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Central Bank Policies and Systemic Risks

Central Bank Policies and Systemic Risks

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Summy
M
ajor central banks have taken unprecedented policy actions ollowing the nancial crisis. Inaddition to keeping interest rates low or a prolonged period, they have taken a host o uncon- ventional measures, including long-term liquidity provision to banks in support o lending, as well as asset purchases to lower long-term interest rates and to stabilize specic markets, suchas those or mortgages. Although the objectives dier somewhat across central banks, these policies have generally aimed to supportthe macroeconomy (by avoiding deation and depression) and address short-term nancial stability risks.Using econometric and other evidence, this chapter nds that the interest rate and unconventional policiesconducted by the central banks o our major regions (the euro area, Japan, the United Kingdom, and theUnited States) appear indeed to have lessened vulnerabilities in the domestic banking sector and contributedto nancial stability in the short term. Te prolonged period o low interest rates and central bank asset pur-chases has improved some indicators o bank soundness. Central bank intervention mitigated dysunction intargeted markets, and large-scale purchases o government bonds have in general not harmed market liquidity.Policymakers should be alert to the possibility, however, that nancial stability risks may be shiting to otherparts o the nancial system, such as shadow banks, pension unds, and insurance companies. Te centralbank policy actions also carry the risk that their eects will spill over to other economies.Despite their positive short-term eects or banks, these central bank policies are associated with nancialrisks that are likely to increase the longer the policies are maintained. Te current environment shows signs o delaying balance sheet repair in banks and could raise credit risk over the medium term. Markets may be alertto these medium-term risks, as central bank policy announcements have been associated with declines in somebank stocks and increases in yield spreads between bank bonds and government bonds. Central banks alsoace challenges in eventually exiting markets in which they have intervened heavily, including the interbank market; policy missteps during an exit could aect participants’ expectations and market unctioning, possibly leading to sharp price changes.Even though monetary policies should remain very accommodative until the recovery is well established,policymakers need to exercise vigilant supervision to assess the existence o potential and emerging nancialstability threats, and they should use targeted micro- and macroprudential policies where possible to mitigatesuch threats to allow greater leeway or monetary policy to support the macroeconomy. Macroprudentialpolicies—which may include robust capital standards; improved liquidity requirements; and well-designed,dynamic, orward-looking provisioning—should be implemented in a measured manner, as needed. Te crisishas shown that corrective policies enacted ater the risks materialize may be too late to contain damage tonancial stability. As the experience with some macroprudential policies is relatively limited, their eectivenessshould be careully monitored. In the meantime, the unconventional monetary policy actions should continue,as they have, to keep nancial stability goals in mind.
International Monetary Fund
|
April 2013
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     c     h     a     p     t     e     r
DO ceNtraL BaNK pOLIcIeS SINce the crISIS carrY rISKS tOFINaNcIaL StaBILItY?
 
GLOBAL FINANCIAL STABILITY REPORT
 2
International Monetary Fund
|
April 2013
he central banks o the largest advancedeconomies have taken unprecedentedmeasures to combat the deepest andmost prolonged period o recession andnancial instability since the 1930s.
 
Tese measuresinclude an extended period o very low interest ratesas well as so-called unconventional policies—provid-ing long-term liquidity to banks to support the ow o credit, lowering long-term rates through bondpurchases, and stabilizing specic markets such asmortgage lending.
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Central banks have also issued“orward guidance,” in which they announce anintention to maintain an accommodative stance oran extended period. We will reer to the combina-tion o exceptionally low policy interest rates andunconventional policy measures as “MP-plus” toindicate that these policies go beyond conventionalmonetary policy in terms o tools and objectives.Te objectives o MP-plus are to benet not only the macroeconomy but also nancial stability. By providing liquidity to banks and buying specicassets, MP-plus directly mitigates short-term insta-bility in nancial markets and vulnerabilities in thedomestic banking sector. In addition, MP-plus alsoindirectly limits stress in the nancial sector to theextent that it succeeds in preventing a sharper eco-nomic downturn. By encouraging economic activity through its easing o credit conditions, MP-plus canhelp strengthen private and public balance sheets andthus make a more durable contribution to nancialstability. Such benets may result, or instance, i rms take advantage o lower longer-term rates by extending the maturity prole o their debt.However, MP-plus may have undesirable sideeects, including some that may put nancial stabil-ity at risk. Ample bank liquidity may raise credit risk at banks by compromising underwriting and loan
Note: Tis chapter was written by S. Erik Oppers (teamleader), Ken Chikada, Frederic Lambert, ommaso Mancini-Grioli, Kenichi Ueda, and Nico Valckx. Research support wasprovided by Oksana Khadarina.
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Examples o the unconventional policies are quantitativeeasing by the Federal Reserve, the Funding or Lending Schemeby the Bank o England, and the announcement o the OutrightMonetary ransactions o the European Central Bank. Te Bank o Japan implemented a program o quantitative easing in theearly 2000s and—along with other unconventional policy mea-sures—again in the atermath o the global nancial crisis.
quality standards, and it may encourage a delay innecessary balance sheet repair and bank restructur-ing. Likewise, low interest rates encourage othernancial institutions, including pension unds, insur-ance companies, and money market mutual unds,to increase risk by “searching or yield.” A search oryield can help push the market value o some assetsbeyond their undamental value (“bubbles”) or drivean excessive increase in balance sheet leverage. Insome cases, risks may stem not rom the unconven-tional policies themselves but rom the difculties inexiting rom them. Where central banks intervenedin markets to mitigate instability, their presencemay aect market unctioning or mask continuing  vulnerabilities, complicating exit and raising thepotential or policy missteps.Tis chapter aims to bring empirical evidence tobear on some o the nancial stability eects o MP-plus. It denes and quanties the MP-plus policies o our major central banks—the Federal Reserve, theEuropean Central Bank (ECB), the Bank o Japan(BOJ), and the Bank o England (BOE)—and thenidenties possible risks to domestic nancial stability and to the nancial health o banks. Banks are theocal point o the chapter because they are naturally leveraged and, as a whole, they are the most systemi-cally important nancial institutions in the advancedeconomies that are actively using MP-plus policies.Te potential eects on pension unds and insurancecompanies and evidence o emergent bubbles arecovered in Chapter 1. Te risk that central bank mea-sures will have macroeconomic and nancial stability eects abroad is an important topic that deservescareul analysis; to keep the scope o this chaptermanageable, it is not covered here, but it is examinedin Chapter 1 and in an IMF paper on unconventionalmonetary policy (IMF, orthcoming).
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In the areas it examines, the chapter nds ew immediate nancial stability concerns associated withMP-plus. So ar, it appears to have increased some mea-sures o bank soundness; and in markets where centralbanks have become major players, their interventioneither has not appreciably aected market liquidity or ithas corrected market dysunction. However, the longer
2
 Also see previous IMF publications or the eect on pensionsand insurance (or example, Chapter 2 o the September 2011GFSR) and spillovers (Chapter 4 o the April 2010 GFSR).
 
