Christian Noyer: Central banks in the financial crisis - a European
perspective
Speech by Mr Christian Noyer, Governor of the Bank of France and Chairman of the Board
of Directors of the Bank for International Settlements, at the Bank of Korea International
Conference, Seoul, 1 June 2010.
* * *
Introduction
Ladies and gentlemen,
It's a great pleasure for me to address such a distinguished audience. First, let me thank the
organizers of the conference for giving me the opportunity to open this second day of the
conference. Yesterday's contributions have been outstanding and, in view of our program I
have very high expectations for our discussions of today.
From the outset, Central Banks have been major actors in fighting the financial crisis. Overall
their actions have been broadly successful. In the period to come, however, steering the
economy may prove more challenging and new risks can weigh negatively on the recovery
underway. A case in point is the brutal reassessment of sovereign risks by market
participants. The euro-area has been at the epicentre of this phenomenon. Some market
segments have become dysfunctional to a point that jeopardized the transmission of
monetary policy. The Eurosystem has therefore resorted to new steps to contain those
tensions and prevent their spill over to the real economy. The sovereign debt turmoil is the
most recent episode of a crisis that started already more than two years ago. It reminds us if
need be that crisis management is a difficult and potentially long lasting task and that we
should always keep in mind that our policies have effects not only the current course of
events but also through the expectation of the private sector that they may be repeated in the
future.
It is therefore timely to reflect upon the past, present and future course of Central Banks'
actions.
I - The seeds of financial instability
It is paradoxical that the crisis took place after a protracted period of nominal and real
stability. In particular, inflation had remained low and remarkably stable for nearly two
decades. This unprecedented degree of price stability mostly reflects a combination of
central banks' credibility and the effects of a benign economic environment.
This macroeconomic stability has however not prevented deep imbalances - macroeconomic
and financial - to grow in parallel, reinforcing one another. The abundance of savings in the
world, specifically in emerging economies, prevented real long term interest rates from rising
and stimulated the pace of credit expansion, especially in the US. Indeed, when policy rates
were raised in 2004 in the US and late 2005 in the euro area, long term rates responded
much less than in previous interest rate cycles and the yield curve flattened unexpectedly.
Over the same period, financial markets have gone through deep structural changes.
Financial innovation and extensive financial engineering fuelled a "search for yield" through
increased risk taking. The development of securitisation has spurred the demand for new
types of instruments. This demand led the financial system to generate new assets even at
the cost of extending credit to ever riskier sub-prime borrowers. This, for a time, helped
sustain a rapid increase of real estate prices which in turn stimulated the growth of
mortgages.
The main causes of the crisis therefore lie in the growing "real" imbalances and the
uncontrolled development of financial innovations. Overall, these combined evolutions led to
a generalized increase in leverage and financial fragility.
Against this background, it is quite unlikely that too accommodative monetary policies played
a central role in the crisis. Some analysts have pointed out to what they see as an
"asymmetric response" by monetary authorities to asset price increases: Central Banks
would not lean against asset price bubbles, but were prepared to clean the consequences
after they burst. However, we need to ask ourselves whether the unusually rapid credit
growth in the years preceding the crisis should not rather have called for complementary
policy actions on the supervision side. Some attempts were made in the Eurosystem. In
particular, the Bank of Spain enforced dynamic provisioning to curb domestic credit
expansion. But the crisis hit globally nevertheless and it raises several challenges for
authorities in charge of macroeconomic policies.
II -Managing the crisis
Starting in august 2007, Central Banks were confronted with major and unprecedented
tensions. Increasing uncertainty led to liquidity hoarding by financial institutions. Banks
severely limited the maturity, the scale and the number of counterparties to whom they would
lend. This liquidity freeze further deteriorated after the bankruptcy of Lehman in September
2008. Central banks intervened massively in order to tame the liquidity crisis and prevent its
spill over to the real economy. This intervention took various forms across countries,
reflecting the specificity local financial markets.
In the Euro area financial intermediation occurs mainly through the banking system. Most of
our actions, therefore, aimed at providing banks with sufficient liquidity through repo
operations to ensure that the flow of credit to the economy would not be severely disrupted.
We have been fortunate to enter the crisis with a very appropriate set of tools. From the
outset, our operational framework was based on a very broad list of eligible counterparties
and collateral. So, we could adjust to the shocks in money and credit markets without
creating new facilities, with the small exceptions of the covered bonds and, more recently,
government bonds purchases.
