22 March 2012

Jens Weidmann: Lessons from the crisis for monetary policy and financial market regulation

"Drawing the right lessons from the crisis requires first of all a clear understanding of the role the financial system plays for the real economy. In my short remarks I will therefore take a somewhat more general approach that goes beyond monetary policy issues. I will argue that, firstly, a highly developed and innovative financial system is indispensable for economic growth, but that there is also an inherent risk of exaggerations. Secondly, regulatory efforts therefore have to strike a delicate balance between constraining such exaggerations without stifling innovation and thereby hampering economic growth. And finally, given that the crisis has laid bare serious gaps in our understanding of the financial system, I will conclude by outlining some fields of research that, at least from a central bank’s viewpoint, are of particular interest."

3. Lessons for financial regulation

Regulatory reforms aim to improve the resilience of the financial system as a whole against shocks in the form of a default or the burst of a bubble. To achieve this, financial regulation has to prevent market forces from getting out of control. But it must not suppress financial innovation; otherwise we would eliminate its indispensable contribution to economic growth and development.  The European sovereign debt crisis has raised awareness of the importance of financial markets and their disciplining effect. True, bond markets took note of differences in sovereign risks much too late. But did not economic  policy perform even weaker in preventing excessive deficits and the emergence of severe macro-economic divergences?

For this reason, I am sceptical about correcting undesirable results in the financial markets by direct prohibition or by suppressing market activities. Instead, regulatory reform should reinvigorate the principle that risks and returns have to be closely aligned: Market participants must be held responsible for their actions, the possibility of losses or even default is a constitutive element of any functioning market, and the financial markets are no exception.

The reforms initiated by the G20 reflect this approach. Measures like Basel III and the new macro-prudential framework explicitly take a systemic view of the financial system. The resolution regimes for SIFIs, the measures adopted to increase transparency and to create a global level playing field strive for a closer alignment of risks and returns. The agenda has picked up on important past trends, such as the increasing role of non-bank-sector and the growing interconnectedness of financial markets.

When looking at the experience of the financial crisis and the channels through which the financial system affects economic growth, the case can be made that the two objectives of an efficient and stable financial system are, to a significant degree, complementary. Well designed regulatory reform can make the financial system more stable without cutting into sustainable growth. But the constant evolution of the financial system and the emergence of new instruments and players also imply that the regulatory framework will never be finalised once and for all.

5. Conclusion

The financial system plays an indispensable role in fostering innovation and growth. This role has never been static: it is evolving constantly. And throughout history, this process has been accompanied by exaggerations. The continuing, never-ending challenge of financial market regulation is to limit the latter without stifling the undeniably beneficial forces at work in the financial system – we have to tame market forces and self-interest, but should not exorcise them. To do so, we have to expand our understanding of financial markets, which is still limited and lacking in a number of policy-relevant fields.

Full speech

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