Ladies and Gentlemen,
Let me begin by thanking De Nederlandsche Bank and Governor Klaas Knot for inviting me to speak at this very well-prepared seminar. My remarks briefly address the four main questions posed by the organisers that constitute the core topics of the sessions of the programme today. I will argue that macro-prudential policy should be ambitious in trying to smooth the cycle and, if so, it has to be prepared to be bold and intrusive. The set of instruments at the disposal of macro-prudential authorities needs to be widened and should be used aggressively, underpinned by robust empirical analysis. While monetary policy should normally not be employed to smoothen the credit cycle, under the principle of “one objective, one tool”, the macro-prudential policy function should be the responsibility of central banks, given the interactions between the two policy functions. This reflects the macro-prudential policy framework adopted for the European Central Bank (ECB)/Single Supervisory Mechanism (SSM).
How ambitious should macro-prudential policy be?
The aim of macro-prudential policy should definitely be about tempering the cycle, rather than merely enhancing the resilience of the financial sector ahead of crises. If it was all about strengthening resilience, we could impose capital ratios of 25 or 30% and a strict leverage ratio, believing that the world is a good approximation to the Modigliani-Miller (M&M) set-up, where the structure of liabilities does not influence a bank’s market value or its funding costs. We would add a good resolution regime with all sorts of bail-in and, exaggerating somewhat, we could perhaps dismantle all the macro-prudential apparatus relying on the central banks to follow their “mopping-up” approach after the crises. However, the world does not fully respect the M&M set-up, but as Miles et al. (2011) have shown, it does not correspond to the banker’s world either,  a world focused on high returns on equity (ROEs) that are unadjusted to leverage and risk. Nevertheless, it seems unacceptable from a welfare perspective that, for instance, we would passively watch the development of a bubble in housing and other asset prices, comforted by the idea that the banking sector is prepared to weather the storm and that the central bank would deal with the painful aftermath. To use a Dutch metaphor, this is not just about building dykes for resilience because, like King Canute, we have no hope of taming the tide. The analogy does not really work because financial instability is something man-made, and not an unassailable fact of nature.
Trying to smoothen out the financial cycle, of course, poses far more challenges than the task of building buffers as it is about addressing exogenous and endogenous risks to system-wide stability with targeted measures. Admittedly, fully controlling the financial cycle is an unattainable objective, but it would not be worth setting up the macro-prudential policy area if it were to refrain from attempting to fulfil the ambitious goal of influencing the credit cycle.
The challenges are multifaceted. The financial cycle has an important endogenous component.  For instance, easier credit encourages investors to buy more assets, which in turn increase the value of collateral, thereby fuelling the credit boom further. Hence, the expansion of credit in good times can, by itself, lead to excessive leverage in the financial system and increase the probability of crises, only to reverse in a symmetric fashion during a bust.  This pro-cyclicality of the financial sector contributes to the endogenous build-up of financial imbalances. 
A macroeconomic downturn, for example, would impair the value of bank loans. What could happen then is that multiple financial institutions decrease their holdings of loans or other assets contemporaneously to meet certain capital ratios, and this could easily lead to a credit crunch and/or fire-sales.  The macroeconomic effects of an excessive shrinkage of bank’s assets would eventually lead to a reduction in investment which would further dampen the economic cycle. This in turn would lead to a more pronounced reduction in credit, creating a vicious circle for the economy. These considerations suggest that the macro-prudential approach to financial regulation needs to factor-in general equilibrium effects by considering the strategic interaction of banks and the interlinkages between the financial sector and the real economy.
Containing systemic risk can thus be achieved largely by tempering the financial cycle. Macro-prudential tools should be used as a pre-emptive policy in the context of credit and asset price booms, especially property prices. In particular, the use of macro-prudential policies offer an approach that is the most targeted to reduce the incidence of credit booms and decrease the probability of costly busts. Earlier and decisive action seems to be paramount in this respect.  Let me also emphasise that it is crucial to address the risk of inertia by providing policy-makers with strong incentives to speedily address the build-up of systemic risk in an early phase. Borio (2012) defines the financial cycle as “self-reinforcing interactions between perceptions of value and risk, attitudes towards risk and financing constraints, which translate into booms followed by busts”,  a set of fluctuations that could be parsimoniously described in terms of credit and property prices. In this vein, one can speculate that, further down the road, a concept of long-term credit equilibrium can become some sort of intermediate target for macro-prudential policy.
My conclusion is that we need to curb the financial cycle, using an adequate toolkit. I will therefore now turn to macro-prudential policy instruments and their effectiveness.
What instruments should we use?
