Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
AmericasSeptember 1 2011

Agustin Carstens: central banks hold the key to financial stability

Agustín Carstens suggests that central banks must play a more pivotal role in order to prevent such a widespread and deep-rooted crisis hitting again.
Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
Agustin Carstens: central banks hold the key to financial stability

We are still immersed in the most severe and extensive international financial crisis since the Second World War. As is the case with most financial crises, the current crisis was preceded by an economic bonanza, characterised by the growth of household and corporate leverage and increasing imbalances between savings and consumption. However, the severity of the crisis and the magnitude of the losses are explained by the fact that this time the crisis originated in the most developed countries.

Financial deregulation and innovation enabled the crisis to spread rapidly at a global level. The increased complexity of financial operations and the excessive fragmentation of entities with regulatory powers led to a lack of proper oversight and a serious underestimation of the risks assumed by economic agents.

Financial authorities failed to identify the first signs of trouble in time to anticipate its potential expansion. The initial responses were generally belated and the measures not always adequate. A lack of clarity with respect to the strategies being followed and a lack of coordination among the financial authorities of the countries involved contributed to worsening the crisis.

A global response

In the end, the magnitude and global spread of the crisis called for a global response. An ambitious regulatory agenda has been designed and pushed forward with the help of unprecedented international collaboration. The centerpiece of the agenda is the strengthening of capital and liquidity standards, but it also covers issues as distinct as the standardisation and regulation of derivatives, the improvement of resolution processes, and the implementation of a macro-prudential approach to regulation and supervision, including changes to institutional arrangements.

Unfortunately, some of the economic imbalances that help explain the severity of the crisis are also leading to an increasing diversity of interests and reform priorities among countries. While advanced countries are focusing on fiscal sustainability and the regulatory treatment of their systemically important financial institutions, emerging market economies are struggling to manage large capital inflows, and middle- and low-income countries are being hit hard by higher commodity prices.

Spreading crisis

The unprecedented amount of fiscal resources mobilised, as well as monetary stimulus put in place mainly by developed countries, helped to stabilise financial markets and played a pivotal role in preventing a collapse of the international financial system.

However, the mobilisation of such a large amount of resources inflated fiscal deficits and public debt levels in many developed economies. The drop in tax income due to lower economic activity, as well as the increase in costs from unemployment and other social benefits, also contributed to a deterioration of fiscal balances. The size of such economies’ fiscal deficits and the magnitude of public debt in relation to gross domestic product have transformed the financial crisis into a sovereign debt crisis.

Doubts about the fiscal sustainability of some developed countries appeared first in Greece, but the scepticism has spread rapidly to other European countries. The re-pricing of sovereign risks in eurozone countries generated a completely new set of challenges for financial authorities. The re-pricing of sovereign risks is leading to interest rate raises, which increases debt costs, weakening government fiscal positions. Interest rate hikes also contribute to the deterioration of the balance sheets of sovereign debt investors, particularly banks. Hence, the increase in the perceived sovereign risks leads to a vicious self-fulfilling circle, which affects both the fiscal position of some countries as well as their banks.

Lessons from the past

The experience from Mexico and other Latin American countries that have suffered these kinds of crisis in the past, teaches us that to break this vicious cycle it is necessary that measures go further than what market participants expect. Our own experience taught us that strategies have to be clear and credible in order to staunch the contagion. For a strategy to be credible it must provide more than temporary breathing room. It needs to be accompanied by overwhelming force.

Another important lesson from past international crises is that financial instability can interfere with price stability. A financial crisis increases the volatility of interest rates and foreign exchange rates notably, affecting costs to firms, the prices of goods and services, as well as expectations. Similarly, a financial crisis disrupts lending by financial intermediaries and alters the functioning of the financial markets. All of these problems distort the transmission mechanisms of monetary policy, making it more difficult for central banks to exert influence on economic performance and price dynamics. This is a valuable lesson and one the US Federal Reserve has confirmed in the recent crisis by acting differently from the way it acted before.

Central role

Through the years we have discovered that central banks can also play other crucial roles concerning financial instability, which are oriented towards preventing financial instability in the first place. Moreover, although autonomous central banks may have some advantages over other financial authorities in undertaking such responsibilities, action should be pursued jointly by the different financial authorities, within an environment of coordination and co-operation. Therefore, currently, the scope for action for central banks in terms of financial stability is broader than it was some decades ago.

In the first place, central banks should establish the foundation for the sound development of the financial sector by conducting monetary policy that is congruent with price stability. Prudent and responsible monetary policy that ensures price stability not only favours progress in the financial system by encouraging savings and investment in the economy, but it also decreases the probability of the occurrence of unsustainable credit growth, which is frequently a major cause of financial instability.

Regrettably, the attainment of price stability by itself cannot guarantee financial stability. The recent international crisis has also showed us that weaknesses in financial regulation and supervision, and lack of coordination among different authorities, can play an essential part in the emergence and spread of a financial crisis. Therefore, in addition to maintaining monetary discipline, central banks can also contribute to the prevention of financial instability by strengthening the regulatory and supervisory framework of the financial sector. In many countries this is done jointly with other financial authorities.

In measuring and monitoring systemic risks closely to foresee threats to a country’s financial stability and taking measures to mitigate them, autonomous central banks have two key advantages over other financial authorities. First, because their mandates are oriented toward macroeconomics, central banks already have the infrastructure in place to watch over the economy and the financial markets as a whole. Second, because they are autonomous, they might be more inclined to take away the punch bowl just as the party gets going.

Agustín Carstens is Mexico's central bank governor

Was this article helpful?

Thank you for your feedback!

Read more about:  Americas , Mexico , Regulations