Doing so, we have been able to maintain a clear separation between monetary policy and
liquidity provision. A major step was taken in October 2008 when we moved to a regime
called in our jargon "full allotment fixed rate", which basically means that banks were given
unlimited access to liquidity at the prevailing policy rate. Over the course of the crisis, we
made several downward adjustments to that policy rate. But we never committed to any
specific path or trend. We always kept the possibility, while providing the banking system
with unlimited amounts of liquidity, to change the interest rates of all our facilities. And,
obviously, this remains true today.
Because asset purchases played a very limited role in our operational framework, the
unprecedented expansion in our balance sheet was never a source of concern. By essence,
repo facilities are self expiring and self exiting. A vivid illustration will come in July when our
one year long term operation expires and our balance sheet will contract by a third. A very
useful complement comes from the systematic sterilization of our more recent asset
purchases.
Our interventions have had significant effects on monetary and market conditions in the Euro
zone. Liquidity conditions improved markedly. The decrease in policy rates, from 4.25 % in
September 2008 to 1 % in May 2009 was largely passed-though to bank lending. This return
to more favourable conditions has supported economic recovery.
During this period, four main factors have contributed to the success and efficiency of our
operations:
 First, our credibility. At no time during the crisis have inflation expectations
significantly deviated from our definition of price stability. This was most apparent,
and crucial, during those months when headline inflation stayed in negative territory,
the output gap was itself strongly negative and the risks of deflation could have
materialized.
With inflationary expectations strongly anchored around 2%, the "zero lower bound"
never really was a problem. Short term real interest rates were brought at negative
levels, with sufficient speed to stabilize the economy despite the unprecedented
shock which followed the Lehman failure.

second, the flexibility of our operational framework
 third, the strong and efficient cooperation between all Central Banks, which
materialized through the speedy implementation of swap agreements and, most
visibly, in the coordinated reduction in interest rates which occurred in October 2009

Finally, for France, we drew important benefits from having the Central Bank taking
important responsibilities in banking supervision and financial stability. At any single
point in time, we could efficiently draw on our knowledge of the banking sector, our
broader vision of financial markets and our macroeconomic expertise.
III - Challenges for the future of central banking
In the past, financial crisis have always triggered important changes in the organization and
practice of Central Banking. Will this one be an exception? Two interrelated but different
questions are currently debated: should Central banks take more responsibility in fostering
financial stability? And should monetary policy itself be conducted in a different way? These
are deep and difficult issues which may take many years to elucidate. Here, I will try and give
some preliminary - and personal - insights.
1/ - Few people would discuss that Central Banks should have a bigger financial stability role
in the future. They have a strategic stake in the functioning of financial markets. Financial
conditions, such as developments in asset prices or in the quantity of credit affect the
transmission of monetary policy. Central Banks also have the expertise needed to address
these issues.
In many countries, the Central Bank is already formally recognized as the systemic
supervisor. In Europe, the ECB will play an essential role in the future European Risk and
Stability Board. There are big advantages in keeping financial supervision close to the
Central Banks. Central Banks need to have an intimate knowledge of the banking system.
And, on the other hand, bank supervisors benefit when they can complement their unique
vision of individual situations by a broader perspective on financial and macroeconomic
dynamics.
2/ - Even when pursued by Central Banks or under their aegis, financial stability should be
first maintained by specific tools. The general objective is to strengthen the financial system's
resilience to downturns and limit activities that increase systemic risk. Three approaches are
currently pursued:

increasing robustness and strength of individual banks through hardening capital
and liquidity requirements. This is the purpose of adjustments considered to the
Basel II framework. A BIS and Central Banks' working group is currently assessing
the macroeconomic implications of the reforms.

mitigating the pro-cyclicality of financial systems. Accounting rules have an essential
role to play, in this regard, both to allow for early recognition of risk through
expected loss provisioning and avoid excessive volatility through adequate valuation
principles.
 systemic risk should be contained via the creation of resolution mechanisms for
financial institutions as well as promoting more resilient market infrastructures, such
as CCPs for clearing and settlement of derivatives products.
