Reforming financial regulation and supervision: going back to basics Conference organised by Banco de España and the World Bank Madrid, June 15, 2009 Session on “The challenges of global financial surveillance and the quest for financial stability” Ignazio Visco Bank of Italy

Need to reassess the monetary frameworks?  The current crisis has shown that:  Financial imbalances may be exceptionally costly for the real economy  Monetary policy may itself be a source (not the only one) of financial instability  The role of huge international spillovers in the global economy cannot be ignored  Addressing these issues has far reaching implications for:  The conduct of monetary policy  The tasks and responsibilities central banks are entrusted with  The degree of international cooperation and the effort to create a more stable international monetary system

The conduct of monetary policy  The primary objective of monetary policy remains price stability; but there may be a short-run trade-off with financial stability, whose severity depends on the financial situation.  In the absence of an independent instrument to pursue financial stability, monetary policy needs to address this trade-off.  At a minimum, it should avoid fuelling bubbles and should behave more symmetrically.  However, the task is challenging:  Enlarging the horizon over which price stability is defined is not enough. Our ability to identify financial imbalances, their non-linear effects on the macro- economy and the impact of monetary policy is limited.  While a larger role for money and credit may help, we need to better understand how financial linkages impact on the macro outlook and how monetary and macro-prudential analysis should interact.

The tasks of central banks  “Leaning against” financial imbalances is important. But we cannot put an excessive burden on monetary policy.  Two goals cannot be pursued with a single instrument. At times, the macro costs may not be sustainable.  If flexibility is granted at the expense of credibility, neither price nor financial stability would be ensured.  An additional instrument is needed to diminish the severity of the trade-off.  Which macro-prudential arrangements (capital requirements, leverage, provisioning) are effective in reducing financial pro-cyclicality?  How do macro-prudential tools and the setting of interest rates interact? Are they independent? How can they be best used in combination?  All in all, the global crisis has reinforced the case for entrusting central banks with explicit macro-prudential functions. The synergies overcome the concerns of a possible conflict of objectives.

The international monetary system  Flaws in the financial system initiated the crisis. But global imbalances in the world economy were essential to its propagation.  No mechanism operated effectively to induce a self-correction.  Surplus countries avoided pressure to adjust, pegging to the dollar.  The role of the dollar as international reserve currency eased the financing of large and persistent US current account deficits.  The dollar-centred system, driven by the preferences of individual countries, with weak multilateral surveillance, is endangered:  by overly expansionary policies in the centre …  and the reluctance to let exchange rates fully adjust in the periphery.  Stepping up international policy cooperation and effective surveillance is a top priority.  The effort to create a more stable international monetary system (vis-à-vis the current “non-system”) is crucial, to avoid perpetuating mechanisms that lead to global imbalances, fragile financial structures, and the risk of disorderly adjustments in exchange rates.