Lucas Papademos: Price stability, financial stability and efficiency, and
monetary policy
Speech by Mr Lucas Papademos, Vice President of the European Central Bank, at the third
conference of the Monetary Stability Foundation on "Challenges to the financial system - ageing and
low growth", Frankfurt am Main, 7 July 2006.
The references for this speech can be found on the European Central Bank's website.
* * *
Ladies and gentlemen,
I. Introduction
Joseph Schumpeter, the Austrian economist, once made a justifiably famous statement:
"Im Geldwesen eines Volkes spiegelt sich alles, was dieses Volk will, tut, erleidet, ist; und zugleich
geht vom Geldwesen eines Volkes ein wesentlicher Einfluß auf sein Wirken und auf sein Schicksal
überhaupt aus."
["A nation's monetary order is a reflection of everything that a nation wants, does, suffers and is; and
at the same time a nation's monetary order has a considerable influence on the way it acts and on its
very fate."]
It is therefore highly appropriate that the foundation "Geld und Währung" devotes its 3rd conference to
the challenges which ageing and low growth pose to financial systems - since these challenges will
have a significant impact on the destiny of our peoples in the years and decades to come. Over the
past few weeks, however, I had the impression that everything that a "nation wants, does, suffers and
is" was a reflection of the performance of the national football team.
It is a great pleasure to be here and address such a distinguished audience. I should like to thank the
Foundation and the Deutsche Bundesbank for inviting me to this conference. The contributions
presented here over the past two days have shown that an efficient and stable financial system is an
important precondition for strong economic performance, particularly in ageing societies like ours.
Promoting financial efficiency and stability is therefore an eminently important task for public policy. As
you know, the mandate of the European Central Bank (ECB) is to maintain price stability in the euro
area. We do not have a similar direct responsibility for ensuring financial stability and efficiency.
However, we do have a very strong interest in these issues, for two reasons: first, because the Treaty
establishing the European Community assigns to the Eurosystem tasks related to the smooth
functioning of the euro area financial system, and second, because monetary policy and financial
efficiency and stability are closely linked. This is reflected in the Eurosystem Mission Statement which
states that we "aim to safeguard financial stability and promote European financial integration."
Let me define the three key concepts and policy objectives of price stability, financial stability and
financial efficiency. Price stability is defined as a state in which the general price level is literally stable
or the inflation rate is sufficiently low and stable, so that considerations concerning the nominal
dimension of transactions cease to be a pertinent factor for economic decisions. This general definition
is widely accepted, although there is some debate regarding the appropriate choice and composition
of the price index, the precise quantitative definition or operational target for price stability, and the
appropriate time horizon over which monetary policy should aim at preserving price stability. As you
are all aware, the ECB aims at a year-on-year increase in the HICP of below, but close to 2% over the
medium term.
Concerning the definitions of financial stability and financial efficiency, there is less clarity and
agreement. One useful way of describing financial stability is as a condition in which the financial
system - comprising of financial intermediaries, markets and market infrastructures - is capable to
withstand shocks and the unravelling of financial imbalances, and it is expected to do so for the
foreseeable future. Safeguarding financial stability, that is the resilience of a financial system to risks
and vulnerabilities, is important as it mitigates the likelihood that shocks to the financial system, or the
unravelling of financial imbalances, can lead to disruptions in the financial intermediation process
which are severe enough to significantly impair the allocation of savings to profitable investment
opportunities. Understood this way, the safeguarding of financial stability requires identifying the main
sources of risk and vulnerability; assessing whether the financial system is facilitating a smooth and
efficient reallocation of financial resources from savers to investors; and evaluating whether financial
risks are being appropriately priced and efficiently managed. This is because financial stability has a
forward looking dimension: inefficiencies in the allocation of capital or shortcomings in the pricing and
management of risk can, if they lay the foundations for vulnerabilities, compromise future financial
system stability and therefore economic stability. Consequently, monitoring financial stability with a
systemic perspective and in a comprehensive manner is of major importance. For this reason many
central banks around the world, including the ECB, are addressing their financial stability mandates in
part through the periodic issuing of a public report.
