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On occasion, central banks (e.g., ECB and Swedish Riksbank) did take financial system developments, especially asset prices or credit growth, into account in setting interest rates, but this tended to be the exception rather than the rule.
Similarly, structural reforms have been seen as the key tool for achieving full employment and higher long-run economic growth.
See Cecchetti and others (2000); Bernanke and Gertler (2001); Borio and Lowe (2002); Richards and Robinson (2003); and papers presented at the 2007 Jackson Hole Symposium on Housing, Housing Finance, and Monetary Policy.
See Global Financial Stability Reports (http://www.imf.org/external/pubs/ft/gfsr/index.htm) and “On Monetary and Financial Stability—Past, Present and Future,” remarks by José Viñals, Robert Marjolin Lecture at the Utrecht University School of Economics, The Netherlands, September 4, 2009 (http://www.imf.org/external/np/speeches/2009/090409a.htm).
These are bilateral (or in a few cases multilateral) agreements between central banks that in essence involve the provision of liquidity from a central bank whose currency was in demand to another central bank for distribution by the latter to local institutions.
Purchases by the Fed of mortgage-backed securities guaranteed by government sponsored agencies are counted here as public sector securities, even though they are formally claims of the Fed on the private sector
Moral hazard and adverse selection are agency problems that are endemic in financial markets. Moral hazard leads financial institutions to take too much risk, especially when there are implicit guarantees. Both moral hazard and adverse selection created weaknesses in the originate-and-distribute banking model. Insufficiently robust payment and settlement systems and lack of transparency in financial markets are rooted in collective action problems. See also Bank of England (2009).
Market risk can be defined as the risk of losses on (real or financial) assets or liabilities arising from changes in market prices and covers interest-rate, foreign exchange, equity price and commodity price risk.
In December 2009 the Basel Committee issued a consultation paper on a set of reform proposals to strengthen the resilience of the banking system, including through a higher quality of capital (http://www.bis.org/publ/bcbs164.htm).
Well designed fiscal tools, such as a tax on uninsured (wholesale) liabilities, can provide additional incentives in this regard. See IMF, 2010e.
Bank-sponsored conduits and special purpose vehicles that take on credit off-balance sheet may also need to be included but could more appropriately be consolidated on the sponsoring bank’s balance sheet.
The proposed arrangements in the European Union, where central bank officials are given a strong voice on the European Systemic Risk Board, is an example. Alternatively, the central bank could be given the role of writing regular “letters” to the supervisory authority, setting out its recommendations for macroprudential policies (as suggested by Turner, 2009).
Arrangements are often deeply rooted in tradition, but may need to be adjusted to reflect developments in the financial sector. Nier (2009) provides further discussion of the appropriate place of central banks in the overall institutional framework, including not only banking supervision but also securities market regulation.
Development of a more complete financial stability framework may parallel in some respects the development of the monetary policy frameworks employed by advanced economy central banks today (Madigan, 1994 and Roger and Stone, 2005).
Lengthening policy horizons could add an element of price level targeting to the policy framework [(Walsh (2009), Carney (2009)]. Price level targeting requires that the cumulative effects on the price level of deviations from the inflation target eventually be reversed in order to achieve the desired long-run inflation objective. This approach might help strengthen policy accountability while at the same time facilitating increased policy flexibility in the short and medium term. However, price level targeting poses a number of practical difficulties (Kohn, 2009).
This is closely analogous to the way that many inflation targeting central banks deal with exchange rate developments. Although the central bank does not have any exchange rate objective per se, exchange rate developments are monitored and analyzed carefully in so far as they affect the outlook for inflation and output.
In principle, higher reserves may interact with more stringent liquidity requirements for banking institutions. However, they need not conflict when they count towards prudential liquid assets.
Reserve levels could be boosted by raising reserve requirements. Alternatively, under a voluntary reserve targeting scheme such as that adopted by the Bank of England in 2006, institutions can choose to raise their own targets in response to stresses.
Systemic vulnerability can be addressed by measures to increase the transparency of market and measures to ensure that market participants have proper incentives. For example, originators and sponsors of asset-backed securities may need to be required to retain an appropriate amount of “skin in the game.”
See Cihak and Nier (2009). Current reform proposals for the United States envisage all systemically important financial holding companies to be subject to special resolution powers.
Since 2005, there has also been an effort on the part of central banks, led by the Federal Reserve Bank of New York, and industry participants to reduce counterparty credit risk in bilaterally cleared “over-the-counter” derivatives markets, most notably markets for credit default swaps.
The efficacy of central bank swap arrangements need to be considered together with other foreign exchange liquidity providing options such as regional pooling arrangements, cross-border collateralization arrangements, self-insurance through foreign reserves, and the Fund’s Flexible Credit Line; consideration of these options is beyond the scope of this paper.
The liquidity providing central bank is not directly exposed to credit risks of local counterparties of the liquidity receiving central bank.