24 March 2012

BIS: Central banking in a balance sheet recession

Panel remarks by Mr Jaime Caruana, General Manager of the BIS, at the Board of Governors of the Federal Reserve System 2012 conference on "Central banking: before, during and after the crisis".

Faced with a balance sheet recession, policymakers need to strike a balance. They need to promote effective balance sheet repair so as to avoid overburdening monetary policy.

• First, an aggressive and prolonged easing can delay the recognition of losses. Large-scale asset purchases and lending to banks can undermine the perceived need to deal with impaired assets. Low interest rates, in turn, can reduce the opportunity cost of carrying non-performing loans on the balance sheet, encouraging ever-greening.
• Second, it can undermine the financial sector's operating profits. Low short-term interest rates and flattened yield curves can sap the earnings of banks by eroding deposit margins and the returns from maturity transformation.
• Third, it can create incentives for a renewed round of risk-taking and leveraging. For example, pension funds and insurers may respond to the pressure on their balance sheets by reaching for yield.
• Fourth, it can distort and atrophy markets. Central banks can end up by taking over financial intermediation from the private sector, in the money markets and elsewhere, contributing to a form of so-called hysteresis there.

By itself, extraordinarily easy monetary policy, whether through interest rates or the active use of central bank balance sheets, cannot be expected to solve underlying solvency problems. Such a policy can buy time, but may actually make it easier to waste that time. It can increase the risk that the balance sheet recession leads to protracted weakness, thereby delaying the return to a self-sustained recovery. At the same time, it can raise political economy risks; therefore there is need to preserve central banks' operational independence and their credibility.

Key challenges for central banks remain. It is important to analyse and to understand the risks and limitations of policy responses to balance sheet recessions so as to recognise them, to factor them into policy decisions, and to communicate them clearly.

Full speech

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