Financial efficiency can be defined as a condition in which the resources available in a financial
system are allocated to the most valuable investment opportunities, at the lowest possible cost. In an
efficient financial system, markets are competitive, information is accessible and widely disseminated,
and the conflicts between borrowers and lenders that arise from agency problems are effectively dealt
with through market contracts.1] In this way, financial efficiency contributes to minimising the wedge
between borrowing and lending rates, as well as the dispersion of risk-adjusted borrowing costs
across individuals.2 From this definition, it is obvious that reducing regulatory entry costs in financial
markets and, more generally, enhancing competition, transparency, innovation and financial market
integration will enhance financial efficiency.
financial stability financial efficiency
While and are different concepts, they are interrelated. Obviously,
a high degree of financial efficiency, in which resources are allocated efficiently from savers to
investors and where risks are appropriately priced and distributed, normally contributes to financial
stability. At the same time, stability is a precondition for a smooth and efficient functioning of the
financial system. However, while financial stability and financial efficiency are in principle
complementary, history has shown that there are also circumstances in which attempts to enhance the
efficiency of the financial system may undermine financial stability at least in the short term. The
converse may also be true, but I will address these issues in more detail later on.
The ECB has a special interest in a stable and efficient financial system: first, because the Treaty
explicitly requires the ECB, without prejudice to the overriding goal of price stability, to contribute to
(i)
financial stability and efficiency. The ECB is required to do this by promoting the smooth operation
of payment systems (Art. 105.2); (ii) by contributing to the smooth conduct of policies pursued by the
competent authorities relating to prudential supervision of credit institutions and the stability of the
financial system (Art. 105.5); and (iii) by acting in accordance with the principle of an open market
economy with free competition, favouring an efficient allocation of resources (Art. 105.1); and second,
because there are close complementarities between price stability on the one hand, and financial
efficiency and financial stability on the other.
For these reasons, the ECB devotes significant resources to studying financial market developments
and the conditions for financial stability and efficiency. This occurs in the context of the monetary and
economic analyses underlying monetary policy decisions and in the context of the Financial Stability
Review, in which the outlook for financial stability is regularly assessed. Moreover, the ECB's
initiatives to promote financial integration contribute, inter alia, to enhanced financial efficiency within
the euro area and the European Union.3
There is, however, a fundamental difference between the roles played by the ECB in the attainment of
these objectives: while the ECB has at its disposal the key instruments and powers needed to
maintain price stability over the medium term and therefore to fulfil this mandate, it does not have the
instruments and powers necessary to ensure financial stability and financial efficiency. The Treaty did
not assign the ECB any direct responsibility for the achievement of these two objectives. But, as I will
argue, we can contribute to their attainment in various ways, including through the maintenance of
price stability, which is an important pre-condition for financial stability and efficiency. I will now go on
to address the following three issues:
•
the contribution of monetary policy to financial stability and efficiency;
•
the implications of financial stability and efficiency for the effective conduct of monetary
policy; and
•
the role of regulatory and supervisory policies in safeguarding financial stability and
promoting financial efficiency.
II. The role of monetary policy
II.1 The contribution of price stability to financial stability and financial efficiency
Monetary policy, by delivering price stability, contributes to the efficient functioning of the real economy
and to economic growth and welfare through various means. First, it protects the real purchasing
power of money and households' real disposable income. Second, it enhances the proper functioning
of markets and eliminates uncertainty created by high and volatile inflation rates. Stable prices make it
easier for people to recognise changes in relative prices as these are not blurred by the general
upward drift of all prices. As a result, markets are better able to allocate resources to their most
efficient use. Third, price stability also facilitates long-term planning and contracting as people can
safely rely on money as a measure of value. This allows people to concentrate on productive activities
rather than on strategies to protect their wealth and income against inflation or deflation.
Another beneficial effect of the credible achievement of price stability, which has become more evident
and better understood in recent years, is the anchoring of inflation expectations to price stability, which
implies that temporary deviations of inflation from levels consistent with price stability are not expected
to be long-lasting. As a result, adverse supply shocks, such as an increase in oil prices, have a
reduced impact on inflation and economic activity and, at the same time, monetary policy has more
leeway to respond to such shocks. In fact, the reduction in the volatility of inflation and economic
activity observed since the mid-1990s can at least in part be attributed to the success in anchoring
inflation expectations.
