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Home > Blogs > Anthony Harrington > The future of central banking, part 2

The future of central banking, part 2

Central banking | The future of central banking, part 2 Anthony Harrington

In his keynote speech to the 9th Bank for International Settlements (BIS) annual conference, Baron Alexandre Lamfalussy, former General Manager of the BIS and Former President of the European Monetary Institute, began from the standpoint that the crash and its immediate aftermath have thrown up “well identified problems for the central banking community which are unlikely to go away – even if we manage to extricate ourselves from our current predicament.”

Lamfalussy began by anchoring the current overriding mandate of central banks to bring about price stability, firmly in the inflationary era that followed the 1970s oil price shocks. The theory behind this was that inflation was a monetary phenomenon and therefore should be kept under control by monetary policy. Moreover, it was generally agreed in the decades that followed, that central banks should be independent of political pressure in order to help them to achieve their goal of price stability. Politicians it was argued, would always try to engineer a boom before elections to get themselves re-elected and then deal with the aftermath later.

However, many also thought that central banks should have a role in the prudential supervision of the financial sector, including, in many instances “micro-prudential” responsibility, i.e. the supervision of individual institutions. Today, with many central banks in full crisis management mode, Lamfalussy asked his audience to consider whether this task is putting at risk both the idea of conducting monetary policy in a manner to maintain the stability of the financial system and the task of ensuring price stability, generally defined as containing inflation to around 2%.

He points out, right at the start, that whatever the answer, central banks could hardly refrain from crisis management. This was something they were bound to get drawn into one way or another.

“… whether they like it or not, central banks are in the front line when it comes to keeping crisis manifestations under control. They have the resources and their traditional banking operations give them a proximity to the money and financial markets which finance ministers or supervisors not connected with central banks do not possess.”

What was new, this time round, was the way in which a liquidity shortage “turned fairly quickly into solvency problems of frightening dimensions – for which there has been no precedent since the 1930s”, he told his audience. Contamination spread like wildfire from country to country and central banks became more and more “innovative” or desperate, in their measures.

"The result has been an increasing variety of “non-conventional” central banking interventions, ranging from the lengthening maturity of liquidity support to quantitative easing of all shapes and sizes. In a number of instances, this has led not only to the spectacular expansion of the balance sheets of central banks, but also to the radical change in the composition of their assets, which implied the acquisition of risky assets. As a result, the key central banks have started navigating in uncharted waters, in terms of both operational techniques and their relations with governments.”

This was inevitable, but it is full of dangers. Lamfalussy suggested that if bankers want to avoid finding themselves in this territory again, they need to really focus on the current discussions about crisis prevention. Lamfalussy’s own solution would be to leave the supervision of individual financial institutions to micro-prudential regulators and to have their macro-prudential colleagues work hand in hand with them when they do their “audits” of specific institutions.

The point here is that micro-prudential regulators are trained to look for specific things, adherence to capital requirements, trading procedures and so on. What they are not trained for, or necessarily good at, is detecting “the potentially systemic impact of new practices, or changing management models, or of innovative new products”. Asking this of them “is to ask something that may well appear alien to the accomplishment of their prime micro-prudential duty.” It may even distract them from carrying out that duty, which is not an easy duty to perform anyway, he suggests. 

In plain words, which Lamfalussy did not use, had a “macro-prudential” regulator glanced at the workings of AIG, he/she might well have asked this question: “You are booking an enormous amount of profit from writing Credit Default Swaps. What contingency reserve do you have to pay out if the market goes south?” At which point the answer, “Oh, a few tens of millions of dollars” on liabilities in the many tens of billions, would have triggered alarm bells – hopefully early enough for AIG to have amended its ways and not to have fallen off the cliff quite so spectacularly. It’s a nice idea, but I’d be astounded if it could be made to work in practice. Turf is turf. If micro-prudential regulation is your business, you don’t want someone from another agency tut-tutting over your shoulder. This doesn’t, however, stop it from being an excellent proposal or the keynote speech from being extremely good.

Further reading on the crisis, central banking and on inflationary threats to price stability:

Tags: 1970s oil price shocks , Alexander Lamfalussy , Bank for International Settlements , BIS , central bank independence , inflation , monetary policy
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