chapter 3
DO CENTRAL BANk POLICIES SINCE ThE CRISIS CARRY RISkS TO FINANCIAL STABILITY?
International Monetary Fund
|
April 2013
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that MP-plus policies remain in place, a number o potential uture risks are likely to increase, including heightened credit risk or banks, delays in balance sheetrepair, difculties in restarting private interbank und-ing markets, and challenges in exiting rom markets in which central banks have intervened. Te markets may be alert to these medium-term risks, since the analysisnds evidence o an increase in the medium-term risk o bank deault ater MP-plus announcements.Policymakers should use micro- and macropruden-tial policies where possible to counter the nancialstability risks that may be emerging over the mediumterm. Implementing such policies in a measured man-ner, as needed, would allow MP-plus greater leeway to support price stability and growth while protect-ing medium-term nancial stability. However, theexceptional nature o current monetary policies andthe relatively untested macroprudential tools in many countries make this uncharted territory or policy-makers, and the eectiveness o the policy mix shouldbe careully monitored. With a ocus on nancial stability, the chapter will not address the timing or modalities o the exitrom MP-plus, although Box 3.1 notes some nancialstability risks that may arise with exit. Te chapter will also not assess the current and uture economiceectiveness o unconventional monetary policies.Tese topics are covered in IMF (2010a) and IMF(orthcoming) respectively.
Mp-plus: an Ovviw
 Ater the start o the nancial crisis in 2007, cen-tral banks in major advanced economies undertook a number o MP-plus measures.
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Tese measurescan be classied into our groups (with some overlapbetween groups):
Prolonged periods o very low interest rates,
 
sometimescombined with orward guidance on the length o time or which rates are expected to remain low;
Quantitative easing 
(QE), which involves
 
directpurchases in government bond markets to reduceyield levels or term spreads when the policy rate isat or close to the lower bound;
3
 Annex 3.1 lists the various announcements o MP-plus mea-sures since the start o the nancial crisis.
 
Indirect credit easing 
 
(ICE), in which central banksprovide long-term liquidity to banks (sometimes with a relaxation in access conditions), with theobjective o promoting bank lending; and
 
Direct credit easing 
 
(DCE), when central banksdirectly intervene in credit markets—such asthrough purchases o corporate bonds or mort-gage-backed securities—to lower interest rates andease inancing conditions (and possibly mitigatedysunction) in these markets.MP-plus measures were taken with both macro-economic and nancial stability objectives in mind, with the mix depending, in part, on the mandates o specic central banks. Te nancial stability objectivesare the subject o this chapter. Box 3.2 summarizesIMF (orthcoming), which looks at the macroeco-nomic eects o unconventional monetary policies.Tese operations have led to a undamentalchange in the size and composition o central bank balance sheets. otal assets have increased signi-cantly, mostly in the orm o government securities,bank loans, equities, and mortgage-backed securi-ties (able 3.1 and Figure 3.1). Tese shits entailedspecic (and new) risks or central banks, including credit and market risks. Unless they are adequately managed, including through enhanced loss-absorb-ing capacity, these risks (or perceptions about them)may aect the ability o central banks to perormtheir mandated roles and their credibility. I balancesheet assets are managed poorly, they could aectnancial stability, as discussed later in this chapter.Outlined below are some risks that are, or mightbecome, associated with MP-plus—not all o themare currently evident—along with recommendationsor corresponding policy responses. Te next sections will examine the extent to which some o these risksare emerging today—in specic nancial markets as well as in nancial institutions—and which o themmay become more pronounced over the mediumterm. Te descriptions below are meant to providethe ull scope o potential channels through whichnancial stability could be aected—some o thesechannels are examined below, others in Chapter 1.Tese eects ocus on domestic institutions and mar-kets; as noted above, other IMF publications addressthe important potential spillovers to other economies.

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