Limited understanding of macro-prudential policies
In advanced economies, experience concerning the use of macro-prudential policies is relatively limited, if you ignore all sorts of administrative interventions that were usual in many European countries from the 1960s to the 1980s, interventions such as limits to credit (or even limits to deposits, as in the United Kingdom in 1971-72) or minimum down payments for consumer credit. It is true that this was done more in the name of monetary policy as the absence of deep money markets made it difficult to use interest rates and open market operations to conduct it Nevertheless the instruments also played a containment role on the credit cycle, but these were times of less sophisticated financial systems. Nowadays, the transmission channels of typical macro-prudential instruments are not well understood, which makes their calibration especially hard. Furthermore, little is known about how long it takes for those policies to work through the financial system, how large their effects are, or how banks react to them. We will, by necessity, have to start with some trial-and-error, to help us identify and address the main operational issues.
Macro-prudential policies can address financial imbalances building up in specific sectors, by using targeted instruments. The possibility of targeting specific imbalances strengthens the macro-prudential framework. At the same time, however, the variety of possible combinations of macro-prudential instruments also makes the implementation of macro-prudential policy a complex endeavour, which has to take into account interactions, leakages and waterbed effects.
It is worthwhile to group macro-prudential policies into different categories. I like the distinction between structural and time-varying policy measures. It partly overlaps the more traditional approach of separating cross-sectional and time-dimensional policy tools. However, structural measures encompass cross-sectional policies to mitigate contagion, but go beyond that, as they also include financial regulation. Indeed, financial regulation should be decided from a macro-prudential perspective, and should be concerned with the design of a resilient financial system. In this broader sense, regulation is the first instrument of macro-prudential policy. Taxes, Pigouvian or other, should also be considered as useful tools for macro-prudential purposes.
It should be noted that the distinction between structural and time-varying measures, is not always straightforward. By adjusting the calibration of a structural measure over time, like foreseen in Article 458 of the Capital Requirements Regulation (CCR), the distinction between the two types of tools becomes blurred. Another relevant concept for characterising policy measures relates to the way in which they operate. A distinction can be made between measures that act through cost-price incentives, like capital instruments, and those that depend on quantitative limits, like large exposures or loan-to value (LTV) and/or debt-to-income (DTI) ratios.
How high should structural capital requirements be?
The area in which the design of macro-prudential tools is most advanced is probably that of capital requirements for banks. In particular, there is a broad consensus that it is important to ensure that sufficient buffers are built up in good times, to be available in bad times. This is, naturally, about ensuring the resilience of the system. However, let us not forget that changing capital requirements over time has also been proposed as a way of dealing with the smoothing of the cycle. Curiously, there seems to be a possible disconnect between the theoretical arguments used to defend strong capital ratios or strict leverage ratios and the reasoning behind a time-varying use of capital instruments. The structural strength is justified per se and is considered as not being costly in terms of the credit financing of the economy and economic growth. On the contrary, when capital instruments are used in a time-varying fashion they are expected to have a significant impact in mitigating the cycle. This disconnect deserves some reflection.
The main economic benefit of demanding higher capital ratios stems from the reduced frequency of future crises. The prevention and mitigation of downside tail risks for the economy implies a sizeable reduction of the expected output losses associated with systemic events and, as such, contributes to more sustainable economic growth over the long term. To be more precise, a study by the Basel Long-term Economic Impact Group has estimated that banking crises occur, on average, every 20 to 25 years. This estimate means that there is a 4.6% annual probability of a crisis. The study shows that a 4 percentage point increase in the capital ratio lowers this annual probability to less than 1%.
Additionally, higher capital levels decrease the likelihood of taxpayers’ involvement in bank bailouts, and therefore decrease moral hazard induced by too-big-to-fail situations. To avoid systemic risk and limit the costs of the associated economic meltdown, governments may have to rescue banks. But such rescues can be very costly to the taxpayers and society as a whole, both ex post – the cost of the bailout – and ex ante – the excessive risk-taking induced by too-big-to-fail. Furthermore, the recent turbulences in the euro area have shown that bank bailouts can trigger chain reactions that are hard to stop. For instance, some governments had to support their systemically important national banks, which weighed negatively on their own public debt ratios. This created a negative feed-back loop between banks and sovereigns that contributed to financial fragmentation in the euro area and impaired the transmission of monetary policy.
In Europe, the establishment of the Single Resolution Mechanism (SRM) and the Bank Recovery and Resolution Directive (BRRD) are crucial steps towards containing excessive risk taking due to bail-out expectations. High capital requirements are the first, ex ante step to get banks to have “skin in the game” and to address moral hazard. An orderly resolution mechanism that credibly rules out bailouts, except in truly extreme circumstances, is an ex post measure with ex ante effects on risk-taking. The SRM puts in place a single authority responsible for the resolution of banks in the euro area and participating Member States. This will enable swift and unbiased resolution decisions, which will address, inter alia, cross-border resolution cases in an effective manner. Public money would only be required at the very end of the resolution process, which should, in practice, happen extremely rarely.
