Central banks have been at the heart of the global financial crisis. They have been blamed for policies and actions that got the world into the crisis; they have been praised for leading the world out of it. Both are fair assessments. Central banks have been a part of the problem and a part of the solution. As the crisis unwinds and recovery takes hold, central banks face a number of issues, of which the Governor of the Reserve Bank of India, Duvvuri Subbarao, covers in a recent speech:

• Monetary policy in a globalizing environment
• Redefining the mandate of central banks
• Central banks and financial stability
• Managing the costs and benefits of regulation
• Autonomy versus accountability

Of these, two are presented here, for the other three see the full speech:

Central banks and financial stability

While there is broad agreement that financial stability is neither automatic nor inevitable, there is less agreement on whether it should be explicitly included in the mandate of central banks. One argument is that explicit inclusion would be redundant, because financial stability is a necessary—although not sufficient—condition for achieving the conventional central bank objectives relating to inflation, output, and employment. On the other hand, there is a growing view that unless financial stability is explicitly included in the mandate of central banks, it is likely to fall through the cracks.

Complicating matters, defining financial stability in a precise, comprehensive, and measurable manner is proving to be difficult. Nevertheless, we now know that there are two attributes of financial instability:

• excessive volatility of macro variables such as interest rates and exchange rates that have a direct impact on the real economy; and
• financial institutions and markets threatened by illiquidity to the extent of jeopardizing systemic stability.

Do central banks have the instruments to address the mandate of financial stability? One clear instrument for preserving financial stability is the lender-of-last-resort function. During the crisis, central banks pumped in enormous amounts of liquidity to unfreeze the system through the lender-of-last-resort window. While this made individual institutions liquid, the market remained illiquid, thereby revealing the limitation of the window instrument in combating illiquidity. A central bank can infuse liquidity, but it’s hard to ensure that the available cheap and abundant money is used to purchase assets whose value is rapidly eroding. The only option may be for the central bank to buy the assets. This means that the central bank must be not only the lender but also the market maker of last resort. These issues have yet to be clearly defined, let alone resolved. But they must be resolved soon.

Managing the costs and benefits of regulation

To safeguard financial stability, the Reserve Bank of India used a variety of prudential measures, including specification of exposure norms and preemptive tightening of the risk weights attached to assets and the requirements for loss provisioning. But these measures often carry a cost. For instance, tightening risk weights arguably tempers the flow of credit to certain sectors, but excessive, premature, or unnecessary tightening can blunt growth. Similarly, exposure norms offer protection against concentration risks; however, such limits can restrict the availability of credit for important growth sectors. Thus, as in the case of price stability, central banks face the challenge of managing the trade-off between financial stability and growth.

After a crisis, with the benefit of hindsight, all conservative policies appear safe. But excessive conservatism can thwart growth and stifle innovation. The question is, what price are we willing to pay, or—conversely—what potential benefits are we willing to give up, to cope with the unexpected, a black swan event? Experience shows that balancing the costs and benefits of regulation is more a question of good judgment than analytical skill. Central banks, especially those of developing countries, such as India, need to hone their judgment skills as they pursue growth and financial stability.