© James B. Thomson
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There are some signs that confidence in financial markets is being restored. The implementation of ‘stress tests' in the spring of 2009 was an important first step in calming the markets. That exercise increased the transparency of the losses sitting on financial firm balance sheets, and we saw short-term interest-rate spreads decline substantially for the first time since the September of 2008. The continuation of the stress tests in the U.S. (under the name Comprehensive Capital Adequacy Review, CCAR) and in Europe should underpin confidence in financial markets.
It is yet to be seen how effective post crisis legislative reforms will be in promoting financial stability – short of full nationalization of the financial sector, no government entity can ensure financial stability. Operating under the notion that central banks, bank supervisory agencies, etc. can ensure financial stability may be the biggest threat to financial stability.
Ultimately, with or without the reforms confidence would return to financial markets because of disaster myopia. As time passes, the farther away we get from the crisis the more people will discount the possibility that another such crisis could occur.
Oliver Blanchard, the chief economist of the International Monetary Fund, called on central banks to assume responsibility not only for monetary policy but also for the oversight of financial markets in order to prevent a similar meltdown from occurring. Do you think it is worthwhile for central banks to take on new responsibility or it would be better to set up a separate institution, which will monitor financial markets?
The prevailing winds in this area are blowing in the direction advocated by Dr. Blanchard. During the 1990s and early 2000s the notion that financial supervision and monetary policy should be separated gained a lot of traction; the prime example being the Financial Services Authority and the Bank of England in Great Britain. On the Continent supervision and monetary policy were de facto separated for Eurozone nations by the creation of the European Central Bank.
A sad thing about history is that we do not always learn the proper lessons from it, particularly in the case of the most recent events. It is not at all clear that financial stability was compromised by the separation of financial market supervision from the central bank. Yet this seems to be the predominant sentiment in financial policy circles.
Personally, I do not see vesting central banks with supervisory powers as part of a financial stability mandate as the direction we should take. Central banks already have a delicate balancing act between short-term economic growth and price stability. In the U.S., the Fed has an explicit mandate to so. I would argue the ECB and other monetary authorities face an implicit dual mandate. Making central banks responsible for both monetary policy and financial supervision creates a complicated set of incentive problems that could ultimately undermine price stability and central bank independence. So Dr. Blanchard's call for housing financial supervision and monetary policy in the same entity is far from a panacea. Let us not forget that a number of economists believe that the low interest rate environment produced by Federal Reserve monetary policy from 2002 through 2005 was a causal factor of the 2007-2009 financial crisis.
In the end, the solution may be to house supervision and regulation of financial institutions in a regulatory authority separate from the central bank and give central banks a limited set of tools to intervene in disorderly markets.
The subprime crisis became the global crisis when one too-big-to-fail bank was allowed to fail. To your mind, has the issue of too-big-to-fail been solved?