The question is then whether banks can and should operate with capital ratios even higher than those agreed in the Basel III accord. The issue is quite thorny, since many commentators argue that increasing equity requirements for the banking system would excessively increase their cost of funding. As a consequence, intermediation would decline, which could seriously dent economic growth. But, in line with another strand of thought in the literature, such concerns about high capital ratios are not necessarily justified from a social point of view.
From a historical perspective, banks have long operated with more capital and with smaller implicit safety nets than today. Historical evidence seems to indicate that there is no relationship between the simple ratio of book capital to total assets (or its inverse, with leverage expressed as a multiplier) and economic growth. Haldane and Alessandri (2009) show that capital ratios for UK and US banks have declined steadily since 1880, until the first decade of the 2000s.  Miles et al. (2011) point out that in the United Kingdom, the leverage ratio as a multiplier over equity in the period from 1880 to 1960 was about half the level of recent decades.  Similarly, Kashyap et al. (2010) demonstrate that the book value equity-to-assets ratio for US commercial banks has declined substantially over time: while the ratio exceeded 50% in the 1840s, it subsequently fell steadily to reach 15% in 1930s, and 6% in the 1940s.  The evidence for both countries indicates clearly that very different levels of capital coincided with similar rates of economic growth, showing no specific historical relationship between the two.
Turning to the relationship between simple book value capital-to-assets ratios and spreads or rates of business loans, neither Miles et al. (2011) nor Kashyap at al. (2010) find any evidence of a clear link between these ratios and bank lending rates in the United Kingdom since 1890 and in the United States since 1920 respectively.
Analysing a more recent period, Miles et al. (2001) find econometrically that doubling the capital ratio would not increase bank costs much. Kashyap et al. (2010) find that the long-run steady-state impact on loan rates is likely to be modest, falling in the range of 25 to 45 basis points for a 10 percentage point increase in the capital requirements.
Taylor (2012) documents that in advanced economies, “the financial sector is now larger than it ever has been. The increase in size has been dramatic since the 1980s; after that date, compared with what had been the norm for more than a century, banks almost doubled their size relative to GDP measured by loan activity, and almost tripled measured by total balance sheet size”. ,  Inter alia, the increasing socialisation of banks’ costs – i.e. the safety nets which governments have extended to the banking system over time – that is not matched by a socialisation of banks’ profits, which in fact remain private, can be responsible for the banks’ relatively low equity buffers.  In other words, as the banking system became progressively too big to fail, it could operate with less own capital, thanks to increasing implicit guarantees from the government. On the other hand, r ecent research at the ECB and at the Bank for International Settlements (BIS) shows that the continuing increase of the financial sector size has not always contributed to higher economic growth, in particular since the late 1990s.  In fact, some empirical evidence suggests that, above a certain threshold, the effects of finance on the growth potential weaken with the degree of economic development, as the effect of finance on growth is not necessarily monotonic. This phenomenon is connected to the complex non-linearities involved in the finance-growth nexus, causing the effect of finance on growth to peter out over the development cycle, as well as to the trade-off between growth and tail risk exacerbated by the expansion of the financial sector.
All the previous analyses seem to indicate that, from a social perspective, the cost of highly capitalised banks would in fact be relatively low. The relatively cheap cost of debt in comparison with the cost of equity is due, among other factors, to the widespread tax advantage of debt financing has over equity financing. It is also due to an implicit subsidy on debt funding that stems from implicit government guarantees for the banks, which is partly passed on to customers. A relatively higher level of equity funding reduces the riskiness of the banking system, and therefore the need of costly bail-outs, so that in the long run, taxpayers should be better off. 
The theoretical underpinning behind these ideas is the M&M theorem which states that if certain assumptions hold (symmetric information and rational behaviour of market participants, complete, frictionless markets, etc.), the funding structure of a firm is irrelevant for the value or funding costs of the firm. In an M&M world, the primary differences between the costs of debt and equity can stem only from their disparate tax treatment. The relevant point is that more capital reduces the volatility of the return on equity and increases the safety of debt, thereby it should reduce the market’s required returns on both equity and debt. This means that the equity risk for a bank should decline linearly with leverage.
These analyses, however, take a long-term view, whereas the problems may lie in the short-term effects. While the basic results of the M&M theorem may approximately hold in the long term, in itself a controversial statement after the crisis, financial markets are characterised, in the short run, by information asymmetries, myopic agents not optimizing inter-temporally and other frictions, which can be especially prevalent in distressed periods.
