Christine Lagarde
Financial stability and price stability are preconditions for each other. Yet history shows that in the pursuit of price stability, monetary policy can face two key trade-offs with implications for financial stability.
The first can occur when monetary policy rapidly tightens. Higher interest rates help to curb inflation, but they can put pressure on banks by eroding asset values and asset quality, even as rising net interest margins offer them some relief.
We saw this during the 1980s, when the Federal Reserve rapidly tightened monetary policy to bring down high inflation.
Combined with US deregulation in the late 1970s, which encouraged riskier lending and weaker oversight, this monetary tightening was one of the key factors in the emergence of the savings and loan crisis. That led to the failure of roughly 1,300 savings institutions owing to the maturity mismatch on their balance sheets.
The second trade-off for monetary policy can arise during or following an extended period of monetary accommodation.
When inflation is below target, low rates can help stimulate demand and push inflation back towards target. But in an environment where regulation is relatively weak and especially where rates remain low for an extended period, they can also encourage borrowing, risk-taking and the build-up of financial imbalances.
These dynamics highlight how monetary policy can affect financial stability not only through banks’ balance sheets but also via market valuations and investor risk appetite.
Crucially, financial vulnerabilities may keep building even after rates begin to rise. We saw this in the lead-up to the global financial crisis of 2008.
Low rates earlier in the decade fed the US credit and housing boom that later unravelled – years after the Federal Reserve had begun to gradually tighten. And in the euro area, the sharp rise in private debt in some countries was a key driver of imbalances that built up before the crisis.
The lesson for policymakers was clear. Insufficient regulation and supervision had allowed risks to build unchecked, leaving monetary policy as de facto the only tool available to confront the fallout.
This placed an undue burden on central banks, forcing them to shoulder responsibilities that could have been better managed through stronger safeguards in the first place. That insight powered the construction of a stronger regulatory and supervisory framework after 2008.
The post-2008 regulatory and supervisory framework was a turning point for the interaction between monetary policy and financial stability. It served as a powerful lever in mitigating the trade-offs between them and, accordingly, increased monetary policy’s room for manoeuvre.
This was most visible during two extraordinary periods for monetary policy that followed in the wake of the global financial crisis.
The first period was when inflation was too low.
Central banks across advanced economies turned to a set of new – and, at the time, unconventional – tools to meet their price stability mandates, including large-scale asset purchase programmes and the introduction of negative interest rates.
These were significant measures to fight a significant challenge. And at the time, there were vocal concerns that these measures would fuel financial instability. Certainly, asset prices and housing valuations did rise notably during this period.
But crucially, given the stronger regulatory and supervisory regime, rising asset prices did not translate into excessive leverage in the banking system. In fact, banks in the euro area deleveraged in the decade after the global financial crisis. Similarly, private sector debt as a share of GDP also fell during that time.
After years of below-target inflation, the second period came unexpectedly – when euro area inflation surged to record highs after the pandemic and the energy shock sparked by Russia’s invasion of Ukraine.
In the Netherlands, for example, inflation rose rapidly, peaking just above 17% in September 2022 – almost six times the rate recorded a year earlier.
Once again, we faced an extraordinary situation – and the ECB had to step up. Alongside the unwinding of its asset purchases, it raised rates ten times by a cumulative 450 basis points, the fastest tightening in its history.
And once again, there were concerns about the financial stability implications of such a rapid tightening.
Tighter financing conditions risked straining borrower debt service and triggering market repricing. That, in turn, could have exposed financial institutions to vulnerabilities from falling asset values, maturity mismatches and weaker asset quality.
While there were some notable bank failures during this period, the global financial system overall remained broadly resilient to rising rates.
In the euro area, for example, banks were supported by stronger capital and ample liquidity buffers. Strong supervision also helped. Even before the inflation shock hit in full, the Single Supervisory Mechanism had factored interest rate risks into its supervisory work programme.
Moreover, in line with the outcome of its strategy review, the ECB’s Governing Council was regularly assessing the links between monetary policy and financial stability as part of its policy deliberations.
