Introduction to Monetary Policy and Bank Regulation

Introduction to Monetary Policy and Bank Regulation Introduction to Monetary Policy and Bank Regulation By: OpenStaxCollege Marriner S Eccles Federal Reserve Headquarters, Washington D.C Some of the most influential decisions regarding monetary policy in the United States are made behind these doors (Credit: modification of work by “squirrel83”/Flickr Creative Commons) The Problem of the Zero Percent Interest Rate Lower Bound Most economists believe that monetary policy (the manipulation of interest rates and credit conditions by a nation’s central bank) has a powerful influence on a nation’s economy Monetary policy works when the central bank reduces interest rates and 1/2 Introduction to Monetary Policy and Bank Regulation makes credit more available As a result, business investment and other types of spending increase, causing GDP and employment to grow But what if the interest rates banks pay are close to zero already? They cannot be made negative, can they? That would mean that lenders pay borrowers for the privilege of taking their money Yet, this was the situation the U.S Federal Reserve found itself in at the end of the 2008–2009 recession The federal funds rate, which is the interest rate for banks that the Federal Reserve targets with its monetary policy, was slightly above 5% in 2007 By 2009, it had fallen to 0.16% The Federal Reserve’s situation was further complicated because fiscal policy, the other major tool for managing the economy, was constrained by fears that the federal budget deficit and the public debt were already too high What were the Federal Reserve’s options? How could monetary policy be used to stimulate the economy? The answer, as we will see in this chapter, was to change the rules of the game Introduction to Monetary Policy and Bank Regulation In this chapter, you will learn about: • • • • • The Federal Reserve Banking System and Central Banks Bank Regulation How a Central Bank Executes Monetary Policy Monetary Policy and Economic Outcomes Pitfalls for Monetary Policy Money, loans, and banks are all tied together Money is deposited in bank accounts, which is then loaned to businesses, individuals, and other banks When the interlocking system of money, loans, and banks works well, economic transactions are made smoothly in goods and labor markets and savers are connected with borrowers If the money and banking system does not operate smoothly, the economy can either fall into recession or suffer prolonged inflation The government of every country has public policies that support the system of money, loans, and banking But these policies not always work perfectly This chapter discusses how monetary policy works and what may prevent it from working perfectly 2/2 ADAM S. POSEN EXTERNAL MEMBER, MONETARY POLICY COMMITTEE, BANK OF ENGLAND AND SENIOR FELLOW, PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS WHEN CENTRAL BANKS BUY BONDS INDEPENDENCE AND THE POWER TO SAY NO Barclays Capital 14th Annual Global Inflation-Linked Conference, New York 14 June 2010   2 WHEN CENTRAL BANKS BUY BONDS INDEPENDENCE AND THE POWER TO SAY NO Adam S. Posen 1 Since the global financial crisis began in 2007, there has been a lot of hand-wringing about the independence of central banks. Some commentators today would suggest that the recent large scale purchases of government bonds by central banks inherently represent a compromise of their independence from elected officials. Others will assert that the central banks which purchased private-sector securities, thereby jeopardizing their balance sheets and supposedly making political asset allocations, are the ones which have put their independence at risk. The recent emergency actions of the European Central Bank [ECB] as part of the European Union’s response to the Greek financial crisis have prompted a whole new round of recrimination and worry on the continent. An unfortunately sizable number of people seem to believe that central bank independence is largely a matter of reputation, and that any apparent fraternization with or accommodation of debt issuers imperils that reputation. That supposed reputational damage is then presumed to have significant costs for central banks’ counter-inflationary credibility. I am not one of those people, and I will try with my brief remarks today to persuade you that this set of beliefs is wrong on all counts. Central bank independence is not primarily a matter of reputation, but of reality – what matters is what central banks do, not whether they maintain an appearance of public disdain towards the messy realities of economic life. The substance of central bank independence is giving monetary policy setting committees the legal autonomy to refuse demands to purchase debt instruments - even when demands come at moments when  1 This speech draws in part on research in progress with Kenneth Kuttner. The views expressed here, however, are solely my own, and not necessarily those of the MPC, of the Bank of England, or of PIIE.   3 politicians are very anxious that those bonds be bought. The desirable reduction of average inflation outcomes associated with central bank independence thus comes from saying no at critical moments, not from ongoing deterrence effects on expectations. 2 As a result, the counter- inflationary credibility of central banks is not fragile to voluntary purchases of bonds, public or private, made with reference to clear economic (as opposed to political) justification. 