Another aspect stems from the fact that capital requirements are imposed in terms of ratios to risk-weighted assets which implies that banks have several possibilities to comply. Banks can raise capital, increase lending spreads, reduce dividends and/or downsize their (risk-weighted) assets or even adjust their internal models to decrease the denominator. In practice, it is likely that banks’ adjustment is achieved through a combination of all these measures. There is empirical evidence, however, that in the short term, and in crisis periods in particular, banks react to capital (and liquidity) constraints by deleveraging and by tightening credit terms and conditions,  and that this can have a measurable impact on the loan supply, and thus on economic activity.  It is this short-term analysis with a greater distance from the M&M world that promises to add some efficiency to time-varying capital measures to smooth the cycle.
Macro-prudential policy: implementation issues and effectiveness
Regulators have recognised the importance of bank capital, notably by introducing not only a higher risk-weighted capital ratio, but also a counter-cyclical capital buffer (CCB) and a simple regulatory leverage ratio. I will discuss the latter two measures in turn.
In the Basel III framework, the CCB is the main counter-cyclical tool. It is designed to increase banks’ resilience by making them set aside capital in good times, and to draw it down in bad times. If a release of the buffer in the downturn fosters bank lending in recessionary periods, the CCB will also have a counter-cyclical effect. Of course, the CCB can also contribute to stymieing the financial cycle in the upswing phase. However, I would see two limitations of the CCB.
First, given the relatively long lags in its implementation and impact, the CCB might not have a timely influence on the financial cycle. Indeed, the CCB should be activated relatively early in the cycle to give it time to display its effects. This increases the possibility of false alarms, which will, in turn, most likely lead to it being set at relatively low levels in order to mitigate the effect of a potential false alarm. In such a scenario, however, it runs the risk of being ineffective.
Second, such a tool could also be subject to so-called “waterbed effects” or “leakages”. In this regard, macro-prudential policies are not exempt from the usual search for regulatory arbitrage. Affected financial intermediaries may have incentives to circumvent regulation by moving activities outside the regulatory perimeter. By pushing financial intermediation towards the “shadow banking” sector, the tool could even reduce the overall soundness of the financial system. Another possibility concerns the leakages towards branches of institutions from countries which do not use reciprocation. For example, for certain risks such as those of buoyant credit markets, the CCB can be set above 2.5%. In that case, the recognition of the higher buffer rate by other designated authorities would be voluntary. This lack of reciprocity might generate substitution effects towards branches of foreign banks, thus mitigating the intent of the buffer itself. Therefore, in order to make an effective use of the CCB, international cooperation will be key. At least in the euro area, the SSM framework helps to internalise some issues; for example, where necessary, the ECB can take action in the case of reciprocation.
Such leakages may explain why, in practice, macro-prudential policies seem, at times, to have had mixed results, which vary widely across countries. Most of the evidence on the effectiveness of those policies comes from experience in emerging market economies. Borio and Shim (2007), for example, argue that these measures have, in some cases, slowed down credit expansion temporarily and restrained imprudent practices.  It seems therefore possible, under certain conditions, to control financial developments in order to avoid the boom-and-bust cycle.
For it to have long lasting effects, macro-prudential policy must be used decisively, and it may be necessary to use several instruments at the same time. In addition, to avoid that imbalances spill over into other parts of the financial sector, possibly out of reach of supervision, the borders of the banking sector need to be carefully patrolled. Two telling examples are Singapore and China. Singapore has been a pioneer in the use of macro-prudential policies to moderate financial stability risks arising from the housing market. Since 2009, a series of measures targeting housing have been implemented, with a tightening of the LTV ratio for individual borrowers from 90% in 2009 to 40% in 2013. The cumulative impact of these measures has been slow, and residential property prices have stabilised only recently. In China, the introduction of an LTV ceiling of 80% in 2001 did not have much of a bite until it was complemented with DTI limits of 50% in 2005–06. But even then, the combination of the two measures was credited with reducing mortgage credit growth by only 2 percentage points of GDP over the period from 2004 to 2008. That is a sobering fact when one notes that LTV/DTI ratios have so far been the most efficient types of macro-prudential instrument. This illustrates that, to be effective, macro-prudential policy has to be pre-emptive, deployed in a timely manner and aggressively. Contemplating these results, we may doubt that, on the scale they have been foreseen, capital instruments, such as the CCB with a maximum of 2.5 percentage points, can be sufficiently effective to achieve more than a contribution to the robustness of the banks in a downturn, after a boom which it was not high enough to mitigate, let alone to prevent.
Capital instruments, from the CCB to sectoral capital requirements, have their impact on the evolution of the cycle mainly through their effect on the cost/price of credit, and this may not be enough to offset the prospects of gain that seem readily available when every asset price is going up. Instruments with quantitative limits like the LTV/DTI ratios, as we have just recalled, can be more effective, but even these measures face difficulties if not used in a draconian way in certain cases.
