Scientific advisor to the Economic Analysis Council (CAE) to thePrime Minister and lecturer at Paris 1 Panthéon Sorbonne University, Jézabel Couppey-Soubeyran discusses recent advances in financial stability for BS Initiative.
We recently posted a definition of financial stability on our website. How would you define this concept?
There are many possible definitions, as financial stability is a multi-dimensional concept. Financial stability refers to the stability of financial markets, the credit market, the payment system, the foreign exchange market… and the list goes on. There are therefore different dimensions associated with financial stability, which is what makes it difficult to grasp.
The threshold at which a situation can be considered stable is difficult to define. For this reason, financial stability is most often defined by reference to its opposite: a situation is considered stable in the absence of shocks or malfunctions in the financial system.
The multidimensional nature of financial stability makes this concept difficult to define and therefore also difficult to quantify. Unlike internal monetary stability (price stability), which can be based on quantifiable targets (an inflation target of less than but close to 2%, for example), financial stability is much more difficult to reduce to a single target. It will therefore be more difficult for a central bank to set objectives in terms of financial stability on which it will stake its credibility. However, the fact that it is more difficult is not a sufficient reason to give up.
Do central banks have a role to play in financial stability through their monetary policy?
I think the crisis has raised awareness of the need to make financial stability a goal on a par with monetary stability. The crisis has shown us that monetary stability is not a necessary and sufficient condition for financial stability. On the contrary, the financial instability that led to the crisis arose in a context of monetary stability, namely that of great moderation in inflation.
Since the crisis, central banks have been taking measures to stabilize the financial system. However, virtually none of them have communicated these actions as being « necessary for financial stability. » Most of them have instead communicated that these measures were necessary to « avoid deflation » or « restore monetary policy transmission channels. » In other words, communication has remained focused on the objective of internal monetary stability.
Financial stability tended not to be sufficiently taken into account ex ante, as central banks always felt capable of intervening (at least they thought so before this crisis) ex post to restore liquidity to interbank or financial markets. Central banks have therefore almost always confined themselves to remedial intervention. It is regrettable that central banks do not seek to prevent financial instability through an appropriate macroprudential policy of monitoring asset prices and the credit cycle. This would help to calm excesses in this type of market ex ante rather than ex post.
What tools can be used in a macroprudential policy?
There are two very important aspects to a macroprudential policy aimed at preventing systemic risk. Systemic risk must be prevented in both its intratemporal and intertemporal dimensions. The latter involves monitoring, containing, and smoothing the asset price cycle and the credit cycle. Instruments are therefore needed to regulate these two variables. In terms of the asset price cycle, we could further tighten the organization of stock markets, derivatives markets, and even real estate markets. This could involve requiring larger margin deposits, ensuring that derivatives transactions can only be carried out if they are backed by underlying assets that are owned… These organizational aspects are, for example, at the heart of the European EMIR regulation on derivatives markets. The asset price cycle also depends on monetary policy and the credit cycle. Intuitively, we understand that these two cycles are linked and feed into each other. Rising asset prices increase the ability of collateral holders to obtain credit, and the credit obtained increases their ability to purchase assets, and so on. Factors that affect the credit cycle can therefore also affect the asset price cycle.
In terms of the credit cycle, instruments such as LTV (Loan to Value) and LTI (Loan to Income) ratios can be used. These two types of instruments require borrowers to make a sufficient contribution relative to their income, and they can be adjusted in line with the credit cycle. LTV and LTI are instruments that are in use in Canada, for example.
The CAE report on central banks and financial stability focused on another instrument, namely reserve requirements based not on deposits but on loans. This could be adjusted according to country and sector. For example, a higher reserve ratio could be required for real estate loans or consumer loans than for SME loans.
What do you think of the idea of a credit cap?