By eliminating market distortions and uncertainties arising from inflation and anchoring inflation
expectations, price stability also contributes to financial stability and financial efficiency in various
ways. First, a direct efficiency-enhancing effect of price stability is the reduction of risk premia in
interest rates as a result of diminished uncertainty about future inflation and future policy rates.
Second, by improving the transparency of price movements in financial markets and anchoring
inflation expectations, price stability reduces the likelihood of misperceptions about possible future
asset returns.4 In turn, this lowers the risk of misalignments between asset prices and economic
fundamentals, which fosters both the stability and efficiency of financial markets. Third, by maintaining
price stability, monetary policy also allows banks and borrowers to avoid potential balance sheet
problems related to unexpected but persisting deflation.5 Such problems may arise because
unexpected deflation increases the real cost of debt-servicing, as well as the real value of the debt
burden, which may lead to an increased number of borrowers becoming unable to repay their debt,
ultimately resulting in financial instability. Finally, a monetary policy that is credibly geared to achieving
price stability also avoids creating moral hazard problems and, as a result, excessive risk taking, which
might arise if financial market participants expect that monetary policy will help cushion a potential fall
in asset prices or will "inflate the economy" in response to a financial crisis.
Transparency in the conduct of monetary policy is of particular importance in this respect. It not only
helps to avoid monetary policy surprises which might trigger inefficient and destabilising asset price
fluctuations, but also clarifies the conditionality of monetary policy to developments and shocks in the
context of its systematic behaviour aimed at preserving price stability. This is important for private
sector risk management and thus financial efficiency and stability. If the financial sector has a good
understanding of the strategy, analysis and "reaction function" of the central bank, it better
understands the conditional co-variances of short-term interest rates and major macroeconomic
variables. This, in turn, helps to improve the management of risk by economic agents, for example,
through the choice of the maturity of financing or the frequency of adjustment of lending rates. Thus,
the more predictable the monetary policy response is, the greater its contribution to financial efficiency
and financial stability.
However, it is important to stress that, while a credible monetary policy aimed at price stability is a
necessary condition for financial stability and financial efficiency, it is of course not a sufficient
condition for achieving these objectives. As I will discuss in more detail later on, it is the responsibility
and the objective of regulatory and supervisory authorities to safeguard financial stability and the
responsibility of finance ministries and competition authorities to foster financial efficiency. Financial
regulatory and supervisory powers could, in principle, also be assigned to the central bank. There is
an ongoing debate as to whether or not this should be the case. The main advantage of such an
approach would be the possible economies of scope arising from having monetary and supervisory
policies under the same roof. For example, the ready availability of supervisory information may help
to improve the conduct of monetary policy.6 On the other hand, the main disadvantages lie in potential
conflicts of interest arising from the conduct of monetary and supervisory policies at the same time.7 In
any case, the involvement of the central bank in banking supervision should under no circumstances
compromise its independence and the unambiguous focus of monetary policy on the pursuit of price
stability.
II. 2. The role of financial stability and efficiency for the conduct of monetary policy
So far, I have argued and explained that monetary policy, by preserving price stability, contributes to
financial stability and efficiency as a welcome side-effect. At the same time, the stability and efficiency
of a financial system have important implications for the conduct of monetary policy. Improvements in
the efficiency of the financial system increase the effectiveness of the transmission of the impact of the
policy rates on the broad range of interest rates and asset prices which are relevant for financing,
saving and investment decisions. There is some empirical evidence to suggest that, as a result of
increased deregulation, integration and innovation and therefore improved efficiency of the euro area
financial sectors, the pass-through of policy rates to bank lending rates in the euro area countries has
accelerated in recent years.8
Instability in the financial system may reduce the effectiveness of monetary policy. For example, in
case of severe financial instability, a reduction in policy rates may have weaker effects than under
normal conditions, because increasing risk premia prevent lending rates from falling, or because of
credit rationing arising from a general unwillingness on the part of banks to lend. In the worst case,
such a situation may ultimately lead to policy rates hitting the zero lower bound, if the monetary
authority's successive attempts to reduce the cost of credit do not succeed in improving credit market
conditions.