3 In contrast, always refusing to intervene in debt markets for appearance’s sake alone, regardless of the economic circumstances, is a sign of immaturity or insecurity, not independence. Some adolescents define their autonomy by being resolutely contrary, and often do damage to themselves (and others) by being deaf to common sense or to appeals to common standards just to stay contrary. Independent central banks can and should behave more like responsible adults than that. Therefore, it is my contention that by acting responsibly to respond to Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute Working Paper No. 126 http://www.dallasfed.org/assets/documents/institute/wpapers/2012/0126.pdf Ultra Easy Monetary Policy and the Law of Unintended Consequences * William R. White August 2012 Revised: September 2012 Abstract In this paper, an attempt is made to evaluate the desirability of ultra easy monetary policy by weighing up the balance of the desirable short run effects and the undesirable longer run effects – the unintended consequences. The conclusion is that there are limits to what central banks can do. One reason for believing this is that monetary stimulus, operating through traditional (“flow”) channels, might now be less effective in stimulating aggregate demand than previously. Further, cumulative (“stock”) effects provide negative feedback mechanisms that over time also weaken both supply and demand. It is also the case that ultra easy monetary policies can eventually threaten the health of financial institutions and the functioning of financial markets, threaten the “independence” of central banks, and can encourage imprudent behavior on the part of governments. None of these unintended consequences is desirable. Since monetary policy is not “a free lunch”, governments must therefore use much more vigorously the policy levers they still control to support strong, sustainable and balanced growth at the global level. JEL codes: E52, E58 * William R. White is currently the chairman of the Economic Development and Review Committee at the OECD in Paris. He was previously Economic Advisor and Head of the Monetary and Economic Department at the Bank for International Settlements in Basel, Switzerland. +41 (0) 79 834 90 66. white.william@sunrise.ch. This is a slightly revised version of the paper circulated in August 2012. The views in this paper are those of the author and do not necessarily reflect the views of organizations with which the author has been or still is associated, the Federal Reserve Bank of Dallas or the Federal Reserve System. 2  UltraEasyMonetaryPolicyandthe LawofUnintendedConsequences 2  ByWilliamWhite      A. Introduction Thecentralbanksoftheadvancedmarketeconomies(AME’s) 3 haveembarkedupononeofthe greatesteconomicexperimentsofalltime‐ultraeasymonetarypolicy.Intheaftermathofthe economic and financial crisis which began in the summer of 2007, they lowered policy rates effectivelytothezerolowerbound(ZLB).Inaddition, theytookvariousactionswhichnotonly causedtheirbalancesheetstoswellenormously,butalsoincreasedtheriskinessoftheassets theychosetopurchase.Theiractionsalsohadtheeffectofputtingdownwardpressureontheir exchangeratesagainst thecurrenciesofEmergingMarketEconomies(EME’s).Sincevirtually all EME’s tended to resist this pressure 4 , their foreign exchange [...]... inviting me to give the prestigious Gaston Eyskens Lectures i i i i i i “rochet” — 2007/9 /19 — 16 :10 — page xi — #11 i i Why Are there So Many Banking Crises? i i i i i i “rochet” — 2007/9 /19 — 16 :10 — page xii — #12 i i i i i i i i “rochet” — 2007/9 /19 — 16 :10 — page 1 — #13 i i General Introduction and Outline of the Book The recent episode of the Northern Rock bank panic in the United Kingdom, with... — 16 :10 — page 2 — #14 i 2 i G E N E R A L I N T R O D U C T I O N A N D O U T L I N E OF THE BOOK Why Are there So Many Banking Crises? Part 1 contains a nontechnical presentation of these banking crises and a first, easily accessible, discussion of how the regulatory–supervisory system could be reformed to limit the frequency and the cost of these crises The main conclusions of this part are the following:... important papers on the sources of fragility of the banking system, notably Allen and Gale (19 98), Diamond and Rajan (20 01) , and Goodhart et al (2006) Solvency Regulations Part 4 contains three articles, which are all concerned with the regulation of banks’ solvency, and more precisely with the first and second Basel Accords The first Basel Accord, elaborated in July 19 88 by the Basel Committee on Banking Supervision... 