The financial crisis also gives us the opportunity to think about Central Banks fundamental
task: the making of monetary policy. Amongst the many questions currently asked in
academic and policy making circles I will select four:
1/ - the mandate: recent proposals have been made to assign monetary policy additional
financial stability objectives, possibly by amending Central Banks mandates. I see those
proposals as misguided. First, adding a financial stability objective at the same level as price
stability could weaken the latter. Second, if price stability is not a sufficient condition to
ensure financial stability, it is certainly a necessary one. And, finally, current mandates seem
absolutely appropriate to allow Central Banks to fulfil all their responsibilities. Looking, more
specifically at the Eurosystem we have a "hierarchical" mandate, giving clear and
unambiguous priority to achieving price stability; and, once this objective has been met, it
allows us to pursue other goals. Financial stability easily fits into the set of those "secondary"
objectives. This clear priority was understood by the markets. It was most apparent in our
decision to raise policy rates in July 2008. It was essential to give us the necessary leeway to
act decisively later - when the financial system was in danger of paralysis - without
compromising our credibility.
2/ - the operational framework: most Central Banks conduct monetary policy through
changes in interest rates. Many do not pay close attention to monetary aggregates. The
Eurosystem stands alone in developing a formal monetary analysis through its "second
pillar". At the very least, however, the crisis has shown that liquidity matters. The assumption
of permanent liquidity allowed the shadow banking system to develop and proper. Excessive
maturity transformation has fueled the growth in leverage. Liquidity premia were all but
eliminated for a long period of time.
It is legitimate question whether those evolutions have implications for monetary policy.
Recent research tends to show that even small changes in policy rates could have had
nonnegligible implications forcing some intermediaries to close leveraged positions and,
potentially, to partially correct some financial imbalances. Those issues may still be relevant
today when in face of uncertainty, liquidity provision remains important. This is why, even for
monetary policy purposes, Central Banks should keep actively monitoring asset prices, credit
flows and liquidity conditions.
3/ - a closely related question pertains to the transmission mechanism. Evidence tends to
show that risk appetite tends to increase when interest rates stay low and liquidity is
perceived as abundant. This is called the "risk taking channel" of monetary policy. Risk taking
behaviors are amplified when monetary policy is permissive. Ultimately, this channel creates
a link between the levels of interest rates and risk premia. And this, of course, means that
movements in interest rates have, everything equal, a bigger (and may be less predictable)
impact on the financial system, credit aggregates and asset prices. A lot of work remains to
be done to precisely quantify that channel and disentangle its effects from those of the more
"traditional" credit channel. Nevertheless, it is clear that, in the future Central Banks will need
to pay greater attention to that specific impact of their decisions on the financial system and
the economy. The risk taking channel provides the best rationale for "leaning against the
wind" when financial imbalances tend to grow.
4/ - the last question is especially topical here, in Korea. How much should we care about
the "global monetary stance"? This is not an easy concept to define, or to use from an
operational point of view. On the other hand, we know that some determinants of price
stability are global: they depend on the combined effects of our national policy stances. Put it
differently, there are externalities associated with our different monetary policies. For
instance, divergences in monetary policies, however justified by national circumstances, can
fuel capital flows and create financial imbalances. In theory, those problems can be dealt
either with total exchange rate flexibility or , on the contrary, fully sterilized interventions and
the dynamic use of foreign exchange reserves. Neither of those polar solutions appear fully
attractive or feasible. This is why the search for new "financial safety nets" i.e. ways to delink
reserves creation from monetary policies and exchange rate management appear promising
and, although very complicated, should be encouraged. These are extremely difficult issues.
But I want to pay tribute to the leadership taken by Korea on this question during its G20
Presidency.
Conclusion
To conclude, I would like to outline what I see as the main lessons central banks should draw
from the crisis.
First, financial crises are a pervasive feature of modern capitalism. While the exact timing of
a crisis is hard to predict, situations of financial fragility, when some sectors have increased
their debt and leverage in parallel to asset prices, reduce the resilience of financial systems
to asset price reversals.
Second, timely and determined interventions of central banks can quench the thirst of
financial markets for liquidity and limit the spill over of liquidity squeezes to the real economy.
Central banks have demonstrated that their international cooperation could be relied upon
even under extreme stress in financial markets that have become integrated at the global
level.
Third, central banks should both prepare to manage future financial crises and design their
policies in order to minimise the risks of future financial crises. For the least, central banks
should avoid that their policies stimulate potential excessive risk taking, which although
benign in good times, increase the scale of insolvency in the event of an asset price reversal.
This is the best way to limit the risks to price stability over the longer run.
Thank you for your attention.