Policy lessons – the big picture

Keynote panel remarks by Mr Agustín Carstens, General Manager of the BIS, at the 2021 Financial Crisis Forum, 12 August 2021.

Thank you very much, Tim. As always, it is my pleasure to participate in this event.

Let me start by recognising the uniqueness of the Covid-19 crisis: it represents an exogenous shock, leading to a "global sudden stop", with the steepest contraction in economic activity in living memory. It called for massive responses of at least three policies: fiscal, monetary and prudential. These three have been at the forefront, sharing the common objectives of stabilising the macro-economy, including by channelling resources to the real economy, and shoring up the financial system. The results have been favourable, with many economies now expanding fast and financial systems remaining sound.

Nevertheless, while the recovery is underway, there are still large differences across countries and significant uncertainties as to where the global economy is heading in the near term.

• One risk is inflation surprises. In the short term, uncomfortably high inflation can catch markets wrong-footed. A key challenge here is for authorities to distinguish between transitory relative price changes and generalised price increases, and to find a credible way to communicate this to society so as to keep inflation expectations well anchored. By and large this risk has been handled well by central banks.
• Another risk is the potential for insolvencies, notably in the corporate sector including SMEs. Policy support, such as furlough schemes, debt moratoriums, government guarantees and low interest rates, were important to help firms to weather the storm. However, they have also entailed a rise in corporate leverage and indebtedness. This means risks that firms cannot repay their loans when interest rates go up and policy support is withdrawn. To avoid unnecessary insolvencies, it is crucial that banks are willing to roll over their loans to viable firms as government guarantees are withdrawn. But we also need to be sure that countries' institutional frameworks allow for quick and efficient resolution of those businesses that are not viable in the new normal.
• A third risk is that the global recovery is proceeding at different speeds among countries. While the recovery has been faster than expected in the United States and China, as well as in some advanced economies, many emerging and developing countries are falling behind. Not only do they have far more limited fiscal and monetary policy space, they also have more limited access to vaccinations.

Having this as a background, some early lessons can be drawn from the Covid-19 policy response.

• One major lesson is that in crises there can be large synergies between policies. Let me give two examples here:

First, between monetary and fiscal policies: Accommodative monetary policy has lowered governments' borrowing costs, while fiscal policy has supported the transmission of monetary policy through the provision of loan guarantees. This has greatly benefitted the overall economy over the past 18 months.

Second, between prudential and monetary policies: To help central banks deploy their large-scale asset purchases, national supervisors provided much flexibility, including by temporarily adjusting leverage ratio requirements to exempt central bank reserves. At the same time, central banks' lending and refinancing schemes contributed much to banks' ability to productively channel resources, while maintaining resilience and stability.

• A related major lesson is the importance of a resilient financial system. Thanks to the Basel III reforms, the banking system entered the pandemic on a much more resilient footing than during the Great Financial Crisis. This is the main reason why banks have been able to maintain the provision of credit and other key services to households and businesses.

Now, looking further out, there are a number of policy challenges.

• One is the eventual need to normalise fiscal and monetary policies. But normalising policies over the longer term will not be easy. Public debt is at a post-World War II peak. Likewise, central bank balance sheets have only rarely reached similar heights, and then only during wars.
• Another challenge will be to avoid counter-productive interactions among policies. This may be trickier than over the past year, as policy objectives may depart and synergies could be less clear. Let me illustrate this by using the two previous examples:

First, between monetary and fiscal policies: Too fast fiscal consolidation in the near term could act as a drag on economic activity, hindering prospects for monetary policy normalisation. Conversely, given increased debt burdens, higher interest rates could force governments to withdraw their policy support too early. The balance thus has to be right.

Second, between prudential and monetary policies. If unconventional central bank policies were to continue for much longer, this could lead to more risk-taking and higher leverage, even as supervisors come under pressure to prolong exemptions for banking systems. This would delay the normalisation of prudential policies, and could undermine the resilience of the banking sector.

One element that would help reconcile all of this, is to restore higher sustainable economic growth. This is the main way to tackle the various challenges and limit the scope for policy tensions. Macrostabilisation policies cannot generate this higher growth. Structural reforms, which have been flagging for some years, are now needed to deliver a vibrant, flexible and competitive economy. Growth-friendly fiscal policies could also play a useful role.

We also have to draw lessons from the events for financial regulation, and adapt the toolkit to address the new risks that have come to the fore. Let me first give two examples on where we should adjust regulations.

• Existing macroprudential countercyclical buffers are designed to be built up during booms. However, in many countries, these buffers were low, in part as a credit boom did not precede the crisis. As these banking systems entered the crisis without having accumulated capital buffers, macro-prudential authorities had little room to respond. We can certainly do better here.
• Even in jurisdictions where regulatory and management buffers had been built up, banks often have been reluctant to use the buffers to help mitigate the effects of the crisis on credit availability. This limited "buffer usability" likely reflects various reasons other than regulation, such as the fear of market stigma or the uncertainty surrounding the macroeconomic outlook. Nonetheless, policymakers have to work on this too.

In addition, the Covid-19 crisis revealed some gaps in the overall regulatory net, some already known before the crisis. A notable example comes from the March 2020 turmoil, which underscored the need to enhance the resilience and regulation of non-bank financial institutions (NBFIs). Some money market funds saw large redemptions, putting the short-term funding market under stress. This was the second time in little over a decade when central banks had to intervene. We said last time that this should not happen again, but it did. Second time around, we should really mean it when we say that this is a situation we should avoid finding ourselves in again. The BIS is doing its part on this score by co-leading an FSB group on MMFs.

More generally, we need to remedy the vulnerabilities in the fast-growing part of the non-bank financial system. Regulation strengthened banks after the great financial crisis (GFC); now policymakers need to ensure that the non-bank financial sector is a lasting source of strength for the real economy. The structures underlying money market funds are being reviewed. However, more is needed to correct those mechanisms in other non-bank parts that expose the overall financial system to large strains.

Let me close by underlining that vaccinations are crucial to achieve a broad based, even recovery of the global economy.  Efforts to speed up the production and fairer distribution of vaccines must be continued and accelerated.  But I fear that it isn't enough to rely solely on vaccination campaigns.  Better treatment and diagnostics are of the essence.  International cooperation plays a major role here.  If we successfully vaccinate and treat together, the global benefits could be much greater than if countries rely solely on their own resources.

Thank you very much!