The leverage ratio is another capital-based instrument that at least has the virtue of simplicity. It is a rougher measure than the CCB, and has been touted as a backstop to prevent risks that are not fully captured by risk weights from inflating banks’ balance sheets. In fact, in some jurisdictions such as the United States, it is still the main constraint for most banks. It has the advantage of being simple to understand and implement, which is an attractive feature in an increasingly complex world.
However, the leverage ratio in its current static form cannot reduce pro-cyclicality In good times, asset values typically go up, and profits and retained earnings increase, which in turn increases book capital. This can help to continue to increase credit, without going beyond the regulatory leverage threshold.
More in general, the impact of capital-based measures on banks’ risk-taking has to be taken into account. Banks choose jointly a capital structure and an asset composition which maximises shareholders’ return, subject to the constraint of having a low probability of default – this is where supervision comes in. If, in order to make sure that this probability of default is sufficiently low, we ask banks to keep a relatively high level of capital, they will increase their returns by taking on more risks on their assets side. If capital is risk-weighted, banks will look for assets with undervalued risk weights. Typically, this is the case for assets that carry systemic risk, which is difficult to measure and to price. I am not advocating letting banks choose higher leverage in the hope that they will reduce risk in their assets; but I wonder whether we can really tailor risk weights to underlying idiosyncratic and systemic risk in a constantly evolving world.
The conclusion I draw here is that the leverage ratio can be a useful structural measure to contain risk-taking, as long as it is binding. If the leverage ratio is too low, it will not be a meaningful backstop to catch failures of the system of risk weights. After the recent new definitions for calculating the leverage ratio with some netting, the initially proposed level of 3% now seems too low and should be increased in the announced future decision on the final calibration. Perhaps capital is not the only instrument we should think of in order to control risk-taking and ensure resilience. Stricter rules on portfolio diversification might be a useful complement, as I will argue in a moment.
All in all, while macro-prudential tools should make an important contribution to effective policy making, we can already foresee that certain activities in the financial system may not be properly covered by the available instruments. Typically, a credit boom is more pronounced in only one or a few sectors, and it is mostly related to real estate. When exposures to certain sectors become especially problematic, they may need to be targeted by additional macro-prudential measures, e.g. capital surcharges on these specific exposures, or large exposure limits at the sectoral level. To identify such critical situations and intervene timely, macro-prudential authorities will need a sound system of risk monitoring across individual banks. To this end, it is necessary that macro-prudential authorities have full access to bank-level data. This would allow macro-prudential models to be fed with detailed high-quality and timely information. Moreover, it would allow micro- and macro-prudential analysis to be fully consistent. Equally important is the need to gain a better understanding of how affected financial institutions react to the adopted policy measures and how this feeds back into the financial sector and into the economy. This would allow policy-makers to choose the appropriate instruments to address financial imbalances.
Macro-prudential tools in the EU are governed by two legal texts: the Capital Requirements Regulation (CRR) and the Capital Requirements Directive VI (CRD IV). The appropriate analytical underpinning needs to be gathered for the adequate design and calibration of tools at the disposal of macro-prudential authorities. At the same time, the range of tools might need to be expanded. The counter-cyclical capital buffer (Articles 130 and 135-140), the systemic risk buffer (Articles 133-134) and the capital surcharge for systemically important institutions (Article 131) fall under the CRD IV. The CRR includes (under Article 458): minimum capital requirements, large exposure limits, the capital conservation buffer, sectoral risk weights (in the residential and commercial property sectors) and intra-financial sector exposures, whereby higher risk weights can be set for financial sector exposures. Furthermore, it includes liquidity requirements (the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR)) and requirements on public disclosure aimed at enhancing market discipline and mitigating informational asymmetries.
While the range of tools might appear quite broad, it would gain in being supplemented with some instruments that are less dependent on costs/incentives and more on quantitative limits, such as large exposure limits for sectors and not just for clients. Other possible toolkit extensions to consider are the LTVs or DTIs ratios, the loans to deposit ratio, or the margins and haircuts used in some financial markets.
A final consideration relates to the fact that the cyclical behaviour of those parts of the financial sector that fall outside of the scope of regulation and supervision needs to be influenced by other policies, possibly by monetary policy. For a central bank with macro-prudential responsibilities, the link between macro-prudential and monetary policy is therefore of particular relevance.
Interactions with monetary policy and governance issues
Let me first recall that financial stability is a precondition for the efficient conduct of monetary policy. Monetary policy that is successful in delivering price stability relies on the effectiveness of the monetary transmission mechanism. The central bank only has direct control over short-term interest rates. Monetary policy decisions on the level of interest rates work their way through the economy via various channels and affect both expectations and a broad range of asset prices. It is clear that financial instability would affect the transmission of monetary policy.
At the same time, price stability is supportive for financial stability. For example, unstable inflation developments could complicate the pricing of assets and blur the signals from relative price adjustments, with detrimental effects on resource allocation and the inter-temporal choices of savers and investors.
