The New Art of Central Banking

Can central bankers stop worrying about inflation and learn to love the new financial stability culture?


For years leading central banks have focused almost single-mindedly on the control of inflation as the bedrock of economic prosperity. Whether they explicitly pursue an inflation target, as is the practice of the Bank of England, the Reserve Bank of Australia and many others, or implicitly do so, as in the case of the Federal Reserve and the European Central Bank, these institutions carefully monitor price and output trends and have developed elaborate models for setting interest rates, all with the paramount goal of achieving low and stable inflation. As Alan Greenspan testified to Congress in the early 1990s, “The most important contribution the Federal Reserve can make to encouraging the highest sustainable growth the U.S. economy can deliver over time is to provide a backdrop of reasonably stable prices, on average, for business and household decision making.”

In the wake of the financial crisis, however, central bankers are rethinking their goals. Price stability is no longer enough by itself. Indeed, many central bankers now acknowledge that low inflation, and the low interest rates that accompanied it, helped cause the crisis by encouraging banks and investors to take on ever-greater risks in the search for yield — a point many private economists have been making. “I’m on a mission to get people to recognize the important role that monetary policy has played in getting us into this mess,” says Stephen Roach, senior fellow at the Jackson Institute for Global Affairs at Yale University and a former chief economist at Morgan Stanley. The Federal Reserve’s mandate of promoting maximum employment and stable prices “doesn’t cut it when you have low levels of inflation,” he adds. “It biases you to excessively easy monetary policy.”

Now central bankers are going back to the drawing board to modify their approach and take on a new role: guarantor of financial stability. If inflation targeting was all the rage in the 1990s, their new mantra is “macroprudential supervision.” Unlike traditional supervision, which aims to ensure the safety and soundness of specific financial institutions, a macroprudential approach seeks to promote the safety and soundness of the entire financial system and to prevent the kind of meltdown that brought banks low in 2008 and nearly crashed the global economy. To that end, central banks and whiz-kid economists are developing new methods for measuring systemic risk by looking at everything from the amount of leverage in the system to trends in credit spreads to the interconnections and shared positions of banks, brokerages and big investors. Central bankers in the U.S. and Europe admit they have something to learn from their counterparts in developing economies about the use of such old-fashioned tools as limiting loan-to-value ratios for mortgage lenders to cool property markets. The Holy Grail of these efforts is to rediscover the art of central banking as defined by William McChesney Martin Jr., who famously described his task as Fed chairman in the 1950s and ’60s as “taking away the punch bowl just as the party gets going.”

“This is really a revolution in policymaking,” Paul Tucker, the Bank of England’s deputy governor for financial stability and one of the leading proponents of the new-style central banking, tells Institutional Investor in an interview.

This revolution is very much in its early days, though, and faces plenty of obstacles. Consider the goal itself. Financial stability is unassailable in the abstract but devilishly hard to define with any precision. “The great thing about inflation targeting is that you had a clear, quantifiable objective,” explains Charles Goodhart, director of the financial regulation research program at the London School of Economics and a former member of the Bank of England’s Monetary Policy Committee. “You can’t do that with financial stability.”


The notion of strengthening the financial system to enable it to withstand shocks — one of the key planks of macroprudential supervision — is almost universally accepted these days. That concept inspired the recent international agreement on higher capital requirements for banks by the Basel Committee on Banking Supervision, which leaders of the Group of 20 nations endorsed in November.

A second macroprudential plank — leaning against the financial cycle to prevent the buildup of asset bubbles — is much more controversial. Under Greenspan, the orthodox view held that central bankers weren’t smart enough to identify a bubble and should limit their intervention to cleaning up after any bust by easing monetary policy. That stance, known as “the Greenspan put,” is now widely believed to have fostered the buildup of risk leading up to the crisis. Today growing numbers of central bankers say they would rather lean against asset prices than clean up after a collapse, but where and when should they act? Risk grows with leverage, to be sure, but are leveraged buyouts priced at 6 times earnings before interest, taxes, depreciation and amortization a sign of excessive leverage, or LBOs priced at 9 times ebitda? At what rate of growth does a housing price boom risk turning into a bust?

There are no ready rules for answering those questions. That poses a dilemma for central bankers, most of whom are monetary economists used to relying on elaborate econometric models in making decisions. Are these bankers capable of exercising the gut-level judgment about economic growth and asset prices that the new stability role requires? And will they be willing to rein in credit despite the inevitably fierce pressure from politicians, homeowners, investors and others determined to let the good times roll?

