Commemorating the emperor’s visit in AD 130, Antalya’s Arch of Hadrian has endured for the best part of two millennia. Hadrian, one may say, was a master in the arts of political, social and even price stability. And, even if his methods for attaining these ends might not win whole-hearted approval, his accession did usher in more than half a century of relative peace and prosperity.
Today’s policymakers might ask themselves if they are on track to match this record. Seven years after the collapse of Lehman Brothers, much has been done to strengthen the banking system. With the crucial support of the G20, regulations have been overhauled and tightened, as have capital, liquidity and funding requirements. This has no doubt strengthened banks, making them better able to withstand the next financial shock.
For the next financial shock will undoubtedly happen. Yet, even if important efforts are in train to reduce its likelihood and severity, it is more difficult to point to progress in preventing it than in preparing banks to withstand it.
In dealing with the underlying causes of financial instability, policymakers confront several challenges. The first is, quite simply, that the understanding of those causes is still incomplete. The second is that the factors that create vulnerability to financial shocks may go beyond the formal financial sector.
Ultra-low interest rates are a case in point. As a legacy of the previous financial crisis, policy rates have been kept low in the advanced economies with a view to shoring up the real economy and restoring price stability. Like any medicine, however, the low-rate treatment is not without its side effects, and may create an unhealthy dependence.
Chief among the side effects, of course, is the risk of inflating another bubble. Low rates may encourage the misallocation of resources. And the search for yield drives investors into riskier assets: in the investment portfolios of North American and European life insurers and pension funds, for example, the share of bonds rated below a single A has risen from about one fifth to almost one third between 2007 and 2013.
But this is not all. By eroding investment returns, including the returns on offer at pension funds and life insurance companies, low interest rates may, paradoxically, induce households to save more and spend less. At the same time, corporate pension fund deficits, like a debt overhang, may deter sponsor companies from making new investments. In this way, low rates may actually erode rather than enhance the economy’s long-term growth potential.
Effects beyond the financial sector
In addition, financial booms may undermine productivity growth long after a boom has ended – perhaps, as research produced by the Bank for International Settlements suggests, by as much as 0.4 percentage points per year in the advanced economies since 2008. The intuition behind this finding is straightforward – after a banking-driven real estate meltdown, idle cranes and laid-off construction workers cannot easily redeploy into other industries.
If both the causes and effects of financial instability go well beyond the financial sector, it follows that efforts to build stability must do so too. A coordinated policy approach would address financial booms and busts through a combination of monetary, fiscal and prudential measures.
As part of a coordinated financial stability programme, fiscal policy would be countercyclical, ensuring that sufficient room for manoeuvre is preserved for busts. This means, first and foremost, that long-term sustainability is ensured. During a bust, that fiscal space would be used to speed up private-sector balance sheet repair, should private-sector backstops prove insufficient.
Prudential policy would also tackle procyclicality head on. The Basel III international regulatory framework does indeed move in that direction with its countercyclical capital buffer, as does the implementation of full-fledged macroprudential frameworks in various national jurisdictions. These deploy instruments such as maximum loan-to-value or debt-to-income ratios, or capital and provisioning requirements, to strengthen financial system resilience and, ideally, to dampen financial booms.
Yet, gaps remain. One is how to reduce the risks posed by the rapid growth of non-bank financial intermediaries. Work is under way, although far from complete, on risks in the shadow banking system. And attention has recently turned to the asset management industry, where the collective behaviour of firms might amplify financial shocks in a leverage-like manner.
A second gap is how best to deal with sovereign risk, given that sovereign risks have historically often been at the root of bank failures. The right approach needs to be systematic and comprehensive, addressing various types of exposure. The work of the Basel Committee on Banking Supervision in this area should be pursued without delay or hesitation.
For their part, monetary policymakers, if and when addressing financial stability concerns, should do it more symmetrically over the boom-to-bust cycle. This means, concretely, that policy frameworks should allow scope for tightening during financial booms, even if near-term inflation is low and stable, and for easing less aggressively and persistently during busts.
Arguably, some current frameworks already provide central banks with sufficient flexibility. On balance, then, the priority should be to use the existing room for manoeuvre, and to encourage analytical frameworks that highlight the cost of failing to incorporate financial stability considerations into monetary policy frameworks.
Even on a purely domestic basis, a joined-up policy approach to financial stability would be a step forward. It would greatly reduce spillovers to the rest of the world. But there is a need to go further. The imperative for cross-border coordination has long been recognised in the case of prudential standards for the financial industry, a journey that continues under the aegis of the Basel Committee and the Financial Stability Board.
Beyond the national sphere
By contrast, such recognition has been much less forthcoming for the monetary elements of the system, at least in normal times. One factor standing in the way of cooperation is policy mandates that are limited to the national sphere. This is a blind spot in the international monetary and financial system.
How far might international policy cooperation realistically go? National policymakers, of course, are guided by their domestic mandates. But one can also envisage supportive action among central banks based on enlightened self-interest, rooted in a thorough exchange of information. This would mean taking cross-border spillovers more systematically into account when setting national policy.