This is a paper in the ECON-630 Monetary Economics course at American University, Washington, DC. Policymakers around the world discuss which implications and effects ultra-loose monetary policy has on financial stability. Although the prevailing opinion is that central bank's mandates should not be extended, voices are raised by proponents of financial stability issues that central banks need to take into account macroprudential risks.

1. Financial stability and systemic risk: should central banks be responsible for a
stable financial system?
Achim Braunsteffer
ECON-630
Prof. Gabriel Mathy
Introduction
Mandates of central banks all over the world mostly include ensuring price stability or sometimes
employment goals as e.g. the Federal Reserve is pursuing. While the prevailing paradigm in the
second half of the 20th century was that central banks should try to “take away the punch bowl
just when the party gets going”1, Alan Greenspan was convinced that central banks should let
asset price bubbles pop on its own and then clean up the mess. After the financial crisis beginning
in 2007, advocates for a safer and more regulated system introduced new macroprudential tools
to prevent excessive risk-taking and dangerous asset bubbles. In this regard, Claudio Borio and
the Bank for International Settlements are proponents of the concept that central banks should
be concerned about financial instability and responsible for financial stability. The paper
elaborates on the notion of financial stability, what central banks can achieve in general, and
whether they are the appropriate institution to address this problem, i.e. whether ensuring
financial stability should be an additional institutional mandate of central banks.
What we know about financial stability
During the times of the Great Moderation, inflation was low and relatively stable while the
economy was expanding at a moderate pace.2 The storm after the calm came in 2007, when the
ensuing Great Recession caused financial turmoil and caught policymakers on the wrong foot.
Most economists did not expect that a banking crisis originating from individual institutions can
shake the financial system to its very foundations and endanger overall financial stability. Policy
actions such as the Troubled Assets Relief Program (TARP), lowering interest rates to the zero-
lower bound, introducing Large Scale Asset Purchases (LSAPs), and subsequently complementing
1
A term coined by William McChesney Martin, who was head of the Fed from 1951-1970.
2
Olivier Blanchard and John Simon (2001) documented that the variability of quarterly growth in real output (as
measured by its standard deviation) has declined by half in the period between the mid-1980s and 1990s, while the
variability of quarterly inflation has declined by about two thirds.

2. monetary policy with forward guidance prevented a meltdown of the global financial system and
fundamentally altered the way economist regard the economy, systemic risk, and monetary
policy. New regulations have been introduced with the aim of mitigating risks and making the
whole financial system safer in the aftermath of the crisis. The expression of financial stability
may be interpreted in several ways. The Bank of England describes the term very broadly as
“public trust and confidence in financial institutions, markets, infrastructure, and the system as a
whole”.3
For better global coordination, the Financial Stability Board (FSB) was established in April 2009 as
an international body that monitors and makes recommendations about the global financial
system. The FSB promotes international financial stability by coordinating national financial
authorities and international standard-setting bodies.4 Alongside unconventional monetary
policies, research about financial stability and how financial imbalances affect the economy and
cause business cycles and crises has taken off in the years after 2007/2008.
Monetary policy and financial stability
The FSB, working through its members, seeks to strengthen financial systems and increase the
stability of international financial markets. While this coordination is necessary and desirable on
an international scale, the question remains if there should be an institution within a currency
area surveilling financial stability. A positive answer entails the conundrum which institution is
best suited for pursuing this goal. Many central banks all over the globe have introduced new
macroprudential instruments and assessment to analyze the current environment and recent
developments in their jurisdiction. Moreover, the European Central Bank (ECB) restructured
banking supervision and followed the Federal Reserve System (Fed) and others in making it the
monetary authority’s task to ensure the safety and soundness of their banking systems. In April
2013 the United Kingdom established an independent Financial Policy Committee (FPC) at the
Bank of England (BoE). The Committee is charged with a primary objective of identifying,
monitoring and taking action to remove or reduce systemic risks with a view to protecting and
3
Bank of England, “Financial Stability”, accessed December 11, 2015.
4
For example, the board issued a final Total Loss-Absorbing Capacity standard for global systemically important
banks. See FSB (2015).