Some recent developments in the euro area financial systems should also mitigate potential funding
constraints in credit markets and thereby reduce their role in the transmission and amplification of
shocks. The rapid growth of the corporate bond market and securitisation issuances in the euro area
in recent years has helped enterprises and financial institutions to tap additional funding sources. As a
result, the importance of the so-called credit channel of monetary policy has been mitigated and
changes in the monetary policy stance are transmitted to the economy in a smoother and more
balanced way, thus reducing the role of inefficient allocative distortions in the transmission process
that may arise via the credit channel. More generally, improved funding possibilities strengthen the
resilience of the economy to shocks.
A higher degree of financial efficiency, resulting from the further development of capital markets, can
also contribute to the conduct of monetary policy by improving the availability and quality of
information that can be extracted from financial markets.9 For monetary policy, this means an
availability of financial indicators
increased which leads to better estimates of private sector
expectations and the improved assessment of uncertainties about future developments in real growth,
profits, inflation and interest rates. This additional information can enhance the formulation and
conduct of monetary policy. However, in order to properly extract financial market information, it is
necessary to have a good understanding of the determinants of the level and evolution of risk premia
in asset yields. For example, the difference between nominal bond yields and real yields of
inflationlinked bonds, known as the "break-even inflation rate", comprises the average rate of inflation
expected by the market over the maturity of the bonds and the premium investors demand for
incurring the inflation risk. Thus, in order to be able to extract investors' inflation expectations, we have
to estimate the inflation risk premium. For this reason, the empirical modelling of risk premia in
financial markets is an important and active area of research at the ECB and other central banks.
In sum, financial stability and efficiency matter for the conduct of monetary policy because the
abovementioned effects and signals have to be taken into account in the assessment of the monetary policy
stance. If this is the case, should financial stability and efficiency also have a bearing on the monetary
policy strategy, i.e. the general framework and guiding principles for the conduct of monetary policy?
This is an interesting and pertinent question. While I have argued that, in the long-run, there is no
trade-off between price stability and financial stability, there can be situations in which such a trade-off
arises over the short to medium term. In particular, a question that is often debated is how monetary
policy should react to perceived asset price misalignments or bubbles. Some of these misalignments
may imply risks to financial stability. A recently expressed view, supported in particular by analysis
presented by the Bank for International Settlements (BIS)10, is that a too narrow focus of monetary
policy on price stability in the short term might pose risks to price stability in the longer term, as the
potential consequences of financial instability for long-term price stability might be overlooked.
The ECB's monetary policy strategy is able to take such considerations into account. It is
unambiguously oriented towards maintaining price stability. The ECB does not therefore target asset
prices or some indicator of financial stability. At the same time, the ECB's monetary policy strategy,
with its medium-term orientation and important role for monetary analysis, allows monetary policy to
respond to the challenges that may arise from financial imbalances and instabilities within the existing
policy framework. The medium-term orientation of the ECB's monetary policy means that we do not
aim to keep inflation below, but close to 2% at every point in time, but rather over a medium-term
horizon. This allows us to take into account the longer-term implications of asset price bubbles and
financial imbalances for price stability. It also gives us the flexibility to accept, if necessary, short-term
deviations of inflation from the price stability objective in order to better ensure conditions for
mediumterm price stability in the event that growing financial imbalances - or bubbles - are expected to
jeopardise the macroeconomic outlook in the future. It is important to stress that such an approach
should be characterised by symmetry in the policy response in order to avoid creating moral hazard
problems. If market participants expected the central bank to respond only to the adverse effects of
unwinding financial imbalances and asset price crashes, the central bank would essentially hedge
investors' risk on the downside. The result would be a systematic under-pricing of risk, leading to an
increased likelihood of growing financial imbalances.
