A Marriage of Convenience

The world of presumed stable monetary and financial conditions was severely shaken by the recent global financial crisis. And with that, the separation in some quarters of financial supervision and monetary policy that reigned supreme over the past decades might also be coming to the end.

Before the crisis, the policy paradigm used to look like this: central banks around the world would focus on inflation-targeting and on setting interest rates, while financial regulation would be left to specialized, ad hoc agencies. Central banks' primary role would be enough to maintain price stability and economic growth. On their side, financial regulators, through so-called "microprudential" rules, would ensure the soundness of financial institutions and protect depositors.

We all know what happened to this picture. The crisis tested the limits of both financial regulation and monetary policy acting individually. The existing regulations were insufficient to contain the spillover effects of the collapse of financial institutions to the rest of the economy. Now, in the wake of the Great Recession, there's an increasing recognition of the need for macroprudential regulation to ensure the stability of the financial system as a whole and to mitigate risks to the real economy.

In fact, prudential regulation and monetary policy are complementary. Neither one can replace the other on its own. The combined use of both tends to be more effective than a standalone implementation of either. After all, financial risks are now seen as important enough for macroeconomic management to deserve a stronger regulation going beyond that of specialized agencies.

As I argue in a recent note, a pragmatic approach that combines elements of both monetary policy and prudential regulation is ideal. In particular, both policies can work in tandem to:

  • Monitor the local market characteristics of financial stability and the various indicators that can be associated with it, such as rapid credit growth beyond past historical trends.
  • Identify precisely the dynamics and determinants of permanent structural changes in credit markets.
  • Look for ad hoc special shocks that might be contributing further to the observed credit and asset price booms.
  • Identify other forms of balance sheet mismatches arising from booms.
  • Assess the maturity structure of credit extension and its usage, discerning whether it is of a more long-term nature (and thus supposedly favoring investment) or of a more short-term nature.

As in other aspects of life, being alone is better than having bad company. But in this case, two together are better than each alone.

Sometimes, a marriage of convenience does work.

For more details on the topic, take a look at "How Complementary Are Prudential Regulation and Monetary Policy," the most recent note in the World Bank's Economic Premise series.

This blog was originally posted on the World Bank Institute Growth and Crisis website.