The idea here would be to monitor the credit-to-GDP ratio. In most Western countries, this ratio has exceeded the threshold below which credit benefits growth. This is something that has been demonstrated in fairly recent literature (see in particular the article « Too Much Finance » by Arcand, Berkes, and Panizza). The authors have shown that above a ratio of around 110%, the previously positive link between financial development (in terms of intermediation) and growth breaks down. The BIS has also carried out similar research, which leads to the idea of a credit growth threshold that should not be exceeded.
It may seem paradoxical, but for credit to become a driver of growth again, its growth must be regulated. First, we need to define the threshold beyond which credit is no longer considered to be beneficial to growth. Once this threshold has been defined, we need to use the macroprudential tools mentioned above (LTI, LTV, credit-indexed reserve requirement ratio) to contain credit growth.
Today in the eurozone, as described in Victor Lequillerier’s article on our website, we are not talking about adding a macroprudential objective to the central bank, but we have entrusted it with the role of microprudential supervisor within the framework of the Banking Union. Don’t you think that the ECB’s strong involvement in financial stability could pose a credibility problem for the monetary institution?
This issue of potential conflict of interest is always raised to argue that it is not necessarily in the central bank’s interest to become more involved in financial stability. I believe that, in any case, in times of crisis, the central bank is obliged to take measures that may run counter to its objective of monetary stability. So the conflict of interest exists, even when we want the central bank’s actions to be based on a strong principle of separation between financial and monetary stability. I don’t think this is a good argument for abandoning the central bank’s involvement in financial stability.
Having said that, we need to think about the nature of its intervention. Today, central banks are expected to become more involved in microprudential supervision. It would undoubtedly have been more effective for improving financial stability to entrust them with macroprudential regulation, as this is a task more in line with the macro culture of a central bank. To carry out its microprudential regulatory mission, the ECB will have to adapt to a different culture, that of off-site and on-site supervision of banking institutions. It is to be hoped that it will succeed in doing so, as failure to do so could have negative repercussions on its credibility.
Some point out that expanding the remit of central banks could undermine their credibility in terms of monetary stability. From this perspective, it seems to me that the risk would have been less with macroprudential supervision (more in line with a central bank’s remit) than with microprudential supervision. In any case, now that the ECB has been given an additional microprudential supervisory role, it would be difficult to add an explicit macroprudential role, as this would be too much and could undermine its credibility. Perhaps it will engage in macro-prudential supervision through micro-prudential supervision, but the central bank cannot be entrusted with an explicit macro-prudential objective involving the regulation of the credit cycle or asset prices.
Perhaps central banks will engage in macroprudential policy without saying so explicitly, but in that case we would be moving away from the strategies we had opted for, which consisted of basing central bank policies on rules. Ultimately, we risk giving central banks a little too much discretion in their actions. Basically, we are living in somewhat confusing times: everyone understands that central banks have neglected financial stability and must now get involved in macroprudential policy, but by getting central banks to deal with microprudential policy, we are making their involvement in macroprudential regulation more uncertain (too many tasks for a single institution). It is therefore unclear whether the response will ultimately be conducive to restoring financial stability.
Could less transparency push central banks to engage in macroprudential policy indirectly?
I am not sure that a return to opacity and discretion would be conducive to the effectiveness of central banks’ actions. On the contrary, if they have many objectives to meet, they must be accountable and sufficiently transparent.
More broadly, I feel that we are promoting a reorganization of prudential mechanisms that is not best suited to preserving financial stability. By involving central banks in micro-prudential regulation, we are also forcing supervisory mechanisms to revert to sectoral mechanisms, which are ill-suited to the integration of banking and finance.
Macroprudential regulation should not be implemented in a roundabout way; it must be implemented properly.
We would like to thank Jézabel Couppey-Soubeyran once again for her time.
Interview by Victor L. and Julien P.
Notes:
[1] A distinction can be made here between internal monetary stability, which is found in the mandates of most central banks and focuses solely on prices, and external monetary stability, which focuses more on exchange rate issues.