“Taking away the punch bowl is going to be hard enough,” says William White, chairman of the economic and development review committee at the Organisation for Economic Co-operation and Development in Paris and former chief economist at the Bank for International Settlements. “Taking away the punch bowl when asset prices are going up and everybody is getting rich and thinks they’re very smart is really tough.”

Central bankers acknowledge the difficulties, both technical and political, that they face in taking on the new financial stability job, but they insist they have no other choice. The cost of the recent crisis in terms of government bailouts, moral hazard, loss of economic output and high unemployment is simply too great to go on with business as usual.

“There has been a fundamental regime shift in terms of the importance to the Fed of taking asset price developments into consideration in the setting of monetary policy,” says William Dudley, president of the Federal Reserve Bank of New York, in an interview in his wood-paneled office at the bank’s palazzo-style building in Lower Manhattan. “There’s more willingness now to be proactive and try to identify these risks in real time, and then do something about it.”

That challenge may seem purely theoretical at the moment. With the U.S. economic recovery losing momentum, unemployment rising, house prices falling and stock prices some 20 percent below their 2007 highs, the idea that the Fed will need to act any time soon to prick an asset bubble seems fanciful. Indeed, the economy is so weak and inflation so low that the central bank has embarked on another round of quantitative easing, in which it will buy up to $600 billion of government bonds in a bid to boost asset prices, confidence and growth. Similarly, Europe’s debt crisis looks likely to forestall any tightening moves by the ECB any time soon.

“Until the economies that were at the center of the crisis have actually recovered, some of the questions about what policies are going to be used are not going to be germane,” says Stephen Cecchetti, chief economist at the BIS.

Yet for many economists, QE2 is all the more reason for the Fed to put greater emphasis on financial stability. The fresh injection of liquidity risks fueling asset price bubbles around the world, if not immediately in the U.S., just as low interest rates earlier this decade helped feed the subprime debacle, critics say. Quantitative easing is “the same prescription that put us into this mess,” says Roach. A macroprudential approach should lead the Fed to be more vigilant about possible bubbles and wind down its unconventional monetary policy sooner rather than later, he adds.

THE CONCEPT OF MACROPRUDENTIAL regulation dates back to 1979, when central bankers gathered at the BIS in Basel, Switzerland, to consider ways to restrain the surge in bank lending to developing countries, especially in Latin America. The idea was to focus on the aggregate exposure of the banking system as a whole rather than on individual institutions. No action was taken, though, and the Latin debt crisis erupted three years later.

The term came back into vogue after the Asian financial crisis in the late 1990s. The International Monetary Fund developed macroprudential indicators — ranging from the banking sector’s capital adequacy and the growth rate of lending to the current-account deficit — designed to provide early warnings of weaknesses in the financial systems of member countries. Major developed economies launched the Financial Stability Forum, a precursor to today’s Financial Stability Board, to focus on strengthening the financial system through improved data collection and regulation. A number of central banks, beginning with the Bank of England in 1996, had begun publishing regular financial stability reports examining everything from market trends to the risks posed by derivatives markets. Many of these efforts remained largely theoretical, though, with few practical consequences for monetary policy or financial regulation in developed economies.

Macroprudential supervision “has been alive and well for 31 years now, but no one knows how to do it,” says David Green, a former U.K. banking supervisor and co-author of a recent book, Banking on the Future: The Fall and Rise of Central Banking, which calls on central banks to pay greater attention to credit growth and financial stability.

The credit crisis has given a fresh impetus to efforts to transform financial stability from a loose concept to tangible policy. The Basel III accord is a notable first step. It will require banks to hold more, and better quality, capital: Common equity capital will rise to 7 percent of risk-weighted assets by 2019, compared with 2 percent currently. That increase should make banks more capable of absorbing losses when shocks hit the financial system.

Global capital rules have been around since the first Basel agreement was reached in 1988. What distinguishes the new accord is that it formally incorporates some macroprudential measures.

The 7 percent equity capital standard comprises a 4.5 percent minimum and a new capital conservation buffer of 2.5 percent. Although the minimum must be maintained at all times, banks can draw down the buffer to cover losses; regulators hope this will keep credit flowing in a slump. Even more innovative, the Basel Committee is expected to add two more macroprudential measures to the accord by the end of 2010: a capital surcharge for systemically important financial institutions, or SIFIs, and a countercyclical capital charge that can range from 0 to 2.5 percent. The SIFI surcharge, which is expected to apply to perhaps 30 to 40 big global banks, would be a sort of insurance premium that seeks to address the too-big-to-fail problem. The countercyclical charge would require banks to build up additional capital during periods when credit growth exceeds the historical trend, which is typically when banks take the big risks that later become their big losses. Regulators hope the countercyclical buffer will moderate the credit cycle, tempering lenders’ exuberance during boom times and giving them a bigger cushion for bad times.