However, price stability is not a sufficient condition for financial stability. The developments in the run-up to the global financial crisis have shown that low and stable inflation rates may well be consistent with the build-up of financial imbalances, leading to an increase in systemic risk and, ultimately, to serious risks to price stability further down the line. More generally, as a result of the establishment of credible low inflation regimes in many parts of the world in the course of the last two-and-a-half decades, unsustainable economic developments seem to manifest themselves primarily in the build-up of financial imbalances and asset bubbles, rather than in traditional inflationary pressures.
Indeed, what has been experienced most recently is not the only case in which financial distress has occurred in an environment of stable price developments. The recent period of extensive financial liberalisation, which started in the early 1980s, has been interspersed by a number of financial stress events. To name but a few, the financial crises in the Nordic countries, Japan, eastern Asia and Mexico all took place in circumstances in which inflation was not a threat. Also the dot-com bubble in the late 1990s was characterised by a rise in stock prices to unrealistic levels around the globe, and the most recent housing price bubbles in the United States and some European countries show that asset prices can deviate from their fundamental values even when the markets for consumer goods and services are stable.
As argued before, the fact that the financial crisis led to large disruptions in the economy is a strong reason to make the financial cycle a subject of stabilisation policies.  Monetary policy has traditionally been defined in terms of the business cycle. While not disconnected from the business cycle, the financial cycle has larger amplitude and is at least twice as long as the business cycle. Furthermore, its dynamics are driven more directly by credit and property price developments.
As part of its monetary policy strategy, the ECB already assigns a prominent role to financial developments, by taking into account the medium-term effects of booming credit and asset markets for the assessment of risks to price stability. Nonetheless, standard monetary policy may not be the most appropriate tool to address all the underlying forces driving the financial cycle.
First, it is not clear what would be the appropriate magnitude of changes in the policy rate to curb excessive developments in asset prices and credit. There is evidence that monetary policy could be a powerful instrument in a boom that is driven by increasing leverage. In such a situation, profits may be sensitive to relatively small changes in interest rates.  However, as just mentioned, the financial cycle differs from the business cycle in its amplitude, which could at times require much larger shifts in the policy rate than would be warranted by the outlook for inflation. It is obvious that such interest rate changes could cause collateral damage in the real economy. 
Second, financial cycles across euro area countries are still heterogeneous, while monetary policy is the same across the board. In fact, the vigorous growth in money and credit observed at the euro area level before the crisis was largely driven by developments in specific regions and sectors. The ECB’s monetary policy is responsible for ensuring medium-term price stability in the euro area as whole. Tailoring monetary policy decisions to specific sectoral or regional differences in credit or asset price developments might have inappropriate side effects in other areas.
In the spirit of Tinbergen, these considerations suggest that two different objectives warrant the use of two different sets of instruments. The objective of monetary policy remains the safeguarding of medium-term price stability. As I have mentioned earlier, the main task of macro-prudential policy is to address risks to financial stability and to ultimately curb the financial cycle, so that the risk of financial crises occurring is reduced and real economic effects of financial crises are dampened. This separation is also consistent with the “principle of effective market classification”, according to which policies should be linked to those objectives on which they have the strongest impact. 
Whether the two different policy functions give rise to friction depends on the degree of complementarity of the respective policy objectives. Usually, there is no trade-off between price stability and financial stability. Price stability contributes to financial stability by eliminating inflation-related distortions in financial markets. At the same time, financial stability facilitates the central bank’s task of maintaining price stability by contributing to a stable monetary transmission mechanism – a precondition for a central bank to be able to discharge its task – and by avoiding that risks to price stability emanate from financial instability. Therefore, in those cases, the respective objectives of macro-prudential policy and monetary policy are mutually reinforcing.
In certain situations, however, the two policies may have different stances, one restricting, while the other is expanding, without this implying that they are in conflict, but that they can be complementary. That is precisely what happened at the time of the so-called “great moderation”, as well as what is happening at present. During the period of “great moderation”, monetary policy was loose enough to allow large increases in credit and leverage; there was a need for restrictive macro-prudential policy, but this policy area did not yet exist. At present, the low nominal growth requires a very accommodative monetary policy with low interest rates and the possibility of activating the “the risk-taking channel”  and a search for yield. This environment calls for restrictive macro-prudential measures in the asset market where some froth is emerging.
In general, the two policy areas interact, and their effects on each other have to be considered. Macro-prudential policy influences credit conditions, and thereby also feeds back effects into the overall economy and, hence, the outlook for price stability. Monetary policy can, in the pursuit of price stability, affect systemic risk via a number of transmission channels. In particular, the risk-taking channel of monetary transmission suggests that the stance of monetary policy is probably an important determinant of financial activity and the overall level of risk in the financial system. These interactions gain force by being taken fully on board by decision-makers, which is an argument in favour of having both competences under the same roof – that of the central bank. The alternative, used in several countries, is to give the macro-prudential policy mandate to a committee in which the central bank is given a prominent role, a solution that may well work, but is not as efficient as the other option.
