Svein Gjedrem: The macroprudential approach to financial stability
Keynote address by Mr Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), at the
conference entitled "Monetary Policy and Financial Stability", hosted by the Oesterreichische
Nationalbank (Austrian National Bank), Vienna, 12 May 2005.
Please note that the text below may differ slightly from the actual presentation.
The Charts in pdf-format can be found on the Norges Bank's website.
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Introduction
First of all I would like to thank the organisers for inviting me to this conference. It's a great pleasure to
be given the opportunity to share with you some views on financial stability issues.
Financial stability has become an increasingly important objective in economic policymaking during
recent decades.
In the 1980s, direct regulation of credit markets and capital flows was dismantled in many countries.
This has prepared the ground for an expansion of the financial system at a faster pace than other
parts of the economy. In this process, the financial system has gone through important structural
changes and become more complex. The instruments have become more intricate, the activities more
diversified and the risks more mobile. As a result of increasing cross-industry and cross-border
integration, financial systems have also become more interwoven, both nationally and internationally.
In parallel with the strong growth of the financial system, we have seen more frequent instances of
widespread financial distress. The resulting macroeconomic costs have often been sizeable. Financial
crises have typically been associated with boom and bust cycles in asset prices and credit. Due to
sharp growth in house prices and household debt in several countries in recent years, the question of
whether monetary policy should be used to mitigate such developments has received increased
attention.
In the light of these developments, I would like to address four main questions. What do we mean by
financial stability, how do we analyse it, how do authorities cooperate in order to support it, and finally,
what instruments are available to secure financial stability?
What do we mean by financial stability?
Despite increasing focus during the last decades, uncertainty about how best to define the concept
'financial stability' remains1.
In order for households and enterprises to obtain optimal consumption and investment over time there
has to exist a well-functioning financial system that can intermediate between savers and borrowers,
carry out payments and redistribute risk in a satisfactory manner. This promotes an efficient allocation
of real economic resources across different activities and over time. From this point of view, financial
stability can be defined as a situation where the financial system is able to meet these requirements,
and thereby enhance economic performance and wealth accumulation
A more narrow approach is to define financial stability in terms of what it is not, that is a situation in
which financial instability impairs the real economy. This definition is more passive in terms of implying
how one should act under normal circumstances, but has the advantage of focusing on the situations
we attempt to avoid.
The latter definition is related to the high costs of financial instability in the last few decades. Costs in
terms of loss of GDP can be substantial. A study of the economic costs of banking crises concluded
that even though such crises have been less frequent in high-income countries than in low-income
countries, they have persisted over a longer period and average total output losses have thus been
higher.2
The preferred definition of financial stability varies across countries. Recognising the need for a
relevant operational definition regardless of the current situation in the financial system, the Central
Bank of Norway has chosen to adopt the broad definition of financial stability.
How do the authorities analyse financial stability?
Given an understanding of what financial stability should imply, the authorities can analyse potential
threats to financial stability. There are two complementary approaches:
In the first approach, we need to focus on risk factors originating within the financial system.
Institutions, markets and infrastructures are continuously faced with risk factors such as credit, liquidity
and market risks. Analyses have become even more challenging in recent years as the financial
system has become more complex and interwoven both across industries and borders.
The increased complexity of the financial system is illustrated by the rapidly expanding market of credit
derivatives. This is a relatively new financial instrument that comes in many and complicated forms.
While contributing positively to greater flexibility in risk management, there is also the possibility that
risk is more easily concentrated, and that economic agents can take on risks without being fully aware
of their ramifications.
Analysing risk originating inside the financial system, it can be useful to divide the approach into two
areas.3 The microprudential analysis focuses on the developments within individual institutions, and
is concerned with limiting the distress of individual institutions, thereby protecting depositors. The
macroprudential analysis focuses on the financial system as a whole, and aims at limiting
system-wide distress and avoiding output costs. An important concept here is systemic risk; the risk
that liquidity or solvency problems in a bank may cause liquidity problems or insolvency in other
institutions. Thus, correlation and common exposures across institutions are important in the
macroprudential approach.
The second approach deals with risks originating from outside the financial system. This field has
increasingly been recognized by researchers and policymakers in later years. Strong growth in debt
and asset prices, as well as macroeconomic disturbances like a surge in commodity prices or the
unwinding of large imbalances in the world economy, can ultimately affect financial stability in a
negative way.
