Central banking post-crisis: What compass for uncharted waters?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The global financial crisis has shaken the foundations of the deceptively comfortable pre-crisis banking world.  Central banks face a threefold challenge: economic, intellectual and institutional.  Claudio Borio in a paper for the Bank of International Settlements, notes the changing environment that central bankers face going forward; operating in a more hostile economic environment, the current economic benchmarks paradigms and models have failed and central banks will need to adjust their policy framework to maintain their independence. 

Policymakers will look for a new compass that should have the following characteristics: (1) tight interdependence between monetary and financial stability; (2) a greater awareness of the global, as opposed to purely domestic, dimensions of those tasks; and (3) the autonomy of central banks will need to be protected and strengthened. 

Borio notes three lessons that central banks learned from the crisis.  The first is that low and stable inflation does not guarantee financial and macroeconomic stability: monetary policy may have contributed to the crisis’s severity.  This is especially true during a period of prolonged easing.  The use of monetary policy to clean the post-crisis debris can be costly.  Interest-rate policy may not the right policy tool for the nature of the crisis: it is not optimal during a balance sheet recession.  There are times when a disagreement on policy may be as good as consensus.

Borio proposes the compass include adjustment to policy regimes, including the tighter integration of monetary policy and financial stability, adjustment for financial imbalances, consideration of monetary policy response to financial busts, the operational independence of central banks and a keener awareness of the global dimensions of these tasks.    

The key challenges for the implementation of the compass: the operational independence of central banks is likely to come under growing pressure and the need for greater international policy coordination.  A compass for central banks is needed as they sail into uncharted waters.

Please see the attached link for more details.  http://www.bis.org/publ/work353.htm

Understanding the Paradigm for Risk Management: Lessons from the Crisis

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

A key question for risk management: do you have the correct framework to analyze risks.  This is a question that Claudio Borio & Piti Disyatat (Bank for International Settlements) ask in a recent VOXEU communiqué “Did Global Imbalances Cause the Financial Crisis?” about international policymakers?  The authors note the emphasis on current-account imbalances diverts attention away from monetary and fiscal factors that sowed the seeds of destruction leading to the underestimation and mispricing of risk.   

 

A key part in G20 and IMF discussions was the role of financial imbalances in causing the recent financial crisis.  The focus on savings-investment balances, current accounts and net capital flows may be flawed.  The authors suggest that other factors should be considered as causal factors and could provide a better understanding of the process and linkages. 

 

The authors object to two key policymaker assumptions: (1) net capital flows from current-account surplus to deficit countries helped finance credit booms; and (2) a rise in savings relative to investment in surplus countries depressed global rates.  The authors argue that global imbalances, which measure net flows, provide little evidence about global financing patterns based on the surge in gross capital flows that was largely between advanced countries.  These flows increased from 10% of world GDP in 1998 to 30% in 2007 and were driven by flows between advanced countries.  The surge in US gross capital flows involved developed areas not running a current account surplus and was private in nature.  Net capital flows do not capture the disruptions created by 2008’s collapse in cross-border lending.  Excess savings or the unwinding of global imbalances did not trigger the crisis; disruptions in the chain of global intermediation did. 

 

Their second critique is that the excess-savings view provides an incomplete explanation of low global rates.  Market interest rates reflect both monetary and financial factors: central bank policy rates, risk premia, market expectations, and supply and demand for assets.  These factors interacting with artificially low policy rates contributed to the turmoil. 

 

The authors conclude that global imbalances offered little explanation about the global intermediation process behind the credit boom or how contagion is transmitted.  The international monetary and financial system lacks a strong policy framework to prevent future credit bubbles and asset booms.  The authors suggest that without a better understanding of the analytical framework, policymakers could be prone to policy errors, faulty assumptions and flawed risk estimation.

 

Do you have the correct framework in place to understand potential risks?

 

The first author, Claudio Borio, was one of the first to note a rise in systemic risk at a presentation at Jackson Hole in 2003.

http://www.voxeu.org/index.php?q=node/6795