03 May 2013

Erkki Liikanen: Banking structure and monetary policy – What have we learned in the last 20 years?

How is today's perspective on monetary policy different from what prevailed 20 years ago? 20 years ago, the world of today was being formed in many ways. In the sphere of banking regulation, a new era was beginning.

1993 was the year when the Economic and Monetary Union project was becoming political reality: the Maastricht treaty had been signed and was in the process of being ratified. It was also the time when the mainstream approach to monetary policy was beginning to converge to the flexible inflation targeting framework. A number of countries had then just adopted an explicit inflation targeting strategy. 

In the sphere of banking regulation, too, a new era was beginning. A significant reorientation was going on, away from regulating the conduct of banks and towards the new risk-based approach. The regulatory trend, based on increased freedom for banks but subject to risk-based capital requirements, would continue all the way to the eruption of the financial crisis in 2008.

In the EU, the second banking directive took effect from the beginning of 1993, creating a single market in banking. The directive sought to prevent discrimination and to increase efficiency through competition. There was discussion on the implications of this for supervision, but little action. So, while European banking markets were being integrated, financial supervision remained a national competence.

In the US, deregulation was also moving forward. For instance the Glass-Steagall Act, separating banking from securities and insurance, was under growing criticism and would be ultimately repealed in 1995. One reason for the dissatisfaction with the Glass-Steagall system in the US was competition from European banks which were less restricted in what they could do.

20 years ago, the striking improvement in macro-economic performance, later named “the great moderation” by chairman Bernanke, was spreading to the whole developed world. The almost surprising success of monetary policy in improving price stability and reducing fluctuations in economic activity, while also keeping interest rates at historically low levels, was interpreted as a major victory for the art of economic policy making.

Now it is known that there was trouble brewing under the surface. The underpinnings of global financial stability were becoming weaker. Global indebtedness increased, fuelled by current account balances and the “deepening” of international financial markets.

Four conclusions:

• First, for monetary policy, financial stability is very important. While monetary policy has proven to be able to pursue price stability even under rather strained financial conditions, the central banks are not able to insulate the real economy completely from the after-effects of financial crises. A more stable banking sector which is less prone to crisis will reduce the likelihood of crises and therefore protect the balance sheets of the central bank from financial risks and thereby protect its independence and credibility.
• Second, the most important part of stability policy is crisis prevention. Improving loss absorbency of banks and the crisis management powers of the authorities are necessary, but it is even more important to make sure that excessive growth of credit and indebtedness can be better controlled in the future. In this way, credit crunches and banking crises can be made less likely – and milder, should they happen.
• Third, financial stability would benefit from structural reform of the banking system. By separating the most risky securities and derivative activities from deposit banking, the spill over from deposit protection to speculative risk taking would be prevented. This would reduce the distorted incentives to expand trading activities and concentrate risks in deposit banks because of their privileged position in the deposit market.
• Finally, the structural reform of banking is a complement, not a substitute for other regulatory improvements. For central banks, the development of macro-prudential policies and instruments is especially relevant. Those macro-prudential instruments which can be adjusted over time to manage the conditions in the credit market will offer a way to better control the accumulation of excess risk and help prevent future crises. These instruments operate so close to monetary policy that central banks should be very closely involved, if not themselves responsible, in developing and using them.

Full speech

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