There are so many aspects that can be investigated when evaluating this very important topic, but for the purposes of this article I am going to briefly focus on risk management and liquidity perspective for central banks.
Financial stability requires maintaining a good supply of credit to companies and households against sudden tightening in liquidity and fire sales, and the functioning of the payments system. These features are integral to monetary transmission.
During both the 2008 Global Financial Crisis (GFC) and 2020’s Covid-19 stress, credit and payment services were impaired, resulting in businesses and households being unable to get the finance that they needed to operate. Systemic crises such as these arise from linkages within the financial system, and through its interaction with the real economy across the cycle.
Financial imbalances tend to build up over time, and during a crisis will turn into costly systematic risk. Monetary policy should aim to decrease the likelihood of crises and pay attention to tail risks such as solvency issues, and be prepared for the expected magnitude of loss if the highest expected loss (CVaR) is exceeded.
Reliance on risk measures such as credit risk and external credit ratings based on historical data values without an understanding of their limitations can give a false sense of confidence. This attitude should be compensated for by planning for unlikely events using forward-looking stress testing and scenario analysis for downturns in economic conditions. The GFC showed that changes to central bank liquidity operations and broad crisis management frameworks are needed, and enhancing the flexibility of central bank operational frameworks will improve the resilience of the system. Today major banks at the core of the financial system are more resilient and better placed to sustain financing as a result of the regulatory reforms in the aftermath of the 2008 GFC.
During Covid-19, policymakers should enable the financial system to continue to provide financing to the real economy under different recovery scenarios. It all comes down to effective long-term and integrated risk management recognising the importance of mitigating crisis risk proactively, rather than only relying on cleaning up after the event. Monetary policy strategies need to lean against the build-up of financial imbalances. Macroprudential policies seek to ensure financial stability by mitigating the build-up of systemic risk. Periodic risk assessments such as macroprudential stress testing can significantly contribute to understanding the sources and the consequences of the risks, including feedback effects and amplification mechanisms.
It is crucial for central banks to continuously re-think their risk management framework to be prepared and able to switch into crisis mode.
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