Another important feature of the ECB's monetary policy strategy which helps to address and mitigate
financial imbalances is the prominent role we assign to monetary analysis. Within the two-pillar
framework, monetary analysis serves to cross-check from a medium to long-term perspective the
assessment of price developments and inflation risks derived from economic analysis over a more
short to medium-term horizon. Historical experience has shown that costly asset price crashes have
often been preceded by asset price booms accompanied by brisk growth of credit and money.11
Recent research at the ECB also shows that broad money growth is a particularly useful indicator of
asset price booms which turned out to be particularly costly in their unwinding.12 Monetary analysis
thus helps to identify distortions and imbalances in the financial system and the implied potential risks
to long-term price stability in a timely manner. Furthermore, market expectations of the monetary
policy response to these long-term risks to price stability would most likely help to contain, and even
diminish, the evolving financial imbalances and thereby mitigate the vulnerability of the financial
system.
The above notwithstanding, it should be obvious from what has been said that monetary policy cannot,
and should not, attempt to target asset prices or respond to financial instabilities by "inflating the
economy". This would undermine the credibility of monetary policy and the predictability of a
systematic policy response in order to preserve price stability. Such a policy would ultimately
undermine financial stability and financial efficiency. There is, therefore, no conflict between the
conduct of a sound monetary policy focused on the preservation of price stability over the medium and
longer-term on the one hand and the safeguarding of financial stability and efficiency on the other
hand.
III. The role of regulatory and supervisory policies
The above conclusions on what monetary policy can and cannot do for financial stability emphasise
the important role of financial regulation and supervision. The financial sector is subject to more
regulation and supervision than other sectors of the economy, for a number of reasons.13 First, the
financial sector is special, because it is potentially more fragile than other sectors. The inter-temporal
nature of financial contracts relies strongly on credibility and trust; there can be mismatches between
the maturity of assets and liabilities of banks; the high degree of interlinkages between banks and
other financial institutions through asset markets and payment and settlement systems may all make
financial systems more prone to instability. This can have significant effects on real activity. Second,
there can be considerable asymmetry in the information available to the buyers and sellers of financial
services and the potential for losses of wealth can be such that individuals and firms may not be able
to absorb them. This can justify a higher level of regulation and consumer protection than is the case
in other sectors. Third, the essential role that finance plays in market economies has also led
governments in the past to intervene in the financial sector to pursue broader social objectives, for
instance to fight criminal activities through rules against money laundering.
For the purposes of my presentation, the potential of financial sector fragility is of primary interest. As I
noted earlier, financial stability is fostered through sound and appropriate regulatory and supervisory
policies. Regulatory policies - including requirements for capital adequacy and disclosure provisions
for financial institutions and effective risk management systems - can provide the basis for banks to
act in a manner which is conducive to fostering a stable financial system. These policies are - so to
speak - the "first line of defence" for stability. Through on- and off-side supervision, compliance with
regulations and the identification of emerging risks are checked further. The existence of deposit
insurance funds reduces the risk of bank depositor runs. In all of this, there is a micro-prudential focus
on the supervision of individual financial institutions.
The ECB does not have a direct role in regulation or micro-prudential supervision. Rather, our
activities in this area concentrate on providing advice and technical expertise to the competent
authorities at national and EU levels and on sharing our macro-prudential analysis and our
assessment regarding identifiable risks to financial stability and potential vulnerabilities within the
financial system.
As regards the efficiency of the financial system, the responsibility primarily lies with the main actors in
the financial system. Finance ministries and the competent national or European competition
authorities can provide incentives and adopt regulations to create an environment conducive to
financial efficiency, for example, by safeguarding a level playing field for effective competition and a
functioning single market in the financial sector across the EU.
I mentioned earlier, that financial stability and financial efficiency are inter-related, but in what manner
precisely? Intuitively, we would expect the two concepts, which reflect different aspects of the
performance of a financial system, to be positively related in the long run. For example, greater
efficiency in the banking system may underpin a better pricing of credit risk. This should, in turn,
reduce the probability that vulnerabilities might be building up over time, thus mitigating sources of
potential future instability. On the other hand, an unstable financial system is clearly detrimental to the
overall efficiency of the financial system in allocating savings to the most valuable investment
opportunities. That said, stability does not, of course, mean immutability or complete absence of
change and development, and, specifically, it should not be understood as implying zero tolerance
towards individual bank failures. Such a policy would create moral hazard problems and ultimately
undermine the efficiency of the financial system.