To identify potential sources of instability, we need indicators that contain useful information. With an
estimate of the equilibrium values of debt ratios or asset prices, for example, we can study the gap
between their current value and their equilibrium value.4 If the gap is wide, the danger of a significant
consolidation is present. However, the results must be interpreted carefully. Equilibrium values are
inherently difficult to determine, and it is not obvious that there is a stable and significant relationship
between gaps and future economic activity. In addition, decisive factors in the judgement of the
financial situation, like agents' confidence in the financial system, are also difficult to incorporate in the
analysis.
A related approach is to analyse the potential impact of adverse macroeconomic shocks on financial
stability. Stresstests are commonly used for this purpose. Such tests investigate banks' ability to
withstand different types of shocks under various economic conditions and with different monetary
policy responses. When conducting stresstests, macroeconomic models have proven to be valuable.
However, considerable work remains to be done in order to capture the behaviour of economic agents
in the case of extreme macroeconomic events.
Financial markets and institutions have become more interdependent. The possibility of contagion
across borders thereby increases.
Cross-border capital flows have increased considerably in recent decades. Equity markets have
moved more in tandem, particularly since the mid-1990s. This also applies to bond markets. Investors
are increasingly spreading their investments across countries. They are both diversifying risk and
seeking high returns. In parallel, governments, banks and companies are issuing more debt externally.
The corresponding development in financial institutions, towards an increasing share of large
cross-border banks, makes it essential to go beyond a purely national analytical focus. However, this
can be a difficult task, as cross-border banks are complex and often part of an even more complex
financial conglomerate.
Examples:

The Iceland-based Kaupthing Group is present in 10 countries and the group's total asset
holdings at the end of 2004 were almost twice the size of Iceland's GDP.

The Sweden-based Nordea Group has substantial market shares in all four Nordic countries.
While Nordea's home country is Sweden, Nordea has its largest market share in Finland.

The HSBC Group has 110 million customers world-wide.

Citigroup is present in about 100 countries and territories.
The central bank has a special responsibility for analysing and monitoring the financial system. The
examples of cross-border integration show how important it is to have a strong international focus in
financial stability analysis. Generally, the increasing range of analytical challenges has forced central
banks to be more innovative. This is reflected in the increasing number of financial stability reports
published world wide.
How do authorities cooperate in order to support financial stability?
Closely connected to the question of analytical focus, is the question of division of responsibility for
maintaining financial stability, both on a domestic level as well as between authorities in different
countries. The task of ensuring financial stability within a country is in most cases divided between the
ministry of finance, the central bank and a financial supervisory authority, with the ministry of finance
having the overall responsibility. To promote efficient cooperation, the regular exchange of information
between these authorities is crucial and some formal framework for cooperation should be
established.
The evolution towards larger cross-border banks makes the issue of responsibilities more complicated.
In the event of a crisis, central banks, supervisory authorities, political authorities as well as deposit
guarantee funds in several countries will be involved.
In contrast to the national banking crises in Norway, Finland and Sweden in the early 1990s, a similar
crisis today would most likely involve authorities from all four Nordic countries. Therefore, it is
important to establish guidelines in advance to ensure effective crisis management. A special
challenge will be to establish leadership. With four ministries of finance involved, the choice of
leadership will not be straightforward.
The traditional view is that the host-country authorities are responsible for subsidiary banks, while
home-country authorities are responsible for branches.5 This view is closely linked to the legal
difference between subsidiaries and branches. Subsidiaries are independent legal entities, while
branches are not legally independent from their parent bank.
However, host country authorities have little influence over foreign banks' crisis management. One of
the key issues is whether the home country authorities, in a crisis situation, should be obliged to take
into account the effects of the crisis in other countries where a bank has branches with extensive
activities.
There are arguments to suggest that home-country authorities should have more responsibility for host
banks also in a subsidiary bank structure. This would reduce the number of authorities that banks
have to relate to. It is also in line with developments in banking where an increasing number of
cross-border banks are organised as global firms with subsidiary structures under central
management.
The question of coordination is far from being solved. One possible way forward is to transfer some
responsibility to supranational institutions. As transfers of responsibilities imply transfer of control, this
solution is not a simple one in political terms. In the EU, the idea of a European supervisory authority
has so far met resistance. A fundamental problem - especially in the case of a financial crisis - is the
lack of a corresponding supranational fiscal institution. Today, any financial support must be granted
by national authorities. Without formal supranational solutions in place, it is all the more important to
ensure cooperation between the central banks and supervisory authorities involved. The fact that a
large share of the financial institutions in the new EU member countries are foreign-owned makes this
issue even more relevant.