Macro-prudential policies and the ECB’s medium-term-oriented monetary policy strategy can therefore be seen as essential and mutually reinforcing elements of a policy framework that is conducive to effectively maintaining price stability in the medium run, and to mitigating systemic risk, and therefore safeguarding financial stability. The interaction effects of monetary policy and macro-prudential policy that I have just described suggest that coordination between the two policy functions is beneficial. The need for coordination and the fact that both monetary policy and macro-prudential policy take a macroeconomic perspective provide a strong motivation for integrating the two policy functions within one institution, the central bank, an entity with broad knowledge of markets, financial stability and the independence to take bold decisions when needed.
The Governing Council of the ECB is well placed to internalise the potential spillover effects between the two policy domains. The ECB’s primary objective remains the maintenance of price stability over the medium term. The SSM Regulation also assigns macro-prudential responsibilities to the ECB, under which the ECB will be able to apply tighter macro-prudential requirements than the designated national macro-prudential authorities. We know that there are gains to be reaped from coordination if spillover effects are sizeable.  When coordination is key, it is best achieved within a single institution. In such a case, all relevant data can be shared promptly, and a common institutional culture and mission ensures internal communications and trust. Furthermore, if policy-makers are members of the same institution, they can decide in a flexible and pragmatic way on where to stand in terms of trade-offs between objectives and instruments that change over time, while discussions in the alternative case of a committee of independent institutions might often turn around the limitations of their respective legal mandates and result in (possibly inferior) non-cooperative equilibria.
It has therefore been decided that the Governing Council will have a prominent role to play in matters related to macro-prudential policy. Regular joint meetings with the Supervisory Board of the SSM will be held to assess the relevant financial stability situation in the euro area and in each of its member countries.
Let me conclude. Macro-prudential policy is an offspring of the financial crisis. It is now being tested in advanced economies, with some encouraging results, notably with respect to the use of LTV ratios to contain housing price booms.
We lack good models for the analysis, with precision, of the transmission mechanisms of macro-prudential policy instruments. Economic theory is still centred far too much on the perfect world of rational agents, with stable and well-defined preferences who always optimize inter-temporally, in markets that eventually clear. Frictions can be added on top of these assumptions but, so far, they appear to be insufficient to adequately capture the stylised facts and non-linearities of the financial world. Policy-makers have to live closer to the real world of incomplete, imperfect markets, of myopic agents with herd behaviour, of distorted taxation and many other messy realities.
For the decisions we have to take, we will have to rely more on empirical studies of real experiences and sometimes precarious econometric evidence. This means that we have to accept uncertainty and cautious experimentation when we decide what is necessary to stabilise an unstable financial system. Macro-prudential policy faces a major test going forward: will there be determination and boldness to try to smooth the financial cycle, or will the authorities just take refuge in strengthening financial institutions and in hiding behind monetary policy expected to “mop-up” the mess created by the boom/bust feature of the financial system. Only time will tell, but in my view, the demands of the task are such that some measure of success can only be achieved if central banks are allowed to play a prominent role in macro-prudential policy decision-making.
Miles, D., Yang, J. and Marcheggiano, G., “Optimal bank capital”, Discussion Paper Series, No 32, Bank of England, 2011.
See Borio, C., “Implementing the Macro-prudential Approach to Financial Regulation and Supervision, " Financial Stability Review, Vol. 13, Banque de France, 2009; and Shin, H.S., "Macro-prudential policies beyond Basel III", in “Macro-prudential regulation and policy”, BIS Papers, No 60, Bank for International Settlements, 2011.
See Kiyotaki, N. and Moore, J., “Credit Cycles”, Journal of Political Economy, No 105 (2), 1997, pp. 211–248.
See Boissay, F., Collard, J.-E. and Smets, F., “Booms and Banking Crises” , Working Paper Series, No 1514, ECB 2014; Hahm, J.H., Shin, H.,S. and Shin, K., “Non-Core Bank Liabilities and Financial Vulnerability”, mimeo, Princeton University, 2011; and Shin, H.S., “Risk and Liquidity”, Clarendon Lecture in Finance, Oxford University Press, 2010.
See Hanson, S.G., Kashyap, A.K. and Stein, J.C., "A Macroeconomic Approach to Financial Regulation”, Journal of Economic Perspectives, Vol. 25, 2011, pp. 3-28.
