This book is no blueprint for a new model central bank. It is too early for that. Where the political and intellectual mood will settle remains too difficult to gauge. Yet few would disagree with the claim of Olivier Blanchard, the chief economist of the International Monetary Fund (IMF), that events point to a greater role for the state in shaping the economic course. Factors specific to political structures, financial markets and economic circumstances have proven to matter more than we might have thought. And a world in which there is a neat segmentation between the monetary, fiscal and supervisory policy strands between central banks, treasuries and regulators no longer seems possible.
So, while there is no framework for a new way to do central banking within these pages, the chapters that follow can – and do – offer much in the way of insight into how the profession can best handle the challenges this much-changed world will present.
The book begins with some outlines of the policy implications of the lessons learnt. Claudio Borio of the Bank for International Settlements, one of the institutions which has found its reputation enhanced by the crisis, notes that the turmoil has shaken the foundations of the deceptively comfortable central banking world. Pre-crisis, the quintessential task of central banks was seen as straightforward. Post-crisis, many certainties have disappeared. The line between fiscal and monetary policy has become blurred precisely at a time when public sector debts are rising along with sovereign risk. Many question the very ability of central banks to keep inflation within acceptable ranges. The years ahead will therefore be a period of experimentation as central banks face up to threefold challenges: economic, intellectual and institutional.
Duvvuri Subbarao notes that the crisis has challenged many pre-set ideas and reopened questions that the profession thought had been settled. Have emerging market economies really decoupled from the advanced economies? Should central banks persist with pure inflation targeting? Should financial stability be an explicit mandate for central banks? Are controls an appropriate mechanism for managing the capital account? Has fiscal dominance of monetary policy ended? All must be revisited.
For the first time in years central banks in advanced economies have had to call on governments for assistance, exposing institutions’ reliance on parliament and undermining their claim to independence from the political process. The implications for central banks’ relationship with lawmakers are discussed by Geoffrey Wood. For Wood, the changes have touched on three matters. First, central banks should maintain inflation targets, but these should have embedded in them some cautions that should be unnecessary but that experience has shown not to be. Second, legislation should codify how the central bank can supply capital beyond the scale of its balance sheet. Third, with that codified freedom should come codified responsibility to parliament.
The second section tackles the integration of the beefed-up financial stability mandate. It begins with a chapter by Sir John Gieve examining the mandate, strategy and governance of macroprudential policy. The need for such a policy strand is well acknowledged; the cyclical nature of credit flows has wreaked havoc on economies around the globe, costing taxpayers dearly. The credit cycle, like price pressures, must therefore be tempered by the state. In a report published in October 2010, the Group of Thirty stressed the need for the macroprudential supervisor to operate under a “clearly articulated mandate provided by the country’s political leadership” and to be “accountable to the legislatures and the public”. Indeed. Yet providing such clarity is proving fraught with difficulty. In order to do so, jurisdictions must determine four things. First, how far to use macroprudential policy to manage the wider economy; second, how risk averse the policy should be; third, how much reliance can be placed on supervision and what structural measures can be taken to make its success more likely; and fourth, how to preserve the best aspects of de facto independence of the central bank while achieving much greater co-ordination across various policy strands.
In her chapter on rectifying the mispricing of risk, Patricia Jackson discusses two causes of the crisis and makes three policy recommendations. The causes are: banks’ tendency to hold concentrated positions owing to misleading risk signals, often the result of flawed modelling, which regulators did little to discourage; and also the way in which the sharp change in markets between 2004 and 2006 and a lack of transparency made it hard to spot such misleading risk signals. The three policy recommendations are: first, the authorities should pay far more attention to risk transparency within the banks, and regulate accordingly; second, regulators must ensure models do not negate the new countercyclical capital buffers being introduced under Basel III; and third, the Financial Stability Board should have a clear mandate to gather risk information on large rapidly growing markets and carry out an independent risk assessment to review risks in booming, but opaque, markets. “Learn from Asia” has been an oft-heard adage over recent years. But how can policymakers in the West best adapt the East’s policy toolkit to their own needs, given the differing geopolitical forces that shape the way in which officials think about financial policy? Gerard Lyons provides some answers. There is, he writes, indeed much to learn from the use of macroprudential measures, especially those of a countercyclical bent, which Asian policymakers have used with particular aplomb.
In the search for adequate buffers for the system, there is much support for contingent capital, or CoCos, among regulators and economists, making them likely to form part of the post-crisis toolkit. Yet officials, bankers and investors alike are unsure what should serve as the trigger to turn debt into equity. Charles Calomiris and Richard Herring have come up with a possible fix. At its root, is the idea that CoCos must create strong incentives for a prompt recapitalisation of banks after significant losses of equity but before the bank has run out of options to access the equity market. No more can a situation be repeated in which an embattled chief executive for too long clings to the notion that they do not need to raise capital.
Central bankers must also keep a weather eye on payments systems. While their resilience is generally regarded as one of the success stories of the crisis, one must guard against complacency. The crisis underlined once again that infrastructure arrangements are crucial for the functioning of markets. Here Daniel Heller and Marc Hollanders argue that the approach followed in the past – that of increasing the resilience of the payment and settlement systems – must continue to be followed.