However, there may also be situations in which a trade-off could emerge between financial stability
and financial efficiency, at least in the short run. A pertinent example is provided by the banking
sectors of certain countries that were under tight public control in the past, at least partly for prudential
reasons, which were stable, but probably not very efficient in terms of cost control or funding of real
investment.14 To mention an extreme case, the Soviet banking system was certainly stable, but it was
not efficient. When excessive forms of regulation and control are abolished, the productive efficiency
of banks is likely to be enhanced. In the short run, however, such deregulation may undermine the
profitability of less competitive banks and therefore their resilience to shocks. The market process can
thus lead to the removal of inefficient banks to the benefit of the more efficient ones.
At the same time, abrupt and inadequately prepared or sequenced deregulation can lead to instability,
as financial institutions and markets may not be sufficiently prepared for the new environment. For
example, the phasing out of Regulation Q in the United States in the early 1980s increased the cost of
thrift institutions floating-rate liabilities relative to their fixed-rate assets and adversely affected
profitability and capitalisation in the industry. This development - combined with high and volatile
interest rates of the late 1970s and early 1980s - together with various other factors, played a very
important role in the savings and loan crisis of the late 1980s.15
The specific examples I mentioned are circumstances in which public policy can be confronted with a
trade-off, at least in the short term, between financial stability and financial efficiency. In the long run,
however, I would regard this trade-off as being a fallacy. The interactions between efficiency and
stability are complex, multi-faceted, and probably time-varying. A brief look at the academic literature
on the relationship between competition and stability in banking confirms this.
Survey studies on the relationship between banking competition and stability tend to find that both
theory and empirical evidence illustrate cases of complementarities between competition and stability
as well as cases of trade-offs. Some influential studies, however, may overstate the trade-offs.16 For
instance, one paper (using partial and general equilibrium models) shows that greater competition
sometimes increases instability.17 In other cases, when a model of bank contagion with imperfect
competition is used, banks are less susceptible to contagion under imperfect competition compared to
perfect competition.18 There appears to be no consensus among academics as to which form of
competitive structure may lead to the optimal combination of efficiency and stability in the system.19
So much for the theory, what does the available evidence tell us? It is equally mixed. Some
economists have found evidence that increased national banking concentration does not lead to more
instability.20 They argue that banking concentration measures are not a good proxy for the degree of
competition in banking markets when controlling for regulatory and other variables related to the
contestability of markets. More recent work shows that more competitive banking systems are less
prone to systemic crises.21
At the same time, the growth of larger institutions as a result of consolidation may also lead to "too big
to fail" dilemmas.22 Some research for the United States finds that return correlations between the
14
The recent studies by Guiso, Sapienza and Zingales (2005) and Bertrand, Schoar and Thesmar (forthcoming) provide some
evidence in this direction.
15
See Federal Deposit Insurance Corporation (1997) and Curry and Shibut (2000). The number of federally insured thrift
institutions declined by about 50% from 3,234 to 1,645 over the period 1986-1995. By the end of 1995, the crisis had cost
the US taxpayers USD 124 billion.
16
See Carletti and Hartmann (2003).
17
See Allen and Gale (2004).
18
This is because each bank reacts strategically as its own individual actions affect the price of liquidity. A bank can avoid its
own bankruptcy and contagion by providing adequate liquidity to the market.
19
See Northcott (2004). Another recent paper by Boyd and De Nicolo (2005) models both deposit and loan markets as a
contracting problem as opposed to just modelling one side of the banks balance sheet. The finding from this model suggests
that banks may rather become more risky as markets become more concentrated.
20
Beck et al. (2005).
21
Schaeck et al. (2006).
22
De Nicolo and Kwast (2002).
BIS Review 64/2006
securities prices