If the countercyclical charge had been in force a decade ago, U.S. banks would have had to build a buffer of 2.5 percent of risk-weighted assets by 2003 — before the subprime mortgage market really took off, according to BIS calculations. Spanish banks would have had to do so even sooner, by 2000. “Banks would have faced the recent financial crisis with much stronger capital bases and would have been able to draw on them,” BIS general manager Jaime Caruana said at a recent conference on macroprudential policy in Shanghai.

Tighter capital standards alone, even ones that seek to moderate the credit cycle, won’t be enough to safeguard the financial system. Risk is constantly shifting, and the system innovates to get around the rules, so central bankers and other regulators need to sharpen their surveillance capabilities and develop tools to mitigate the buildup of risk.

To that end, Western governments have established new institutions to promote financial stability that give pride of place to central bankers. As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the U.S. has established a Financial Stability Oversight Council to identify threats to the financial system and direct regulatory agencies to take action. Chaired by Treasury Secretary Timothy Geithner, the council’s members include Fed chairman Ben Bernanke and the heads of major regulatory agencies, including the Securities and Exchange Commission, the Commodity Futures Trading Commission and the Federal Deposit Insurance Corp.

Similar moves are afoot in Europe. With responsibilities similar to the FSOC’s, the new European Systemic Risk Board, chaired by ECB president Jean-Claude Trichet, will hold its first meeting in December. In the U.K. the government is due to introduce legislation in 2011 requiring the Bank of England to set up a Financial Policy Committee, similar to its rate-setting Monetary Policy Committee.

Establishing these regulatory bodies is an essential first step toward taking real action, advocates insist. “No one before really had the responsibility and the mandate clearly defined” for financial stability, says ECB vice president Vitor Constancio. “And so no one was accountable. No one moved. Now it will be completely different because someone is accountable. That changes everything.”

The FSOC has already made some early moves. At its first two meetings, in October and November, the council issued advance notice of plans to designate certain nonbank financial firms for closer supervision and to declare some financial utilities, such as securities clearinghouses, to be systemically important and subject to tighter scrutiny. In January the council is due to set out detailed guidelines for implementing the so-called Volcker rule limiting proprietary trading by banks. These initiatives are simply carrying out existing provisions of the Dodd-Frank Act, though. Broader changes that could alter the way central banks set policy will require a lot more work by economists and regulators to turn macroprudential supervision from theory into practice. Policymakers acknowledge they have few reliable gauges of systemic risk or agreed-upon rules for containing such risk.

“We’re not even in the position that Don Brash was in in the late 1980s,” says the Bank of England’s Tucker, referring to the Reserve Bank of New Zealand governor who pioneered inflation targeting as a central bank strategy.

The first step for central bankers and regulators seeking to control systemic risk is to measure it. The crisis has spawned a cottage industry of risk analysis at central banks and other regulatory agencies and in industry and academia, and new forces are being marshaled in the effort. In keeping with Dodd-Frank, the U.S. Treasury is setting up an Office of Financial Regulation to collect and standardize financial data — everything from lending exposures between banks to derivatives positions held. The European Commission has launched a similar initiative, Forecasting Financial Crises, in which scientists from seven universities and economists at the ECB will try to measure systemic risk and develop models to predict future crises.

Some of the work under way is promising, if still some ways from being operational. Economists at New York University’s Leonard N. Stern School of Business have developed a model that attempts to measure a bank’s likely contribution to the banking system’s capital shortfall if a shock — a big drop in stock prices, say, or a spike in credit default swap rates — was to hit the financial system. Among other things, it incorporates a given bank’s leverage and its exposure to correlated assets likely to suffer big losses when other banks are in trouble. “Leverage and concentration of risk have to be the two pillars of any macroprudential approach,” says Viral Acharya, one of the economists involved in the work.

The model, which is updated daily on the web site of the Stern School’s Volatility Institute (, indicated in early December that Bank of America Corp. and Citigroup posed the greatest systemic risk in the U.S., followed by JPMorgan Chase & Co., Morgan Stanley, Wells Fargo & Co. and Goldman Sachs Group. A rival model dubbed CoVaR, developed by Princeton University economist Markus Brunnermeier and Tobias Adrian of the New York Fed, looks at a given firm’s leverage, its dependence on short-term funding and the volatility of its stock price, among other variables, to predict how distress could spill over to other institutions, causing contagion.