3. enhancing the resilience of the UK financial system. It is responsible for the BoE’s bi-annual
Financial Stability Report.5 All these actions and new entities can prove helpful in increasing
financial stability, however, central banks cannot be hold accountable for failing to achieve this
goal. Notwithstanding, the conceptual challenge of an adept measure of financial stability is
persistent and complicates the way central banks can possibly ensure this goal.
One condition for the demand of expanding a central bank’s mandate in this direction is that
monetary policies have an effect on financial stability and can create instability in financial
markets. Claudio Borio, Head of the Monetary and Economic Department at the Bank for
International Settlement (BIS), presented a synthesis of his work at the IMF’s 16th Jacques Polak
Annual Research Conference on November 5-6, 2015. He finds that ultra-low interest rate can
hurt the economy in the long-run and can be self-perpetuating. First, it misallocates resources to
low-productivity sectors and incentivizes banks and companies to borrow more. This in turn raises
the probability of defaults if rates will be raised again, possibly destabilizing the financial system.
Therefore, second, low interest rates in the past result in too much leverage and force central
banks to lower rates even further, a pattern observable in the run-up to the Great Recession.
Nowadays near zero interest rates are artificially low. Hence, they do not display the natural
interest rate, the interest rate which balances employment and inflation.6 This assessment is a
boon for advocates of the thesis that central banks have to take impacts on financial stability into
account when deciding on monetary policy.
Furthermore, every decision by monetary policy makers has spillover effects, affecting foreign
economies and the domestic economy alike through its repercussions. For instance,
announcements in May 2013 by the Federal Reserve that the central bank was slowing its pace
of asset purchases sparked a “Taper Tantrum” in financial markets with particular spillover effects
in emerging countries. The term “Taper Tantrum” refers to the surge in US treasury yields and
other government bonds in the months after the announcement, as money was pouring out of
the bond market. It is clear that both interest rates changes and the introduction and shifts in
unconventional monetary policies such as quantitative easing programs or forward guidance can
5
Bank of England, “Financial Policy Committee“, accessed December 11, 2015.
6
Borio, Claudio (2015).

4. cause gyrations in financial markets with negative effects on the economy. Furthermore,
quantitative easing may have important side-effects contributing to financial instability through
additional risk-taking in financial markets.7 They can also create spillover effects through capital
flows in search of higher yield, which fuel asset prices as well as currency movements.8
Why financial stability is crucial
Jean-Pierre Danthine, former Vice Chairman of the Governing Board of the Swiss National Bank,
wants central banks to expand their instruments of conventional measures (such as cutting
interest rates, providing liquidity, and act as lender of last resort) and unconventional measures
(some of them have been mentioned above). He would like to see “a reinterpretation of central
banks' financial stability mandate towards a more active role in crisis prevention” in order to
reduce the need for another round of extensive crisis management in the future. The reason is
threefold. To begin with, central banks would prefer to avoid precarious financial situations in the
first place, although they play an important role in managing crises as lender of last resort.
Second, financial stability is a critical precondition for ensuring price stability. Financial instability
can distort prices directly and affect transmission mechanisms of monetary policy. Third, the
coordination of macroprudential and monetary policy tools is considerably easier if they are both
managed by the central bank, increasing the effectiveness of the policy mix. In sum, according to
Danthine, there is a “compelling rationale for giving central banks a prominent role in the fight
against systemic risk, in the design of macroprudential policy and in the management of
macroprudential instruments.”9
Rey and Miranda-Agrippino (2015) find that monetary policy is one of the determinants of a global
factor explaining an important part of the variance and returns of risky assets around the world.
The profound theory that there is a global financial cycle in capital flows, asset prices and in credit
growth has implications on how central banks should set monetary policy optimally and how
financial spillover effects are transmitted and possibly destabilize the whole system. Although the
authors do not recommend monetary authorities to include ensuring financial stability as one of
7
Chodorow-Reich, Gabriel (2014).
8
Rajan, Raghuram (2013).
9
Danthine, Jean-Pierre (2014).

