An interesting paper “Financial Stability frameworks and the role of Central Banks: Lesson from the crisis” . Erlend W Nier IMF, april 2009 (Wp/09/70),explores quite accurately the implications for Central Banks about including the financial stability parameter within its policy reaction function.
So far, it is usual for Central Banks to consider within its policy reaction function ,only real parameters, leaving aside those which are connected with the financial side. Thus it might be the case that Central Banks actions ,goes in the opposite direction with financial innovation requirements . For this matter, whether Central Banks are going to be involved as the Lender of last resort(LOLR),it seems appropiate to improve its financial oversight of financial institutions, based on four considerations:
· Assessing solvency: Central Banks will be call to lend when the markets credit´s channels are not working because of long run uncertainty. The only way to get such a knowledge ,is throughout permanent supervision.-
· Gauging systemic impact: Access to supervisory information, allow Central Banks to have the ability for balancing the systemic impact that institutions under financial stress, might have.-
· Moral hazard arising from the safety net: Financial institutions might feel secure enough to go beyond the boundaries of long run systemic risk ,the market take into consideration. Thus ,there are strong incentives for moral hazard ,that the Central Bank is interest to regulate keeping close supervision about prudential liquidity levels.-
· Potential loss of credibility. Central Banks faces potential credibility cost from any mistakes handling the crisis. Thus It is not a “free lunch” path for Central Banks ,to go deeper on the financial root of such crisis. The risk of Failure, would impose high transaction cost for getting its message across to shape future market expectations. Therefore ,it is not only on Central Bank interest but ,on market interest as well, to have a better supervision and regulatory framework on systemically important institutions, for Central Bank to work on a prevention based approach.
It follows ,that Central Bank support for financial innovation goes hand by hand with a better and more active prudential regulation framework to the path such financial innovation might take. More so, when the Central Bank includes in its policy reaction function, the ratio of private debt/ GDP ,to decide to increase or not interest rate. As long as it has a better assessment of financial markets conditions, the better the quality of its judgment to decide the magnitude of interest rate changes, designed not just to get back prices stability , but also to protect financial innovation going on as an essential variable for long run economy growth .
Like any economic policy option, there are benefits and cost associated with this Central Bank closer to financial market .The main benefit ,comes from the lower output variability arising from stable financial conditions , and its lasting impact on welfare and efficiency. What about the cost ?. That is for another article.