19 91 Lender of last resort: a contemporary perspective Journal of Financial Services Research 5:95 11 0 Kim, D., and A M Santomero 19 88 Risk in banking and capital regulation Journal of Finance 43 :12 19–33 Koehn, M., and A M Santomero 19 80 Regulation of bank capital and portfolio risk Journal of Finance 35 :12 35–44 Levonian, M 20 01 Subordinated debt and the quality of market discipline in banking Mimeo,... introducing these ceilings, the regulator increases the franchise value of the banks (even if they are not currently binding) which relaxes the moral hazard constraint Similar ideas are put forward in Caminal and Matutes (2002) The empirical literature (e.g., Bernanke and Lown (19 91) ; see also Thakor (19 96), Jackson et al (19 99), and the references therein) has tried to relate these theoretical arguments to the. .. Calomiris, C 19 99 Building and incentive-compatible safety net Journal of Banking and Finance 23 :14 99– 519 Calomiris, C W., and C Kahn 19 91 The role of demandable debt in structuring optimal banking arrangements American Economic Review 81: 497– 513 Calomiris, C W., and J Mason 19 97 Contagion and bank failures during the Great Depression American Economic Review 87:863–83 Calomiris, C W., and P Powell... ratings and subordinated debt prices Journal of Money, Credit and Banking 33:900–25 Dewatripont, M., and J Tirole 19 94 The Prudential Regulation of Banks Cambridge, MA: MIT Press Diamond, D., and R Rajan 20 01 Liquidity risk, liquidity creation and financial fragility: a theory of banking Journal of Political Economy 10 9:287–327 Evanoff, D D 19 93 Preferred sources of market discipline Yale Journal of Regulation. ✐ ✐ “rochet” — 2007/9/19 — 16:10 — page 21 — #33 ✐ ✐ ✐ ✐ ✐ ✐ Chapter One Why Are there So Many Banking Crises? Jean-Charles Rochet 1.1 Introduction The last twenty years have seen an impressive number of banking and financial crises all over the world. In an interesting study, Caprio and Klingebiel (1997) identify 112 systemic banking crises in 93 countries and 51 borderline crises in 46 countries since the late 1970s (see also Lindgren et al. 1996). More than 130 out of 180 of the IMF countries have thus experienced crises or serious banking problems. Similarly, the cost of the Savings and Loan crisis in the United States in the late 1980s has been estimated as over USD 150 billion, which is more than the cumulative loss of all U.S. banks during the Great Depression, even after adjusting for inflation. On average the fiscal cost of each of these recent banking crises was of the order of 12% of the country’s GDP but exceeded 40% in some of the most recent episodes in Argentina, Indonesia, Korea, and Malaysia. Figure 1.1 shows the universality of the problem. These crises have renewed interest of economic research about two questions: the causes of fragility of banks and the possible ways to remedy this fragility, and the justifications and organization of public intervention. This public intervention can take several forms: • emergency liquidity assistance by the central bank acting as a lender of last resort; • organization of deposit insurance funds for protecting the depos- itors of failed banks; • minimum solvency requirements and other regulations imposed by banking authorities; • and finally supervisory systems, supposed to monitor the activities of banks and to close the banks that do not satisfy these regula- tions. ✐ ✐ “rochet” — 2007/9/19 — 16:10 — page 22 — #34 ✐ ✐ ✐ ✐ ✐ ✐ 22 CHAPTER 1 Figure 1.1. Banking problems worldwide, 1980–96. Light gray, banking crisis; dark gray, significant banking problems; white, no significant banking problems or insufficient information. This map was constructed by the author from table 2 in Lindgren et al. (1996). Important reforms have recently been introduced in banking super- visory systems. For example, the American Congress enacted the Fed- eral Deposit Insurance Corporation Improvement Act in 1991 after the Savings and Loan crisis. Several countries, notably the United Kingdom, have created integrated supervisory authorities for all financial services including banking, insurance, and securities dealing. Finally, in 1989, the G10 countries harmonized their solvency regulations for international active banks. This harmonization, known as the Basel Accord, since it was designed by the Basel Committee of Banking Supervision, was later adopted at national levels by a large number of countries. The Basel Committee is currently working on a revision of this Accord, aiming in particular at giving more importance to market discipline. The object of this article is to build on recent findings of economic research in order to better understand the causes of banking crises and to possibly offer policy guidelines for reform of regulatory supervisory systems. In a nutshell, my main conclusions will be: • Banking crises are largely amplified, if not provoked, by political interference. • Supervision systems face a fundamental commitment problem, analogous to the time consistency confronted by monetary policy. 1 1 After finishing this paper, I became aware of an article of Quintyn and Taylor (2002), also presented in the Venice Summer Institute of CESIfo (July 2002), that basically arrives to the same conclusions. ✐ ✐ “rochet” — 2007/9/19 — 16:10 — page 23 — #35 ✐ ✐ ✐ ✐ ✐ ✐ WHY ARE THERE SO MANY BANKING CRISES? 23 • And finally the key to successful reform is independence and accountability of banking supervisors. The plan of this article is the following. I will start by studying the historical sources of banking fragility. Then I will examine possible remedies: creation of a lender of last resort, and/or ... Reserve Banking System and Central Banks Bank Regulation How a Central Bank Executes Monetary Policy Monetary Policy and Economic Outcomes Pitfalls for Monetary Policy Money, loans, and banks are... How could monetary policy be used to stimulate the economy? The answer, as we will see in this chapter, was to change the rules of the game Introduction to Monetary Policy and Bank Regulation. . .Introduction to Monetary Policy and Bank Regulation makes credit more available As a result, business investment and other types of spending increase, causing GDP and employment to grow