The right time for its activation will be difficult to determine and there is uncertainty on
the appropriate size of the buffer.
Third, another important element of the new regulation is the introduction of a new leverage
ratio. The result is that two different approaches, one risk-weighted based and the other one
non risk-weighted, will coexist under the roof of Basel III. This, I believe, introduces some
tension in the regulation.
Fourth, it is worth noting that, while Basel III brings in convergence in the numerator of
capital ratios - which is a positive development - improvements will be needed in the
calculation of its denominator. Available evidence - that is now being considered by the
Basel Committee - points to differences in the measurement of risk weighted assets across
jurisdictions, which are not always easy to justify on the basis of differences in the nature of
risks.
And, fifth, Basel III introduces liquidity standards aimed at addressing the deficiencies in
liquidity risk management that became evident during the crisis. Even though maturity
transformation is indeed intrinsic to banking activity, an excessive mismatch between assets
and liabilities increases the vulnerability of banks to negative liquidity shocks. However, this
is the first global regulation of liquidity, and our experience in this area is limited.
Recovery and resolution frameworks
The last component of this regulatory overhaul is the treatment of the systemic institutions.
Much attention has been paid to the capital surcharge that will be imposed, as mentioned
earlier, on the so-called Global Systemically Important Banks. However, key to dealing with
problems posed by systemic - and non-systemic - banks will be the setting up of effective
recovery and resolution frameworks as recommended by the Financial Stability Board (FSB).
In this connection, let me note that Spain has just established a new resolution regime,
strengthening the powers of our resolution agency, the Fund for Orderly Bank Restructuring
(FROB), which was set up in 2009.
Are further measures needed?
Summing up, on the whole, capital requirements have been considerably strengthened. The
largest banks, for instance, will have to hold at least seven times as much capital as before
the crisis. These measures have undoubtedly strengthened the whole banking system.
However, it is to be noted, and regretted to some extent, that while Basel III capital
requirements had been carefully planned to be implemented gradually until 2019, markets
and, in some cases, regulators have accelerated this process. In Europe, banks are
generally already recording ratios of Common Equity Tier 1 of 9%. Banks have achieved this
not only by raising capital in the markets but also by contracting credit and deleveraging. This
raises a concern about the impact the regulatory "overhaul" may be having on credit and
growth.
At the same time, however, we are engaging in the discussion of a possible "structural
reform" of the banking sector which might come on top of all the regulatory changes.
It is argued that the measures adopted so far do not deal with the risky trading activities of
banks profiting from financing with favorable conditions on the basis of the implicit subsidy
associated to deposit insurance. These concerns have led to different responses worldwide,
such as the Volcker rule in the United States, the proposals of Sir John Vickers in the United
Kingdom and, more recently, the draft banking reforms in France and in Germany. At the
European Union level, a high-level group chaired by my colleague Erkki Liikanen has
prepared a report on the convenience of implementing structural reforms in Europe.
The most relevant proposal of the Liikanen report is to separate into a distinct legal entity
risky trading activities of banks where such activities are significant. However, the two
entities - the retail bank and the trading bank - may form part of the same banking group,
hence preserving the universal banking model.
I believe that this proposal is well oriented, as it addresses an issue that is not tackled by the
current regulation, although its effectiveness will depend on the details of its implementation.
There might be scope for improving or further specifying some technical aspects of the
proposal. For instance, a distinction should be introduced between "proprietary trading" and
"market making" in line, by the way, with the draft banking sector reform that is being
currently discussed in France.
Concluding remarks
Ladies and Gentlemen, let me conclude.
Central Banks have played a crucial role in the economic and political response to the
financial crisis of 2007/2008. Their use of new and non-conventional tools was decisive to
control the financial deterioration and economic contraction that the world was confronting at
the beginning of 2009. In so doing, central banks have moved away, to a certain extent, from
the old monetary policy model. It might be said that a new one is emerging where central
banks will use two sets of policies - monetary and macroprudential policies - to ensure a
broadly defined financial stability objective.
Thank you very much for your attention.