The new challenges facing central banks
Colegio de Ingenieros de Caminos
Luis M. Linde
Governor

Let me begin by thanking the School of Civil Engineering for inviting me to inaugurate this
cycle of meetings with regulatory agencies. Many thanks to the President of the School, its
Management Board and all of you for being here today.
The international financial crisis that began in 2007 has given rise to various changes and to
the emergence of new challenges. Central banks are, today, in a rather different and novel
situation compared with where we were before the crisis some 10 years back, and we are
affected by a debate about our functions in the economy and the thrust of our policies.
In the past decade central banks have increased monetary stimuli manifold and there have
been deep-seated changes in the monetary and regulatory policy objectives and
instruments implemented. We are now emerging from the crisis and this is raising even more
the profile of the debate on the role central banks should play and whether the policies
pursued in recent years should be maintained, or progressively abandoned, and at what
speed and to what extent either alternative should be taken.
The challenges facing central banks can be grouped in three areas:

first, what is being labelled as the "new normal" in the macroeconomy and its
implications for monetary policy;

second, the challenge for financial regulation policies;

and third, the new challenges posed by financial innovation and the new technologies.
The impact of the crisis on monetary policy
But before addressing these challenges, I think it might be useful to take a short step back
to remember where we have come from. We can only understand today's challenges if we
bear in mind the changes, often far-reaching, that have come about in central banks in
response to the crisis.
The global financial crisis came about following a build-up of bubbles in the advanced
economies, mainly in the financial and real estate sectors, a process to which easy financing
conditions proved conducive in a setting in which risks were not appropriately priced.
In any event, what was surprising was the intensity and global nature of the crisis that broke
in 2008. Given highly integrated financial markets and complex interconnections, instability
spread rapidly, leading to the most serious financial crisis since the Second World War. In
the European Union the crisis was, moreover, exacerbated by a double-dip recession, which
has prolonged the recovery period and has also revealed the weakness of the euro area's
institutional framework.
The crisis also left the monetary and regulatory policy "manual" that central banks had been
applying in tatters.
Pre-crisis, monetary policy in the advanced economies was essentially defined by inflation
targets and a key instrument, the interest rate. In parallel, the goal of financial stability was
chiefly addressed with microprudential regulation and supervision. This framework was
broadly consistent with the goal of economic growth, given that the control of inflation was
estimated to be the best means for ensuring the economy drew closer to its potential
growth.
The crisis showed that this framework was no longer valid. The control of inflation, though
it remains a necessary condition, is not sufficient to ensure growth; and microprudential
regulation was no longer effective, in or of itself, for guaranteeing financial stability.
As a result, central banks have adapted their policies, which are now more complex in terms
of objectives and instruments.
Monetary policy has had to face up to the problem of what is known as the "zero bound"
on interest rates. Basically, this is the situation that Keynes coined the "liquidity trap":
interest rates close to zero cease to be an effective monetary policy instrument. This has
led to the development of new instruments, so-called "unconventional monetary policy",
which mainly includes quantitative easing, private and public-sector financial asset
purchases, and the explanation and signalling of the monetary policy to be applied in the
future, namely "forward guidance".
The outcome has been a large increase - four- or fivefold - in the balance sheet of the main
economies' central banks. In the case of the Eurosystem, the ECB balance sheet accounted
for 12% of euro area GDP before the crisis and now stands at approximately 40%, around
€4.4 trillion.
Supervisory policy, for its part, has had to face the challenge of macrofinancial instability in
a context of highly interconnected markets at the global level. In this area, the response has
been three-pronged.
First, the strengthening of microprudential regulation, with the new Basel III Accord, which
includes greater capital requirements and a stricter framework for systemically important
financial institutions. Second, the development of a new instrument, macroprudential policy,
which addresses systemic risk and the procyclical behaviour of the financial system as a
whole. And, third, the greater international coordination of regulation, which is necessary
given the reality of globalised financial markets. Notable in terms of coordination has been
the creation of the Financial Stability Board and, in the case of the European Union, the
activation of the Banking Union, beginning with the SSM and the Single Resolution
Mechanism.
The new monetary policy
I shall now turn to the challenges central banks face. The first is, evidently, identifying what
is understood by the "new normal".
One question on which economic policy discussions are focusing is whether the advanced
economies are in a new situation of secular stagnation, a "new normal" characterised by
low growth, low inflation and low interest rates.
We are seeing how, despite lower unemployment rates and the closing of the gap between
potential and real output, inflation rates remain persistently low. A series of factors can
account for this behaviour. Some are transitory, such as the insufficient increase in
employment, or the impact of deleveraging processes in some economies. But there are
also factors of a more structural nature, including the effect of globalisation and
technological progress, or demographic factors.
In any event, it should be stressed that there are other policies apart from monetary policy.
In particular, both fiscal policy and structural reforms have a key role to play in supporting
demand, boosting real interest rates and raising productivity and potential growth.
Regarding monetary policy, the central question is this: to what extent should the
macroeconomy of the "new normal" lead to a new "conventional model" for monetary
policy? In particular, it is considered whether the management of the central bank's balance
sheet will become entrenched as a permanent part of the normal instruments of monetary
policy. Estimates, while subject to major uncertainty, suggest that real interest rates and
inflation will remain at low levels, meaning that nominal rates will also be low, thereby limiting
their effectiveness as a monetary policy instrument.
Against this background, central banks are likely to retain the use of unconventional
monetary policies. Analysis of these policies is leading to debate, as yet inconclusive, on
their effectiveness, the optimal size of central bank balance sheets and on the impact that
they might have in terms of financial stability and the medium- and long-term fiscal situation.
True, as the recovery gains momentum, and provided this translates into a sustained
adjustment by inflation towards its target, the need for monetary policy to support the