In June 2003, the governors of the Nordic central banks signed an agreement on the management of
a potential financial crisis in a Nordic bank with activities in two or more Nordic countries. The
agreement contains procedures for the coordination of crisis management between the central banks.
The Nordic supervisory authorities have drawn up a similar cooperation agreement.
One particular problem in the Nordic region is the differences in the countries' deposit guarantee
schemes. The different schemes vary both with respect to guaranteed amount and type of deposit
covered. However, these differences are also widespread across Europe and some convergence of
rules and operating procedures is certainly long overdue.
What instruments are available to secure financial stability?
Monitoring and analysis of the financial system result in an assessment of the current situation
regarding financial stability. This leads to the question: what instruments are available to enforce and
secure financial stability? We can distinguish between preventive measures and measures for crisis
resolution. Of relevance to the latter is the role of the central bank as the lender of last resort. In some
countries this role was the main reason for establishing the central bank in the first place. Today it
remains an important task of central banks, but is reserved for very special situations where financial
stability may be threatened. In this address, I will focus on preventive measures.
As a general measure, the authorities use surveillance and regulation in order to enforce financial
stability.6 Surveillance of markets, institutions and infrastructure may in itself contribute to sound
financial risk management.
Effective and appropriate prudential regulation will reduce risks and promote sound financial
institutions. For instance, an important motivation behind the Basel II agreement is to increase the
efficiency of financial institutions by revising existing standards of capital requirements for banks.
Prudential regulation can also be used by the authorities as a special measure to curb undesirable
developments. Countercyclical variations in capital requirements (or collateral requirements) can
respond to potential imbalances. However, there are several arguments against using this instrument.
First, it is very difficult to decide the appropriate timing and size of a policy response. Also, while
authorities may regulate financial institutions, market outcomes are difficult to control. Risks may be
transferred through the market, away from the regulated institutions, only to show up somewhere else.
Financial agents need to operate on a level playing field. In many countries, branches and subsidiaries
of foreign banks have large market shares. If one country decides to increase the domestic capital
requirements for banks, this creates competitive distortions in the national markets between domestic
banks and branches of foreign banks, the latter complying with the regulation of their home country
authorities.
Clear and concise communication, verbally or in writing, from the authorities to the public on risk
factors they consider to be the most pressing could also be used as an instrument in the event of
rising financial imbalances. For central banks, a suitable arena could be financial stability reports, an
increasingly common publication. These reports can be described as a signalling device. However,
there are limits to how effective signalling and information can be in curbing financial imbalances.
Fiscal policy also contributes to financial stability, for example through a stable tax system built on
well-founded economic principles. Some have argued in favour of counter-cyclical changes in the tax
system, for example adjustments in tax deduction on interest rate expenses or property tax. However,
such changes can prove to be difficult to adopt and implement for institutional and political reasons.
Financial stability and monetary policy
In recent years, the relationship between monetary policy and financial stability has received increased
attention. Monetary and financial stability are two intermediate goals for public policy. In my view,
these goals are often mutually reinforcing.
Financial stability has a positive influence on price stability. First, it promotes a stable credit supply and
capital flow, which is crucial to balanced economic development. Second, financial stability supports
the transmission mechanisms of monetary policy. A stable financial system ensures that changes in
the monetary policy instrument have the intended effects on market rates. Hence changes in monetary
policy will affect the behaviour of consumers and enterprises and, eventually, inflation and economic
activity.
Moreover, price stability has a positive influence on financial stability. A successful monetary policy will
support financial stability by removing distorted price signals associated with high and volatile inflation.
Low and stable inflation provides households and enterprises with a clear indication of changes in
relative prices. Allocation of resources will then be more effective.
It is easy to identify situations where the objectives of price stability and financial stability imply the
same medicine. For instance, expansionary periods are often accompanied by stronger inflationary
pressures and asset price increases, both implying a need for tighter monetary policy. There are,
however, examples of situations where the consideration is more complex.
As the chart illustrates, surges in asset prices and a low and stable general price level of goods and
services can appear simultaneously. There can be several reasons for this.
First, a highly credible monetary policy results in low inflation expectations among economic agents.
Explicit or implicit long-term price and wage contracts can be more common. It may then take more
time for higher demand to translate into higher inflation. Asset prices on the other hand, will not be
constrained by expectations such as those for consumer prices and may well react strongly to
changing economic activity.
