10 November 2011

Peter Praet: The (changing) role of central banks in financial stability policies

Peter Praet, Member of the Executive Board of the European Central Bank, pointed out that challenges are immense both on the technical side as well as on the governance side to safeguard financial stability. Central banks have an important role to play as coordinator/facilitator/initiator.

Over the last four years, central banking functions have been stretched to the limits. Recent developments demonstrate how fragile our financial system remains, not only because of debt legacy but more worrisome because of its mere design.

Lack of attention and preparedness to tail-events has been particularly striking. While central banks have always paid attention to the possibility of extreme events in payments and post-trade infrastructures, too little effort has been devoted to the prevention of the conditions under which emergency liquidity assistance would be provided to the financial sector. Other authorities were concerned, such as supervisors at the micro level and ministries of finance. The necessity of constructive “ambiguity” was also invoked to keep a low profile.

Central banks should undoubtedly assume important roles in macro-prudential policies. Central banks bring in essential expertise in analysing financial systems from an aggregate perspective. They also have proper incentives to mitigate systemic risk ex ante since central banks typically have to deal with the fallout from financial crises. Last but not least, involving central banks in macro-prudential policy should foster effective coordination between monetary policy and financial stability policies in a manner that preserves their autonomy. Policy coordination is likely to become important in light of the strong mutual interdependencies between the financial and the real sectors and thereby between both policy functions.

A wide range of different approaches exist to institutionalise central banks’ role in the new financial stability frameworks. A “one size fits all” approach simply doesn’t exist.

Business as usual would imply adhering to what has become known as the “Jackson Hole consensus”. Maintaining price stability is simply the best central banks could do to contribute to financial stability. In the light of the obvious breakdown of the Jackson Hole consensus, the view has become more popular that under certain circumstances, central banks may be well advised to lean actively against the emergence of financial imbalances in order to mitigate systemic risk and the associated longer-term risks to price stability and economic welfare.

Full speech

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