Reviving a Policy Marriage

WASHINGTON, DC – Not long ago, the separation of financial supervision and monetary policy was in vogue in many countries. Some countries – like the United Kingdom and Australia – went so far as to unbundle these functions by assigning responsibility for financial stability to specialized agencies and extricating their central banks from financial supervisory issues altogether. In the aftermath of the global financial crisis, however, financial supervision and macroeconomic management have been forced to reunite.

This rapprochement is a consequence of the growing recognition that asset-price cycles must be taken into account for both macroeconomic management and financial supervision. Prior to the crisis, asset-price cycles were seen by many as basically harmless or, at least, as a relatively insignificant monetary-policy channel. Even when the frequent appearance of asset-price bubbles was acknowledged, most believed that efforts to detect and prick them at an early stage would be impossible – and potentially harmful. Interest-rate cuts after bubbles burst would be a safer way to safeguard the economy.

The dominant policy blueprint looked roughly as follows: the monetary authorities’ focus on inflation-targeting in setting interest rates should suffice to maintain price stability and economic growth near its potential rate. As for financial supervision, stability would be guaranteed by ensuring that individual financial institutions adopt sound prudential rules that preserve capital cushions commensurate with their risk exposure. While central banks should be in charge of maintaining adequate levels of liquidity in the system, so-called “microprudential” financial regulation should independently oversee financial institutions’ soundness and the protection of depositors.

The crisis has shattered the belief that well designed microprudential rules alone are sufficient. It is now increasingly recognized that significant asset-price increases (for example, in real estate or existing equities) may well be reinforced by the pro-cyclical nature of risk assessment embodied in those rules.