See, for example, Borio, C. and Lowe, P. “Assessing the risk of banking crises”, BIS Quarterly Review, Basel, December, 2002; Mendoza, E.G. and Terrones, M.E. “An anatomy of credit booms: evidence from macro aggregates and micro data”, Working Paper Series, No 14049, National Bureau of Economic Research, 2008; Alessi, L. and Detken, C., “Real time early warning indicators for costly asset prices boom/bust cycles: a role for global liquidity”, Working Paper Series, No 1039, European Central Bank, 2009; Schularick, M. and Taylor, A.M. “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870–2008”, Working Paper Series No 15512, National Bureau of Economic Research, 2009; Behn, M., Detken C., Peltonen, T. and Schudel, W. ”Setting countercyclical capital buffers based on early warning models: would it work?”, Working Paper Series, No 1604, European Central Bank, 2013. During the recent financial crises, countries that experienced greater credit growth, such as Iceland, Ireland, Spain, also suffered larger repercussions (see, for example, S. Claessens, S., Dell’Ariccia., G., Igan, D. and Laeven, L. “Cross-country experiences and policy implications from the global financial crisis”, Economic Policy, vol. 25, Issue 62, 2010.
Borio, C., “The financial cycle and macroeconomics: What have we learnt?”, Working Paper Series, No 395, Bank for International Settlements, 2012.
Haldane, A.G. and Alessandri, P., “Banking on the Stare”, paper based on a presentation delivered at the Federal Reserve Bank of Chicago’s 12th annual International Banking Conference on “The International Financial Crisis: Have the Rules of Finance Changed?”, Chicago, 25 September 2009.
Miles, D., Yang, J. and Marcheggiano, G., “Optimal bank capital”, Discussion Paper Series, No 32, Bank of England, 2011, p. 6.
Kashyap, A.K., Stein J.C. and Hanson, S., “An analysis of the impact of ‘substantially hightened’ capital requirements on large financial institutions”, mimeo, 2010, p. 19.
Taylor, A., “The Great Leveraging”, NBER Working Papers, No 18290, National Bureau of Economic Research, 2012.
A number of factors can explain these trends in capital levels, such as financial liberalisation and deregulation, as well as financial innovation, including the increasing role of shadow banking, and securitisation.
See Haldane and Alessandri, op. cit.
See Manganelli, S. and Popov, A., “Finance and diversification”, Working Paper Series, No. 1259, ECB, 2010; Popov, A., “Financial liberalization, growth, and risk”, mimeo, ECB, 2011; and Cecchetti, S. and Kharroubi, E., “Reassessing the impact of finance on growth”, Working Paper Series, No 38, Bank for International Settlements, 2012.
See Admati, A.R., DeMarzo, P.M., Hellwig, M.F. and Pfleiderer, P., “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive”, Working Paper Series, No 161, Rock Center for Corporate Governance, 2013.
See Hempell, H. and Kok Sørensen, C., “The impact of supply constraints on bank lending in the euro area – crisis induced crunching?”, Working Paper Series, No 1262, ECB, 2010.
See De Bondt, G., Maddaloni, A., Peydró, J.L., and Scopel, S., “The bank lending survey matters: Empirical evidence for credit and output growth”, Working Paper Series, No. 1160, ECB, 2010.
Borio, C. and Shim, I., “What can (macro-)prudential policy do to support monetary policy?”, Working Paper Series, No 242, Bank for International Settlements, 2007.
See, for example, Borio, C., “The financial cycle and macroeconomics: What have we learnt?”, Working Paper Series, No 395, Bank for International Settlements, 2012; Aikman, D., Haldane, A. and Nelson, B., “Curbing the credit cycle”, Economic Journal, forthcoming; and Claessens, S., Kose, M.A. and Terrones, M.E., “Financial Cycles: What? How? When?”, IMF Working Papers, No 11/76, International Monetary Fund, 2011.
See, for example, Adrian, T. and Shin, H.-S., “The Changing Nature of Financial Intermediation and the Financial Crisis of 2007-09”, Staff Reports, No 439, Federal Reserve Bank of New York, March 2010.
See, for example, Bean, C., Paustian, M., Penalver, A. and Taylor, t., “Monetary Policy after the Fall’, Macroeconomic Challenges: The Decade Ahead, Federal Reserve Bank of Kansas City, 2011.
See also Mundell (1962) who discussed this question in the context of monetary and fiscal policy.
The risk-taking channel suggests that monetary policy affects risk premia via lenders’ or investors’ willingness to take risk, e.g. via sticky return targets or an inherent counter-cyclicality of investor risk aversion (see Borio, C. and Zhu, H., “Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?”, Working Paper Series, No. 268, Bank for International Settlements, December 2008, and the references therein).
There is rich research on the topic (see, for example, Dixit, A. and Lambertini, L., “Interactions of Commitment and Discretion in Monetary and Fiscal Policies”, American Economic Review, Vol. 93, No. 5, 2003, pp. 1522-1542.