Session 5: Links between macro stability and financial stability

Loretta J. Mester, Federal Reserve Bank of Cleveland

Isabel Schnabel, Universität Bonn

Monetary policy affects the banks’ risk-taking and thereby also indirectly growth in the economy. So from an economic perspective, an important question is when a central bank should act on tendencies towards financial crises. If one takes this to an extreme, the rhetorical question is how much growth and thus welfare one is prepared to sacrifice to avoid major financial crises. A person who is aged 80 now, has experienced two major financial crises during his or her lifetime. Is that too many?

Loretta J. Mester said that central banks can do even more than they do now to increase financial stability, or to decrease the effects of financial crises, without sacrificing growth in the economy.

It is important that central banks, for this reason and to also to avoid moral hazard, distinguish between normal financial crises, which unavoidably arise in a dynamic economy, and those that are system-critical. The first type of crisis should be left to run their course. However, central banks must take action in system-critical crises, as monetary policy affects financial stability and vice versa.

One complicating factor is that financial bubbles and crises are so difficult to detect in advance, so it may be too late to nip them in the bud. Even when a central bank takes action at an early stage, it may be too late to stop the course of events. This applies in particular to the United States, where there are very many authorities with responsibility for different parts of the financial system and it is therefore very difficult both to act quickly and to coordinate measures. 

Loretta J. Mester therefore advocated systematic solutions (such as capital requirements) and frameworks that give better stability in the entire financial system, and which in the best case lead to financial agents reducing the risks in advance themselves. It is also important that the regulatory framework is not so complicated that it becomes difficult to see whether it is being observed. She did not want to see any extension of the central banks’ mandate with regard to financial stability. On the other hand, a central bank should of course give consideration to the effects of its measures on financial stability.

No central bank can ignore financial stability, as the banking system plays an essential role in the impact of monetary policy on the real economy.

The question is then how far central banks should become involved in financial stability. While the role of lender of last resort is uncontroversial, as it supports both macroeconomic stability and the entire financial system, opinions are divided regarding whether central banks should be proactive when financial bubbles arise, or whether they should just mop up afterwards. This also applies to the question of to what extent central banks should use macroprudential tools, that is, regulation and supervision aimed at limiting the risk of serious shocks to the financial system as a whole.

Isabel Schnabel observed that with regard to financial bubbles, the type of asset involved and the specific section of the market in which they arise appear unimportant with regard to their effects on the economy. On the other hand, something that is decisive for the size of the damage to the economy is whether they arise with the aid of borrowed funds or own capital. It is also important to detect financial bubbles at an early stage.

She said it was unlikely that merely mopping up after a financial bubble has burst could be considered optimal, not least as a pure mopping-up strategy could help create the next crisis.

However, there did not appear to be any individual tool best-suited to combating financial bubbles. The interest-rate weapon and crisis prevention tools appear to be supplementary. The most effective results come from a combination of different measures, where crisis prevention supervision functions as an early warning system and a first line of defence. It is also important that different measures do not counteract one another by one promoting risk-taking while the other prevents it.

A much-discussed question is whether central banks should both establish regulatory frameworks for the banks and oversee them, which is the case with the ECB as of November 2014. Earlier research in this field is limited, and does not come to any clear conclusions, though it indicates that the banks tend to be more robust if overseen by the central bank.

In her research, Isabel Schnabel has examined more closely the degree of cooperation between the overseer of the banking system and central banks in the cases where these roles were separate, and it is clear that more cooperation improves both monetary policy and financial stability. Inflation is then lower and the risk of financial crises arising reduces with greater cooperation.