5. their mandate, the findings clearly show that the Fed, ECB, BoE, and others with their potentially
unlimited firepower cannot pretend as if they were insulated from the global financial system.
Their actions heavily influence major financial institutions and investors and can be a tipping point
creating herding behavior.
Recent Developments
There is much talk about a new “Taper Tantrum” as an effect of an interest rate hike on December
16 by the Fed. In its latest quarterly review the BIS sees “less favorable financial market
conditions, combined with a weaker macroeconomic outlook and increased sensitivity to US
interest rates, heighten the risk of negative spillovers to EMEs once US rates do start to rise in the
United States. Tighter financial conditions could also accentuate rising financial stability risks in a
number of EMEs.”10
Many economists focusing on financial stability believe that the US central bank should have
tightened rates earlier. Gita Gopinath, Harvard University, objects to what she calls the Fed’s
“dollar distraction”11 whereby US policymakers have deviated from their inflation-fighting
mandate because of unnecessary worries about the dollar’s strength. In a similar vein, Stephen S.
Roach, former chief economist at Morgan Stanley, argues that the Fed has already made a fatal
mistake by keeping interest rates so low for so long, thereby transforming monetary policy “from
an agent of price stability into an engine of financial instability.”12
Howard Davies, former Deputy Governor of the Bank of England, explains that it is “justifiable to
increase interest rates in response to a credit boom, even though the inflation rate might still be
below target.”13 Nobel Laureate Robert J. Shiller agrees, warning that excessively low interest
rates have created “overheated asset markets [which] could lead to a major correction and
another economic crisis.”14
10
BIS (2015), p. 1.
11
Gopinath (2015).
12
Roach (2015).
13
Davies (2015).
14
Shiller (2014).

6. Conclusion
Central banks and monetary policy are one of the main factors influencing stocks and bonds, bank
lending, and a sound financial system. When artificially low interest rates and unconventional
monetary policies in the wake of anemic economic growth distort market prices and create
booms and busts, the recommendation is a no-brainer and policy makers have to react.
Nonetheless, there are many opponents, the most prominent is perhaps Ben Bernanke, to this
consideration of financial stability. Central banks should not be overburdened in their view, which
is definitely true, however, central banking and monetary policy is constantly evolving and so are
their mandates. With the BIS as the admonitory institution concerned about financial stability,
the possibility of an additional mandate in the medium-term is high and should help mitigate
system risk. The main problem remains the exact measurement of financial stability since it can
be hardly observed ex-ante. More research has to be done on this question as well as how to
implement this “financial stability mandate” in reality.
References
BIS (2015). “International banking and financial market developments”, BIS Quarterly Review,
December 2015.
Blanchard, Olivier, and John Simon (2001). "The Long and Large Decline in U.S. Output Volatility",
Brookings Papers on Economic Activity, 1, pp. 135-64.
Borio, Claudio (2015). “Policy Lessons and the Future of Unconventional Monetary Policy”,
Sixteenth Jacques Polak Annual Research Conference, November 2015.
Chodorow-Reich, Gabriel (2014). “Effects of Unconventional Monetary Policy on Financial
Institutions”, Forthcoming in Brookings Papers on Economic Activity.
Danthine, Jean-Pierre (2014). “Are Central Banks Doing Too Much?”, Speech at the Foire Du
Valais, Martigny, October 2014.
Davies, Howard (2015). “The Trouble With Financial Bubbles”, Project Syndicate, published
October 19, 2015, accessed December 12, 2015.
FSB (2015). “Total Loss-absorbing Capacity (TLAC) Term Sheet”, Financial Stability Board,
November 2015.
Gopinath, Gita (2015). “The Fed’s Dollar Distraction”, Project Syndicate, published November 20,
2015, accessed December 12, 2015.

7. Rajan, Raghuram (2013). “A Step in the Dark: Unconventional Monetary Policy After the Crisis.”
Andrew Crockett Memorial Lecture, delivered at the Bank for International Settlements, Basel.
Rey, Hélène and Miranda-Agrippino, Silvia (2015). “World Asset Markets and the Global Financial
Cycle”, Working Paper, October 2015.
Roach, Stephen S. (2015). “The Wrong War for Central Banking”, Project Syndicate, published
October 27, 2015, accessed December 12, 2015.
Shiller, Robert J. (2014), “Booming Until It Hurts”, Project Syndicate, published July 15, 2014,
accessed December 12, 2015.