economy will tend to diminish. The US Federal Reserve has already begun to reduce its
balance sheet at a gradual and predictable pace, and the ECB has slowed the pace of
increase of its own balance sheet. This reduction in stimuli will extend the monetary policy
headroom for acting effectively in the face of possible future crises.
The monetary policy normalisation strategy can but be slow and will tend to be applied
predictably, with close scrutiny of its impact both on economic growth and inflation and on
financial stability.
It is worth recalling that, in 2013, the markets rather hastily interpreted some statements by
the Federal Reserve, the clarification or correction of which gave rise to a bout of turbulence,
owing to the different forecasts as to the speed at which expansionary monetary policy
would be abandoned or softened. That episode provided a lesson for all central banks that
have applied unconventional policies, in two respects: monetary policy should be corrected
very slowly, and the correction should be predictable to the markets. In sum, predictability
and a clear communication strategy will be important in preventing adverse market
reactions.
Financial regulation and supervision
The second area I would like to mention concerns the challenges in financial regulation and
supervision. As I said, the crisis has led to an overhaul of financial regulation, centred on
three main areas: the strengthening of microprudential regulation; the development of
macroprudential regulation; and the stepping-up of international coordination.
These new regulations provide a scenario of greater security for the financial sector. If we
have learned anything in recent years it is that there is always a risk of another crisis. But I
believe we are now better prepared. The new regulations impose greater capital
requirements on financial institutions and stricter supervision, including new instruments for
the early identification of financial risks.
The main challenge for regulatory policy is now to fully implement the reforms approved and
to closely monitor their impact on the financial sector, and, where appropriate, to calibrate
the new regulatory framework. Along with this general challenge, I would highlight two
elements that will have a bearing on regulatory policy management.
Firstly, the interrelatedness of monetary and macroprudential policy. Generally, both policies
can be complementary. But, as the years of expansion prior to the financial crisis
demonstrated, the economy's cyclical position and the accumulation of financial risks may
become decoupled. Financial imbalances thus built up, and yet inflation was contained and
the real economy appeared to show no signs of overheating.
Central banks will have to have both policies strike a balance in order to achieve the dual
objective of economic and financial stability. Here it is important to have an institutional
structure that ensures synergies and consistency between monetary and prudential policies.
The second conditioning factor is the fact that globalised financial markets are a reality,
which requires a permanent international coordination effort in the management of financial
policies. Coordination is needed to tackle contagion across different markets in jurisdictions
and, also, to prevent regulation being distorted by means of regulatory arbitrage, or the
competitive lowering of regulatory standards across jurisdictions.
Fora such as the Financial Stability Board, the Basel Committee and the European Single
Supervisory and Resolution Mechanisms have gained in importance. A third pillar, the
European Deposit Insurance Scheme, has still to be defined and remains the subject of
political negotiations.
The challenges of financial and technological innovation
Finally, I shall refer to the challenges posed by financial and technological innovation.
Since the year 2000 we have witnessed a proliferation of technological changes that are
reshaping the global economy. This started with the Internet, which was only incipient at the
turn of the century, followed by electronic trade, mobile phones, artificial intelligence and
big data. Technology is introducing new types of services and products, and is challenging
the traditional commercial models in all economic sectors.
In the case of the financial system, there is considerable scope for improving the efficiency
and quality of services through the application of new technological processes. We are
seeing how new technologies are being incorporated into traditional functions, for instance
in how payments are made, in the automated management of risk pricing and in financial
consultancy.
The financial sector is adapting to this new reality. Traditional banks are taking the new
technologies on board, occasionally through strategic alliances with new technology firms.
New companies are also being incorporated into the sector, ranging from small start-ups to
large firms. The new firms must, however, win the confidence of consumers and investors,
something that traditional financial institutions have secured over a long period of time,
anchored by strong regulation and financial supervision.
From the standpoint of the regulators, the fintech challenge affects both prudential and
consumer protection policies.
From the prudential perspective, regulators must strike a balance between catalysing
innovation and the efficiency that new technologies can provide, and maintaining a sound
regulatory framework. The guiding principle should be to apply the same regulation for the
same type of financial services. In this respect, as the presence of fintech increases, it might
be useful to put greater emphasis on the regulation of services, instead of placing it on the
institutions that provide these services.
Turning to consumer protection policies, it is vital that investors and consumers should
understand how the new services function and the attendant risks, including, for example,
credit, cyber-security and privacy-protection risks. Here we should strengthen our
information and financial education policies.
We are mindful at the Banco de España of the need to step up our efforts in this area.
Indeed, last week we approved a reform whereby, under our Directorate General
Operations, Markets and Payment Systems, a new Associate Directorate General Financial
Innovation and Market Infrastructures was created to assume the competencies in these
areas, centralising in this new structure the functions previously assigned to different units
in the Bank.
This Associate Directorate General will have to face two families of problems.
First, the questions that arise with the emergence of new agents and new operators in the
financial markets, providing services that already existed (but in a different way), or services
that did not exist, namely new types of financial services. As regards these new market
players, two groups of problems are posed: on one hand, those referring to matters of
competencies, i.e. all agents and operators should be subject to the same demands or
regulations; on the other, investors and consumers should be protected and alerted as to
the new risks, just as they are in respect of the former operators and their products.
The second family of matters which the new Associate Directorate General of the Banco de
España must face concerns new technology and its application in financial markets,
something which, in these times of continuous innovation, is obviously of great importance.
Thank you for your attention.