As the financial markets get integrated worldwide, the role of central banking has become important in addressing domestic as well as systemic risks. The tools in the hands of central bankers have seen many innovations in recent times. As capital flows freely among countries rapidly, liquidity management at a systemic level has led to growth of various instruments of sterilization. India, faced with huge captal inflows, leading to liquidity and inflationary pressures have resorted to the market stabilisation scheme ( detailed in one of my earlier blog) , quite successfully.
The objectives of monetary policy have also widened beyond the traditional concerns of growth and price stability. Many countries have explicitly added financial stability as the third objective of monetary policy . As a result. monetary policy announcements in many countries have , along with the guiding in interest rates and money supply devotes attention to issues of stability of financial sector and the risks faced by it in terms of excessive risk appetite in assets where the perceived risks are higher.
Central Banks, thus, are not just interested in the risks faced by the institution ( such as reputational risks arising from poor conduct of monetary policy or risks of exchange loss in their pool of forex reserves) . Their concern extends to controllong risks of financial institutions, which have become far more diversified and in many cases more speculative. Risks no longer increase with distance and the high correlation between domestic saving and domestic investment is breaking down. highly leveraged derivatives grew in size and complexity and as Alan Greenspan observed :
" Weshould recognise that if we choose to enjoy the advantages of a system of leveraged financial institutions, the burden of managing risks in the financial system will not lie with the private sector alone. Leveraging always carries with it a remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can thwart such a process before it becomes destructive."
The central banks, however, are not prepared to let the financial sector problems escalate to that intensity. That's why they stress financial stability , get worried with any signs of financial instability. A potential worry could be the real estate sector, which has seen more asset bubble bursts than even the stock markets in the last few decades. The central banks take a keen interest in the developments of such vulnerable sectors and asks banks to keep higher capital by assigning higher risk weights and provisioning requirements.
Indicators of capital adequacy, liquidity, solvency and asset quality have become important in that context. Central Banks as supervisors of the banking system keeps close watch on these ratios at aggregate level and also the outliers.
Being acutely aware of the linkages between the systemic risks and bank performance, the central banks today actively manage and monitor the risk appetite of Banks . Adoption of Basel 2 in many countries reinforces the role of central banks in ensuring financial stability.
Thankfully, such interventions have matured beyond just holding enough capital for bad days and now looks into people, systems and processes.
Unfettered competitive capitalism is thus by no means accepted as an optimal economic paradigm. Regulators, including central banks try to contain the unhealthy effects of competition and facilitates market growth in a healthy manner. The focus of this action is more on early detection of risks and preventing the damages caused by such risks through appropriate policy actions. The key issue here is in achieving this without adversely affacting the growth path and without discouraging innovations, two major sources of financial prosperity of future generations.