Second, periods of higher productivity growth may lay the basis for high corporate earnings,
heightened optimism and reduced risk awareness. At the same time, with strong productivity growth,
inflation remains low. Banks that record low losses and solid results can increase lending without
eroding their capital. Debt-financed investments may then lead to a faster rise in property prices.
Third, strong international competition may contribute to curbing inflation during a period of strong
economic expansion.
Given that a conflict between the two goals may arise; how are financial stability considerations
incorporated into monetary policy decisions?
There seems to be widespread agreement among central banks, that extreme events which could
threaten financial stability should be met by resolute use of monetary policy. For example, leading
central banks made an effort to ensure continued liquidity in the markets in the aftermath of the
terrorist attack on the World Trade Centre on September 11, 2001. As a consequence, the risks
confronting the financial system were limited.
However, risks to financial stability due to evolving financial imbalances are likely to develop over a
long period of time. From this perspective, the question of whether financial stability considerations
should be explicitly included in monetary policy is heavily debated, both in academia and within central
banks. The answers diverge and international consensus has not yet been reached.
One view is that an explicit and proactive monetary policy response to financial imbalances is neither
desirable nor feasible. A number of concerns have been raised to explain this view.
First, it is well documented that asset price bubbles and financial imbalances are very difficult to
identify ex ante. Second, the appropriate timing of a proactive monetary response is likely to be
difficult to determine, given the lags in the impact of monetary policy. Third, even in the case where the
central bank knew that financial imbalances were building up, the size of the interest rate rise needed
to reduce the imbalances might be so large that it could lead to a severe economic downturn.
A more general concern is the potential moral hazard risk of a systematic proactive response of
monetary policy to financial imbalances. For example, investors may "undervalue" the risks they take
on if they expect that the central bank will act to offset future financial instability concerns.
In later years, the idea of using monetary policy to prevent a build-up of financial imbalances has
received increased attention.
Several central banks can be seen as supporters of taking into account the impact of financial
imbalances on future output and inflation. The selected quotes on the chart are examples of the
attention given to financial imbalances in conducting monetary policy, based on slightly different
justifications. Mr. Bernanke's quote recognises the channel between the stock-market boom and
incipient inflationary pressures.7 Mr. Issing focuses attention on financial imbalances on the grounds
that strains in the financial system may conflict with price stability in the long run.8 Mr. Heikensten calls
attention to the possible repercussions of financial imbalances on the real economy in a situation
where the household debt burden is high and interest rates are increasing rapidly.9
Seen from an institutional perspective, flexible inflation targeting is becoming an increasingly common
monetary policy regime. With a target horizon that is forward-looking and sufficiently flexible, it is
possible to take into account the impact of potential financial imbalances on future inflation and output.
However, it is important to keep in mind that the unwinding of financial imbalances may lay many
years ahead, well outside the horizon for the inflation target. Some situations may require a careful
weighting of the probabilities and costs of not reaching the inflation target within a medium-term
horizon against possible economic turbulence further ahead. In the worst case, this turbulence may
result in the actuation of a financial crisis.
Another interpretation of the role of monetary policy is that it demands that financial instability is taken
into account beyond its impact on inflation and output. For instance, structural costs may arise as a
result of incorrect decisions by economic agents, based on incorrect information in the period
characterised by financial imbalances. The Reserve Bank Act in New Zealand explicitly states that the
Bank, in formulating and implementing monetary policy, should "have regard to the efficiency and
soundness of the financial system".
In Norway, a flexible inflation-targeting country, we have chosen to incorporate financial stability
considerations into the monetary policy decision process. This is partly because financial balances are
important for inflation and output and partly because this will secure sufficient attention to potential
risks to financial stability. In addition, departments dealing with financial stability gather structural and
empirical information about the financial system and the financial position of households and
enterprises. In my view, these are important inputs to the monetary policy process.
Challenges ahead
There has been substantial development in the way we think about financial stability. From viewing it
as a state merely distinguished by the absence of a financial crisis, we now see it as a state where the
financial system's favourable qualities are allowed to function in an efficient and proper manner.
At the same time, the financial system in itself has changed. Its instruments have become more
numerous and more sophisticated. Positive welfare effects are gained because of greater efficiency
and more opportunities in the market. The flip side of the coin is that increased complexity makes the
system less transparent and harder to follow.
This development is bound to influence the way authorities pay attention to financial stability issues.
New challenges have been brought to our attention, new questions have to be raised and new
scenarios have to be analysed. As a consequence, new solutions may be required.
We should use the opportunity to plan ahead now, while the outlook for financial stability
internationally is benign.