Visco, I., (2013), “The aftermath of the crisis: Regulation, supervision and the role of central banks”, Centre for Economic Policy Research, Policy Insight No.68, December.
The financial crisis has brought to the fore a number of issues. It has been severe and widespread, and has affected many economies in different and long-lasting ways. Maintaining financial stability has once again become a major concern of policymakers and central banks are heavily involved in this endeavour. A clear need has emerged for a substantial overhaul in financial regulation and supervision, also considering that the financial system of tomorrow will most likely be rather different from the one that has developed over the last two decades. Scepticism has grown about the role of finance in the economic system, and especially its apparent separation from, if not conflict with, the real economy. We should take stock of what has gone wrong, and in so doing reflect on the way forward – as it is already taking shape – as well as on how to better link our theories to real world developments.
In the decade before the crisis both the size of the financial system and its role and pervasiveness in the economy increased dramatically. The process has only slowed down with the crisis. In the Eurozone, the overall amount of financial resources collected by the private sector (bank credit, bonds issued domestically and stock market capitalisation) rose from 140% of GDP in 1996 to 210% in 2007, to further increase to 240% in 2012. Broadly similar patterns are found for the US, where the ratio rose from 230% in 1996 to 360% in 2007 and then declined to 310% in 2012, and for the UK, where the ratio increased from 280% to 440% and then remained stable. The total outstanding notional amount of over-the-counter (OTC) and exchangetraded derivatives has risen from less than 100 trillion US dollars at the end of 1998 to around 500 trillion at the end of 2006, 700 at the end of 2007 and still 700 trillion in December 2012.
Financial deepening, by allowing greater diversification of risk and making finance accessible to larger numbers of countries and firms, can be instrumental to broadening economic development. But there is a risk that finance turns into an end in itself, with consequences that can be more damaging as the system becomes more interconnected and the potential for externalities increases.
At the same time, the interaction between monetary policy and financial stability becomes more relevant as heightened financial complexity amplifies the widespread non-linearities in the dynamics of financial and economic variables, and the consequences of interconnections between the financial and the real side of the economy. In these conditions, the risk of systemic crises increases.
The correct conduct of financial business requires competence and good faith on the part of intermediaries, as well as appropriate regulatory, supervisory and policy regimes. The fact that fragilities in the financial system were not properly and timely identified, and that their potential consequences for macroeconomic and price stability were largely underestimated reflects inadequacies in regulation and supervision, as well as in the analytical framework for monetary policy.
The financial crisis has provided two main lessons for policymakers:
- First, complexity is not a justification for a lighttouch approach to regulation and supervision, quite the contrary.
- Second, financial stability is a precondition for price stability.
Two implications, then, have followed suit:
- On the one hand, a deep and far-reaching reform in financial regulation and supervision was needed (including tighter international cooperation).
- On the other hand, central banks had to rethink their role and the tools of their trade, specifically concerning the relationship between monetary and macroprudential policies.
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Relevant Posts
- Sinn, H.W., (2013), “Rescuing Europe from the Ground Up”, Project Syndicate, 21 December.
- Masciandaro, D. and Passarelli, F., (2013), “Single supervision and resolution rules: Is ECB independence at risk?”, VoxEU, 21 December.
- Davies, H., (2013), “The Fox and the ECB”, Project Syndicate, 19 December.
- Münchau, W., (2013), “An exercise in prolonging a banking credit crunch”, The Financial Times, 22 December.
- Micossi, S., Bruzzone, G. and Carmassi, J., (2013), “The New European Framework for Managing Bank Crises”, The Centre for European Policy Studies, CEPS Policy Brief No.304, 21 November.
- Wolf, G., (2013), “Europe rightly pursues the road to a single resolution mechanism”, Bruegel, 27 November.