Reforming financial regulation and supervision: going back to basics

Conference organised byBanco de España and the World Bank

Madrid, June 15, 2009

Session on “The challenges of global financial surveillance and the

quest for financial stability”

Ignazio ViscoBank of Italy

Need to reassess the monetary frameworks?

The current crisis has shown that: Financial imbalances may be exceptionally costly for the real economy Monetary policy may itself be a source (not the only one) of financial instability The role of huge international spillovers in the global economy cannot be

ignored

Addressing these issues has far reaching implications for: The conduct of monetary policy The tasks and responsibilities central banks are entrusted with The degree of international cooperation and the effort to create a more stable

international monetary system

The conduct of monetary policy

The primary objective of monetary policy remains price stability; but there may be a short-run trade-off with financial stability, whose severity depends on the financial situation. In the absence of an independent instrument to pursue financial stability,

monetary policy needs to address this trade-off. At a minimum, it should avoid fuelling bubbles and should behave more

symmetrically.

However, the task is challenging: Enlarging the horizon over which price stability is defined is not enough. Our

ability to identify financial imbalances, their non-linear effects on the macro-economy and the impact of monetary policy is limited.

While a larger role for money and credit may help, we need to better understand how financial linkages impact on the macro outlook and how monetary and macro-prudential analysis should interact.

The tasks of central banks

“Leaning against” financial imbalances is important. But we cannot put an excessive burden on monetary policy. Two goals cannot be pursued with a single instrument. At times, the macro costs

may not be sustainable. If flexibility is granted at the expense of credibility, neither price nor financial

stability would be ensured.

An additional instrument is needed to diminish the severity of the trade-off. Which macro-prudential arrangements (capital requirements, leverage,

provisioning) are effective in reducing financial pro-cyclicality? How do macro-prudential tools and the setting of interest rates interact? Are

they independent? How can they be best used in combination?

All in all, the global crisis has reinforced the case for entrusting central banks with explicit macro-prudential functions. The synergies overcome the concerns of a possible conflict of objectives.

The international monetary system

Flaws in the financial system initiated the crisis. But global imbalances in the world economy were essential to its propagation.

No mechanism operated effectively to induce a self-correction. Surplus countries avoided pressure to adjust, pegging to the dollar. The role of the dollar as international reserve currency eased the financing of

large and persistent US current account deficits.

The dollar-centred system, driven by the preferences of individual countries, with weak multilateral surveillance, is endangered: by overly expansionary policies in the centre … and the reluctance to let exchange rates fully adjust in the periphery.

Stepping up international policy cooperation and effective surveillance is a top priority.

The effort to create a more stable international monetary system (vis-à-vis the current “non-system”) is crucial, to avoid perpetuating mechanisms that lead to global imbalances, fragile financial structures, and the risk of disorderly adjustments in exchange rates.

Global measures of liquidity (1)(percent; annual data)

50

60

70

80

90

100

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

0

1

2

3

4

5Ratio of broad money to GDP - left scale (2)

Ratio of bank credit to GDP - left scale (3)

Real long-term bond yield - right scale (4)

Source: IMF, World Economic Outlook, October 2008.Notes: (1) Aggregated using GDP weights at PPPs. (2) end of period; weighted average of China, Japan, Euro area, UK and USA. (3) end of period; weighted average of Japan, Euro area, UK, USA and, starting in 1999, China. (4) averages; deflated with CPI inflation; weighetd average of Japan, Euro area, UK and USA.

Spreads on corporate and sovereign bonds (basis points; daily data)

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

EMBI Global

US high-yield corporate

US high-grade corporate

Source: Bloomberg.

Global asset prices in real terms (1)(indices 1990=100; quarterly data)

0

50

100

150

200

250

300

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

75

85

95

105

115

125

135

Equities - left scale (2)

Housing - right scale (3)

Sources: Datastream, IMF and OECD. Notes: (1) Deflated with G7 CPI index; (2) MSCI index; (3) total OECD.

United States: household sector net worth and saving rate(in percent of disposable income)

-200

-100

0

100

200

300

400

500

600

700

800

'80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09

-4

-2

0

2

4

6

8

10

12

14

Financial assets other than equity Equity Real estate assets of households Other nonfinancial assets

Financial liabilities Saving rate (right axis) Net worth

Source : Federal Reserve (Flow of Funds) and Bureau of Economic Analysis. Note: Other nonfinancial assets include tangible assets owned by non-profit organizations and consumer durables.

US household sector: selected balance sheet ratios(percent; quarterly data)

55

75

95

115

135

155

175

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

11

13

15

17

19

21

23

Total debt, ratio to disposable income (1)

Net housing equity, ratio to disposable income (1) (2)

Leverage (3) (right scale)

Source : Federal Reserve and Bureau of Economic Analysis. Notes: (1) disposable income is calculated as a 4-month moving average. - (2) Net housing equity is calculated as the difference between real estate wealth and home mortgages. - (3) Total debt over total assets.

Current account balances(in percent of world GDP)

-2

-1

0

1

2

3

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

United States Euro area China Em. Asia excl. Japan and China Oil exporters Japan

Source: World Economic Outlook, April 2009.

Cumulated current account balances(in percent of GDP)

-60.00

-40.00

-20.00

0.00

20.00

40.00

60.00

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Japan (1)

China (1)

Euro area (1)

United States (1)

United States (3)

Sources: IMF, World Economic Outlook, April 2009; Bureau of Economic Analysis.Notes (1) Calculated as the cumulated current account balances, starting in 1980. (2) Inludes only emerging and developing economies. (3) Actual net foreign asset position (at market values).

Oil exporters (1), (2)

Em. Asia exc. China (1)

Total reserves minus gold(USD billions)

0

1000

2000

3000

4000

5000

6000

7000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Japan Advanced Economies excl. Japan China, P.R.: Mainland Oil exporters Other Emerging & Developing Economies

Source: IMF, International Financial Statistics.