These economists believe the authorities could use their models to regulate firms, either by imposing a tax or boosting capital requirements for firms that pose the highest risk. To do that, however, regulators will need much more, and more timely, data on everything from firms’ commercial paper and repo positions to their exposure to rival firms via CDS holdings and currency and interest rate swaps.

In contrast to those kinds of bottom-up models, which focus on the contribution of individual firms to systemic risk, other models take a top-down approach, drawing on macro data to indicate when overall market risk may be reaching dangerous levels. Economists at the BIS led by Claudio Borio have focused on the growth of credit relative to the economy, noting that this has historically been the best sign of brewing problems. This indicator will serve as the trigger for the proposed Basel countercyclical capital buffer. The buffer would kick in when the ratio of credit to gross domestic product exceeded its long-term trend by more than 2 percentage points, rising to a maximum of 2.5 percent if the credit-to-GDP ratio exceeded its long-term trend by more than 10 points. Credit patterns vary by country, though, so the indicator would operate as a warning sign rather than an automatic trigger. National authorities would be able to exercise their judgment about whether and when to require banks to build up their buffers.

Another indicator, developed by the New York Fed’s Adrian and Hyun Song Shin, a Princeton economist, looks at the relationship between balance-sheet growth and leverage to assess the financial system’s vulnerability. Rising asset prices encourage banks to step up their borrowing to acquire more assets, the inherent reason that good times can lead to credit excesses. By charting the growth in repos, one of the main vehicles that banks use to fund their activities, the researchers believe they can forecast changes in the volatility risk premium, a gauge of whether the system is becoming more or less stable.

If central banks had been paying closer attention to credit-to-GDP ratios and leverage indicators, they might have acted sooner to avert the recent crisis or to moderate its impact, says the Bank of England’s Tucker. “The fault lines in the system could have been identified and reduced, if not eliminated,” he explains. “The erosion of capital and the extent of leverage in the banking system could have been addressed. Do I think we can do better than in the run-up to the crisis? Yes. Do I think we’ll always get it right? Of course not.”

There’s a fundamental reason for most credit expansions. The Internet really did transform business, even if the price of technology stocks got out of hand a decade ago. Subprime mortgage lending was useful in expanding home ownership before excessive growth and outright fraud laid the seeds of disaster. The key for central bankers is to try to contain excessive credit growth without stifling innovation. Leaning against credit expansions is a bit like taking out insurance, the New York Fed’s Dudley says. If the fundamentals behind the expansion are sound, a slightly tighter central bank stance shouldn’t hurt the economy. If they aren’t, the central bank’s posture could help limit the damage of a bubble bursting.

As they improve their methods for measuring risk, central bankers need to consider what policy tools would best contain risk and prevent a crisis from erupting. The Committee on the Global Financial System, a BIS arm that monitors markets for central bankers, identified an array of tools in a May 2010 report; they range from setting maximum loan-to-value ratios for mortgage lending to imposing debt-service-to-income ratios for consumer lending to varying margin requirements for securities purchases. Even more draconian, central banks can resort to outright curbs on certain activities — for example, imposing limits on credit growth in particular sectors, such as housing, or restricting foreign currency lending.

Western central banks can learn a lot from the experience of regulators in emerging markets, notably in Asia, who haven’t hesitated to try to contain credit and asset price booms. The People’s Bank of China raised reserve requirements five times in 2010, ordering banks to set aside 18.5 percent of their deposits, in a bid to curb the rapid pace of lending growth. Also in 2010, the China Banking Regulatory Commission issued a warning to banks to avoid fueling speculative housing purchases, after mortgage lending surged by 49 percent in 2009. The agency has also mandated that buyers make minimum down payments of 40 percent on second-home purchases. In Hong Kong, where apartment prices have soared by about 50 percent over the past two years, the Hong Kong Monetary Authority in 2009 lowered the mortgage loan ceiling to 60 percent of value for properties worth more than HK$20 million ($2.6 million), down from 70 percent; in August it applied that loan-to-value ceiling to properties worth more than HK$12 million. In November the Bank of Thailand imposed loan-to-value limits of 95 percent for low-rise housing and 90 percent for condominiums. The Thai central bank also set minimum income requirements for credit card holders to contain consumer lending. “Emerging markets, especially in Asia, have long used macroprudential measures,” Bank of Thailand governor Tarisa Watanagase said at a macroprudential conference at the Chicago Fed in September.

