José De Gregorio: Financial stability, monetary policy and central
banking
Introductory speech by Mr José De Gregorio, Governor of the Central Bank of Chile, to the
12th annual conference of the Central Bank of Chile "Financial stability, monetary policy and
central banking", Santiago, 6 November 2008.
* * *
Welcome to this 12th Conference of the Central Bank of Chile, entitled Financial Stability,
Monetary Policy and Central
Banking, which will gather a select group of central bankers,
experts and academics today and tomorrow.
I cannot open this conference without sending my most heartfelt condolences to Klaus
Schmidt-Hebbel, our former director of Economic Research and creator of this series of
conferences, and to all his family, on behalf of the Central Bank of Chile and myself, for the
terrible loss of his beloved son Diego. To him we dedicate these two days' work.
Like every year since 1997, we are looking forward to two days of intensive work with
discussions of the highest technical level, which usually have opened areas for us to develop
our research agenda with rigor and relevance, in an ever more complex world.
This version of our Annual Conference finds us in the midst of severe global financial crisis.
After the Asian crisis, many of us wondered about where the next blow would come from and
what shape it would take.
The academic literature has analyzed foreign exchange and financial crises in small, open
economies. First there were the first-generation fiscal and currency crises, which gave way to
second-generation crises such as the one endured by the European monetary system in the
early 1990s, and finally to third-generation ones occurring in Asia. All of them featured a
variety of origins and transmission mechanisms.
Now we are facing an international financial episode that many concur in labeling as the
worst since the Great Depression, which originated in the developed economies, particularly
the United States. Its initial symptoms are known: rapid financial innovation, credit expansion
and asset price bubble. Its progression and repercussions, however, are unprecedented.
On the other hand, our better understanding of the distortions that bad macroeconomic and
financial policies can trigger, has made emerging economies in general, and Chile in
particular, build a strong position to deal with a very weak international scenario. There is no
better moment than this to get together and exchange our visions and opinions, and draw the
first lessons from the events unfolding in the world economy.
I want to begin with some comments on the present crisis. This episode has several
unprecedented aspects stemming mainly from the complexity and sophistication of financial
institutions and instruments, in a context of high financial and trade globalization.
Of course, some elements have been observed before, such as the loss of confidence in key
financial institutions by investors and the general public, and the uncertainty regarding its
duration.
As we all know, this crisis started little over a year ago, with the end of the real estate boom
in developed economies, which would end up exposing both the weakness and the excesses
of the subprime mortgage loans. However, and as was apparent in the subsequent
developments, the problem went far beyond lending to agents with low payment capacity.
Overall, an asset price bubble, particularly in the housing sector, fueled by an accelerated
credit expansion has proven to be a dreadful combination. Maybe bubbles cannot be made
to disappear, but the integrity of the financial system must be preserved and requires
continuous monitoring.
The collapse of Lehman Brothers can be considered a landmark event that took the financial
markets from a period of turmoil to a major crisis. In fact, after the downfall of this investment
bank, commercial banks in developed economies, regardless of size, began fearing that their
counterparts might go broke and stopped lending to each other, which nearly dried up an
already precarious interbank market. Every fragility indicator in this market, and stock
exchanges around the world, reflected the onset of a confidence crisis.
Whether or not it was a prudent decision to let Lehman Brothers go bust will be argued over
for years to come, an institution whose fragility was common knowledge since early this year.
Probably some bet on a Bear-Sterns-type rescue, a clear example of moral hazard. Maybe it
should have been intervened months ago. But anyway, had Lehman been salvaged, one
cannot be sure that other systemically important institutions would not have followed. Would
a 750 billion dollar package been approved without the collapse of Lehman? If Lehman had
been thrown the lifeboat, would such a large package have been necessary? There will be
plenty time to discuss this and other issues. However, there is a very straightforward
conclusion, which is that policymakers should have been aware of the magnitude and
consequences of the downfall of a major financial institution. This is at the core of this
conference: evaluating systemic risks in a very complex world. Such a complexity offers big
benefits, but also poses enormous challenges in regulation, monitoring and risk assessment.
In the future, it will also be necessary to discuss what to do about weak institutions. As has
happened in Chile in the past and is now happening in developed economies, in my opinion
the balance is tilted towards allocating the losses to shareholders and executives, intervening
institutions to ensure good use of public funds and preserving financial discipline.
In the past few years we have accumulated a lot of experience, which permits us to be
certain that asset price drops and credit market difficulties can impose a large burden on the
economy if ignored. Investors have lost confidence in the ability of certain firms to meet their
obligations, complicating access to the capital market and short-term financing, and thus
accelerating the fall in those firms' stock prices. Here, the role of central banks as liquidity
provider is essential to ensure the proper functioning of the financial system, and this is one
of the main lessons we learned from the mistakes made during the Great Depression that
wrecked havoc in the real sector, which could have been substantially reduced.
