Finally, the central bank needs to look over the horizon and identify market practices and processes that could make the financial system more vulnerable to shocks or that could  3  2  See “Asset Bubbles and the Implications for Central Bank Policy”, Economic Club of New York, April 7, 2010. BIS central bankers’ speeches  amplify such shocks. As an example, a tougher response to the poor mortgage underwriting practices evident during the U.S. housing bubble would have been appropriate in my opinion. Or more attention to bank compensation practices could have mitigated the incentives for excessive risk-taking. The second implication is that when financial instability does occur, the central bank needs to respond forcefully to mitigate such instability. This includes ensuring that appropriate liquidity backstops are available. This is necessary in order to reassure counterparties that solvent institutions will have access to liquidity so that they can repay their obligations regardless of the degree of illiquidity or stress in the financial system. As we saw in the fall of 2008, without appropriate backstops, markets can seize up completely even when counterparties are perceived as solvent. That is because market participants tend to hoard liquidity during times of stress and because counterparties may not engage with one another when they are uncertain whether others will do so. Central bank liquidity backstops act as a coordinating device, solving the collective action problem faced by private market participants. However, in the most serious stress episodes, credible liquidity backstops alone will not always prove sufficient.

The first implication, that the central bank has a strong stake in preventing financial instability, has several elements. The central bank needs to be willing to respond to limit financial market bubbles from developing in the first place. This includes not just paying attention to asset price bubbles, but also to related excesses in leverage and in short-term funding markets. As I noted in a speech a few years ago, this is difficult to do in practice.3 After all, bubbles are difficult to identify in real time and the central bank’s policy toolkit to deal with bubbles may be limited. However, this difficulty cannot be an excuse for inaction. Using the bully pulpit, implementing macroprudential measures, or adjusting monetary policy can generate superior results compared to inaction. The central bank also has to ensure that the financial system is sufficiently robust and resilient so that if there are financial market shocks, the banking system can absorb any shocks and continue to perform its credit intermediation function. This has many elements including tough capital and liquidity requirements for banks and strong financial market infrastructures. It also includes taking action to eliminate sources of vulnerabilities whenever they may arise – for example, strengthening the triparty repo system, reducing the vulnerability of money market mutual funds to runs, or forcing derivatives contracts to be standardized and centrally cleared. These actions should be undertaken during “peacetime” rather than when a crisis is already underway.