Financial Stability for Central Banks (Part II)

A financial stability mandate doesn't just help improve the country-specific conduct of monetary policy. It would also empower central banks to take on the new and important responsibility of serving as systemic risk regulators.

This is one of the new areas of focus in the post-crisis debate on which there is a broad consensus. But the key here, like in so many global issues, lies in execution — specifically, the mechanism by which systemic risks are identified and addressed.

In essence, systemic risks are all about spillovers — across financial institutions, asset markets, financial products and economies. By definition, no one central bank can address these complications alone. It would be like putting pressure on one end of a water balloon.

In an increasingly interconnected world, systemic risk regulators all need to be on the same page in this critical aspect of policy setting. To do otherwise runs the risk of fragmenting global risk management and regulation — thereby creating market-specific opportunities for "regulatory arbitrage" that could well end up exacerbating global imbalances.

If the G-20 wants to get serious about establishing a new global policy and regulatory architecture, collaborative consultations between national authorities in the area of systemic risk assessment would be an important place to start.

It is not enough to discuss systemic risks periodically at high-profile meetings such as G-20 summits. A new framework needs to be established that explicitly incorporates international policy coordination into the global architecture.

Such an effort may well require a global systemic risk manager to coordinate the surveillance and early warning responsibilities that would mitigate systemic risks.

This functionality should reside in an international organization — either the Bank for International Settlements (BIS) or the International Monetary Fund. But it should be delegated to the professional staffs of the BIS or the IMF, who would then need to be insulated from any pressures from their politically selected boards of directors.

This could be an important transformational step for the G-20 — converting the rhetorical flourishes of periodic communiqués into ongoing operational capabilities. A robust global architecture demands nothing less if the world is ever to cope with systemic risks and the global imbalances they spawn.

A failure to address the global dimensions of a financial stability mandate would be a major impediment for global rebalancing. Yet that's exactly the direction the world is headed.

National governments are now hard at work in crafting their own individual approaches to global issues. This mismatch reflects a dangerous presumption — that the best global policies are the sum of the best national policies. Nothing could be further from the truth.

This key shortcoming of the global policy architecture has also given rise to an increasingly contentious blame game. For example, the so-called "global saving glut" explanation was used repeatedly by Messrs. Bernanke and Greenspan to pin the blame for America's asset bubbles on Asian savers — especially the Chinese.

While there can be no denying the impacts of Chinese purchases of dollar-denominated assets as one of several sources of support to U.S. asset markets, such foreign buying pales in comparison to the dominant role played by domestic investors.

Moreover, it is ludicrous to blame China for the Fed's failure to put a stop to the widespread mortgage lending and consumer leverage abuses that became pervasive in the period leading up to the sub-prime crisis.

Under a global financial stability mandate, the international blame game could be avoided — and turned, instead, into an agenda for coordinated and collaborative policy action.

A new and expanded policy mandate is not a sure-fire fix for all that ails a post-crisis world. Nor is it an inoculation against future crises. But in the rush to regulatory reform, the vengeance of a polarizing populism has fixated on the compensation of risk takers as the major post-crisis remedy.

It will take far more than that to create a sounder financial system. Risk taking was excessive not just because of misaligned bonus incentives, but also because the price of leverage and risky assets was set far too low by misdirected central banks.

New proposals for pay guidelines, regulatory consolidation, or counter-cyclical capital provisioning will work only if they are set in the context of the clearly defined goals and principles of financial stability.

Learning the lessons of this crisis is an exercise in shared responsibility. Like the rest of us, central banks hardly deserve special dispensation from this critical reappraisal. In the end, they must be held accountable for their failed stewardship of the financial system.

A key lesson from the crisis of 2008-09 is that such accountability requires a new financial stability mandate for central banks. The establishment of a global systemic risk regulator would provide an important global overlay to this approach.

Only then will the world stand a better chance of avoiding a replay of the destabilizing interplay between asset bubbles and imbalances that nearly pushed the system into the abyss in the autumn of 2008.

Editor's Note: This is the second of a two-part series. Read Part I here.

This feature is adapted with the permission of the author from his essay entitled “The Financial Stability Imperative for Central Banks,” published on October 22, 2009.