The experience across these two monetary policy eras confirmed the lessons of 2008. Stronger regulation and supervision were able to contain financial exuberance and limit vulnerabilities. They allowed monetary policy to focus on its job of delivering price stability.
Does the progress we have made in strengthening the regulatory and supervisory framework mean that policymakers can now let their guard down? The answer, of course, is no.
Today’s global financial system looks very different from the one that stood on the brink in 2008. Two key shifts stand out compared with then.
The first has been the massive structural transformation that has taken place, the most striking change of which has been the growing footprint of non-banks in financial intermediation.
In the euro area, non-banks – ranging from investment funds and insurance corporations to money market funds and securitisation vehicles – have grown from about 250% of GDP in 2008 to more than 350% today.
Non-banks are also highly interconnected with the banking sector. In the euro area, banks’ asset exposures to non-banks are sizeable, averaging around one-tenth of significant institutions’ total assets.
At the same time, a second key shift is becoming increasingly evident – namely, signs of regulatory fatigue, which is creating an uneven playing field for financial institutions.
In particular, investment funds, despite their increasing systemic importance, operate under far lighter rules compared with the banking sector. That has in part helped to fuel their growth.
One of the reasons behind this regulatory fatigue is that the post-2008 global regulatory framework has arguably been a victim of its own success.
In policymaking, 17 years is a long time. Not only do painful memories fade, but so too does the recognition that the financial stability the world now enjoys is thanks to the robustness of that global regulatory framework established back then.
This fading sense of urgency, together with concerns that banks’ competitiveness vis-à-vis non-banks is threatened by the uneven playing field, has ignited calls to revisit the existing set of financial rules and regulations.
So how should policymakers react to these shifts in the financial system?
In short, policymakers must adapt regulation and supervision to this challenging environment. They should do so not by lowering standards for banks, but by levelling them up for non-banks that are involved in bank-like activities, or with significant links to the banking sector.
That helps to address banks’ concerns about the uneven playing field. And better supervision of non-banks would make potential financial stability risks that have lain dormant in darker corners of the economy more visible, allowing policymakers to pre-empt them.
If risks were to build outside the banking system, beyond the current reach of regulators and supervisors, the trade-offs that were evident before 2008 may re-emerge, with monetary policy de facto being the only tool to “get in all of the cracks” and rein in financial exuberance.
That would be a suboptimal outcome, one that potentially constrains central banks’ full freedom to defend price stability.
So as referees on the playing field, it is vital that policymakers resist regulatory fatigue and redouble their efforts to extend stronger global rules to non-banks involved in bank-like activities, or with significant links to the banking sector.
At the same time, after a decade of adding regulation, this is a good moment to take stock and assess how regulation can be simplified to avoid duplication and unnecessary burdens on financial institutions.
In this respect, the ECB High-Level Task Force on Simplification is developing proposals for simplifying the European prudential regulatory, supervisory and reporting framework for the European Commission’s consideration.
The goal is not to relax rules, nor undo what has been achieved. Instead, the task force is exploring how to reduce undue complexity in selected aspects of the capital structure, reporting and supervision, while also maintaining the resilience of banks and fostering greater integration and harmonisation in EU frameworks.
In his Adagia, the humanist Erasmus gathered the wisdom of past centuries for the benefit of those living in the present. Among the proverbs that still resonate today is, “Prevention is better than cure”.
In the Netherlands in particular – often said to have witnessed the world’s first financial bubble, though historians debate its true scale – that lesson endures: vigilance is wiser than complacency.
This principle lies at the heart of sound regulation and supervision. As the financial system evolves, regulators and supervisors must retain visibility of potential risks, since preventing instability is always less costly than repairing the damage afterwards. It also helps to limit the potential trade-offs between monetary policy and financial stability.
Policymakers should not wait for another financial crisis to be reminded of how high the stakes are. It is imperative to extend oversight to non-banks involved in bank-like activities, or with significant links to the banking sector – and policymakers must do so sooner rather than later.
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