The advantage of such measures is that they focus on the source of speculative excess rather than slowing the overall economy, as interest rate hikes do. The disadvantage is that they are difficult to implement, at least in the West. Intellectually, most Western central bankers resist the idea of administrative controls as inherently anti–free market. The Bank of England imposed a ceiling on bank lending, known as “the corset,” in the 1970s in a bid to contain inflation, but the Thatcher government discarded that as one of its first market liberalization moves in the early 1980s. The idea of turning the regulatory clock back to the ’70s is anathema today, says former supervisor Green.

Targeting specific sectors for lending restraints also risks a political backlash. In May the Bank of Israel was attacked for keeping young couples out of the housing market after it told banks to set aside loan-loss provisions for mortgages in which buyers made down payments of less than 40 percent. In 2006 the Federal Reserve sought to slow commercial real estate lending because of concerns about overexposure among small and midsize banks. “There was so much blowback, including from members of Congress who said, ‘What are you doing? This is perfectly good lending,’” says Donald Kohn, senior fellow at the Brookings Institution, who was vice chairman of the Fed’s Board of Governors at the time. The Fed ended up watering down its stance to merely issuing guidance to supervisors to scrutinize banks more closely if commercial real estate lending exceeded 300 percent of capital.

The problem with macroprudential tools is that “it will be very, very difficult to push the button in good times,” says the BIS’s Caruana.

The ultimate central bank tool, of course, is setting interest rates. The Fed, the ECB and others raise rates in good times to slow the economy and contain inflationary pressures, and lower them in bad times to promote borrowing and growth. But the idea of using interest rates to promote financial stability is the biggest area of controversy among policymakers.

The consensus view, espoused by Greenspan and Bernanke, is that interest rates are too blunt a tool to be used to restrain credit. Bank of England chief economist Charles Bean presented a paper in August at the Kansas City Fed’s annual conference in Jackson Hole, Wyoming, that asserted that to dampen house price growth early in the boom, the Fed would have had to begin hiking rates in 2003, one year earlier than it did, and would have had to boost them to a peak of 7.5 percent in 2006, 2.25 percentage points above the actual high point. Such a policy would have had some impact on housing — home prices would have peaked 7.5 percent lower than they actually did — but it also would have reduced the economy’s output by 3.3 percent over the period.

Few central bankers find that trade-off attractive. Even officials at the ECB, which unlike the Fed doesn’t have a mandate to promote growth and views credit expansion as a potential harbinger of inflation, caution against using interest rates to prick asset bubbles. “Monetary policy is not going to be compromised by pure financial stability considerations,” says the ECB’s Constancio.

Still, the heavy costs of the financial crisis and the fact that it followed a period of exceptionally low interest rates by the Fed are convincing more economists and policymakers that central banks should lean against the credit cycle in setting rates. The OECD’s White has been pushing that view since 2003. He contends that very low rates fuel speculative activity, cause the misallocation of capital — for example, to unsustainable housing booms — and create an expectation among investors that the central bank will bail them out in times of trouble. “Ultra-low interest rates are no free lunch,” he says. “Maybe there are benefits, but there are certainly costs. Do the benefits outweigh the costs? I don’t think they do.”

Yale’s Roach puts it even more bluntly. “What I want is a Fed that’s willing to impose a sacrifice on the U.S. economy if the financial stability mandate is violated,” he says. Sure, higher rates might have slowed the U.S. economy’s growth rate to about 2.75 percent from 3.5 percent, he acknowledges, but that’s a price worth paying. “The alternative is the 10 percent unemployment rate we have today,” he says.

No Fed official talks about financial stability in those terms, but increasingly there are signs that some key members are open to leaning against the credit cycle in setting interest rates. In a recent speech to the National Association for Business Economics, vice chairman Janet Yellen said the Fed shouldn’t rule out raising interest rates to curb credit booms, a view that the New York Fed’s Dudley shares. “I would not want to argue that it is never appropriate for monetary policy to take into account its potential effect on financial stability,” Yellen said. “Regulation is imperfect. Financial imbalances may emerge even if we strengthen macroprudential oversight and control.”

The crisis has changed the thinking of many central bankers, and the establishment of new bodies like the FSOC promises to elevate the importance of financial stability considerations. But changes in actual policy are likely to evolve at a very slow pace. Many central bankers worry that there isn’t yet a broad enough social consensus in most Western countries for restraining credit in the name of financial stability, notwithstanding the crisis and its painful aftermath. It took the ravages of 1970s inflation, and the determination of former Fed chairman Paul Volcker, to persuade most people that central banks should concentrate on fighting inflation. “It took decades to get a consensus on price stability,” Jean-Pierre Landau, deputy governor of the Banque de France, told the Chicago Fed conference. “Maybe in 40 years we’ll have the same kind of consensus on financial stability.”