The prime cause of the crisis is a global monetary order in which currencies are free to misalign, Jacques de Larosière writes. Here he proposes an alternative: a form of macroeconomic oversight which calls on central banks and regulators to together watch for signs of nascent systemic risk and act to prevent disruptions.
Old debates must be revisited too. And the third section tackles what Andrew Sheng notes is the oldest conundrum in central banking. Whether central bankers should be constrained by rules is a discussion older than many of the central banks, having first been raised in 1936 by Henry Simons. The impact of the crisis on the discussion is covered in two chapters.
As Charles Plosser notes in the first of the two chapters, the crisis has sparked debate and discussion over the extraordinary actions taken by policymakers. However, without careful attention to commitment mechanisms, these discretionary actions may risk undermining the Federal Reserve’s credibility. There is, the president of the Federal Reserve Bank of Philadelphia says, ample evidence that credible commitments that ensure systematic, rule-based policy and limit discretionary behaviour yield better economic outcomes over the long run. And a rule-based approach to policy can also deter moral hazard, one of the key catalysts of the crisis.
In the second chapter of the section, Sheng believes that there is a time for both rules and discretion. Normal times warrant rules, not least because in a situation in which market players know more than the officials regulating them, rules offer a check against regulatory capture. Yet exceptional times demand discretion. In a world where there is Knightian uncertainty, it must surely prove impossible to devise a rule for all time. The trick, Sheng says, is to recognise when the time for discretionary decision-making is nigh.
The three chapters that comprise our final section present bold visions of what the future financial and central banking landscape should look like. The central banking profession has been split between those who have advocated the more stringent application of existing regulatory and supervisory norms, and those who argue for measures which seek to fundamentally and irrevocably reshape the landscape of the banking industry and the business models it pursues. Alistair Milne here comments on the feasibility of some of the more radical ideas for re-shaping the banking industry.
In the following chapter, Robert Pringle and Hugh Sandeman argue that properly implemented, structural separation between investment banking activities and core deposit banking services could go far to create a sounder financial system. It could achieve this primarily by changing the incentives facing the managers, as well as the creditors and shareholders, of large financial institutions. Drawing on their two submissions to the UK Independent Banking Commission, they argue that the current system creates temptations, for managers and shareholders alike, to gamble on a high-risk, high-return strategy. It should actually be designed to let people take risks in financial services – with their own money at stake – but also to allow more stable, slower-growing, lower-return firms to survive. But the benefits of such a restructuring will accrue only if the ring fence itself is strong and as impermeable as possible. The test is whether, in an impending crisis, the day-to-day activities of consumers and businesses that depend on the banking system and have no other alternatives immediately available would be protected from disruption. The market’s awareness that such activities could be protected in an emergency would lend credibility to the efforts of regulatory authorities to increase market discipline throughout the financial system.
Such a ring fence would be neither a magic bullet nor a substitute for other measures, such as those to be implemented in the Basel III framework, ie, improved capital adequacy rules, better coverage of risks, minimum liquidity requirements, stronger supervision, a macroprudential toolkit including leverage rations, and bank resolution regimes. But it is predicated on the view that even all of these would not be sufficient.
If major monetary authorities agreed to adopt inflation targets and others to peg to one – or a basket – of the major currencies, then we would witness a more stable global monetary system, Allan Meltzer argues in the final chapter.
The ultimate aim of economic policymaking is fixed; the challenge for officials remains to spur growth that is sustainable. Yet with the political and intellectual mood much shifted, central bankers’ role in creating a climate in which such growth can thrive will without doubt differ a great deal.
The challenges facing the profession, as Borio notes here, are huge. Yet if central banks are to continue to enjoy the freedom granted, and power attained, pre-crisis, then such challenges must not be shirked.
- Publish date
- 17 Jan 2012
- 155mm x 235mm
Table of contents
1 Central banks re-arm for battles ahead
Robert Pringle and Claire Jones
II MAJOR CHALLENGES
2 Central banking post-crisis: what compass for uncharted waters?
3 New answers to old questions
4 Relationships between governments and bankers
III INTEGRATING THE FINANCIAL STABILITY MANDATE
5 Macroprudential policy: mandate, strategy and governance
Sir John Gieve
6 Risk management: the role of internal risk transparency
7 Learning from Asia’s success
8 How to use contingent capital buffers
Charles Calomiris and Richard Herring
9 Building sounder market infrastructures
Daniel Heller and Marc Hollanders
10 International monetary reform: a regulatory fix
Jacques de Larosière
IV NEW POLICY GUIDELINES
11 Why monetary policymakers need constraints
Charles I. Plosser
12 A time for rules, a time for discretion
V A BRAVE NEW WORLD
13 The case for radical change in banking
14 Structural reform of banking: can the UK set an example?
Robert Pringle and Hugh Sandeman
15 Towards a global monetary policy
Allan H. Meltzer?