We have also learned that sound regulations designed for normal times and as crisis
preventing mechanisms are not necessarily the best for moments of great stress or turmoil,
including mark-to-market practices in some segments of the financial industry.
It would be premature to draw definitive lessons from the present crisis that is still in the
making and going through the damage-control phase. A new wave of discussions on the
international financial architecture will come. And although this happens every time there is a
world crisis, progress to date has been rather timid.
Nonetheless, the potential liquidity constraints that economies outside the epicenter of the
crises may suffer, may add an unnecessary burden to countries that had little or nothing to
do with today's events and at the same time are the basis to sustain growth in the world. In
synchrony with this, the new liquidity swap facility that is being offered by the IMF is very
appropriate. It should be disbursed quickly as current conditions require. In the present
circumstances, countries that have saved their terms-of-trade windfalls and enjoy a solid
international liquidity position, as is the case of our country, should not have the need to
apply for these facilities.
Once the emergency is over, the present international financial architecture will have to be
examined carefully, in terms of its extreme dependence on the decisions of more advanced
countries, its governance and its surveillance role, particularly in the financial system. The
World Economic
IMF has made great progress with the Outlook, which had already warned
about the real-estate bubble and global imbalances, and the Global Financial Stability
Report. These efforts must now be redoubled.
From the standpoint of central banks, recent events have underscored not only their role in
monetary policy, but also their important function in the stability of the financial system. In
this context, research on issues related with financial stability has been dramatically
intensified. Clearly, there are varied degrees of consensus regarding how to characterize a
good financial policy framework, how to measure it, achieve it and preserve it, as well as its
possible tradeoffs with monetary policy.
This conference seeks to contribute the study and analysis of these topics, as well as
cooperating in our management, as policymakers, of financial stability and associated
macrofinancial risk.
Today, our work will focus on defining the concepts of financial stability and systemic risk,
and on understanding the conceptual frameworks that support their evaluation and the links
with and feedback from monetary policy.
Garry Schinasi will open the day, introducing what we must understand by financial stability
and examining the implications and challenges of understanding systemic risk. Claudio Borio
will explore the operational aspects and the precautions we must take regarding the
methodologies we use to measure systemic risk. Dale Gray will handle the third presentation,
integrating the idea of financial risk - by using options - with macroeconomic models
focusing on monetary policy analysis, then applying the tools to the particular case of Chile
based on his joint research with Leonardo Luna and Jorge Restrepo. Johan Molin will share
with us the experience of the Sveriges Riksbank, which has led financial stability analysis
since the problems it endured in the early 1990s.
This afternoon, Francis Diebold will analyze, for the financial markets of the United States
and four Latin American economies, stock returns and volatilities to look for evidence of
contagion and its characteristics. Charles Goodhart, Dimitrios Tsomocos and Alexandros
Vardoulakis will present us the study of a heterogeneous agent model with a real-estate
sector and financial fragility. Later on, Ethan Cohen-Cole and Enrique Martínez-García will
present their research on the interaction of financial intermediation and banking system
regulations and its effect on the optimal monetary policy response.
Tomorrow will begin with the presentation of Jaime Ruiz Tagle and Marcelo Fuenzalida, who
will examine, for the case of Chile, the systemic risk of household debt. Miguel Segoviano
will follow, with a review of systemic risk and banking stability from a macroeconomic
perspective.
Then comes a presentation by Jaime Caruana, who will draw some lessons from the recent
crisis and the international financial integration. In the afternoon we will feature Sujit Kapadia
and Prasanna Gai with an analysis of financial contagion using a network model. In addition,
there will be two panels that will review financial risk management with two important
nuances: its incidence in emerging economies on one hand, and on systemically significant
financial institutions, on the other. The economists invited to these panels include Michael
Bordo, Paul McCulley, Martín Redrado, José Darío Uribe, Martin Wolf and Roberto Zahler.
Finally, Charles Calomiris will share with us his vision on the current crisis and the
implications of the works presented in this conference.
Two intense days that hold in store enormous technical content that, without any doubt, will
make a fundamental contribution to our future view of macroeconomic and financial
phenomena.
I want to finish by thanking Rodrigo Alfaro, Dale Gray and Jorge Selaive for their work in
putting together this conference. Also Mauricio Calani, Mónica Correa and Soledad Gallardo,
and our Institutional Affairs Management for their help in organizing this event.
I also want to thank the many authors and discussants of the papers for their dedication to
preparing their valuable presentations. To all of you, dear participants, I wish you two days of
fruitful discussion. Thank you.