Prudential policy and financial dominance: exploring the link

FredericBoissay frederic.boissay@bis.org ClaudioBorio claudio.borio@bis.org CristinaStefanaLeonte cristina.leonte@bis.org IlhyockShim ilhyock.shim@bis.org Prudentialpolicyandfinancialdominance:exploringthelink1 Sincemid-2021,centralbankshaverapidlytightenedmonetarypolicyagainstthebackdropofhistoricallyhighdebtlevelsandastrongincreaseininflation.Experienceoverthepastfivedecadesrevealsthat,underbroadlysimilarcircumstances,monetarypolicytighteningcouldusherinfinancialstress.Wefindthatprudentialpolicytightening,whetherbeforeorduringmonetarytightening,helpstoavoidsuchstress.Tighterprudentialpolicythereforereducestheriskoffinancialdominanceandprovidescentralbankswithmorepolicyheadroomtofightinflation. JELclassification:E52,G18. Sincemid-2021,centralbankshaverapidlytightenedmonetarypolicyagainstthebackdropofmulti-decadehighdebtlevelsandstronginflationarypressures(Graph1).Thishasraisedquestionsaboutthepossibleimpactonfinancialstability.Sofar,thefinancialsystemhasprovedresilient,butexistingvulnerabilitiescouldconstraincentralbanks’fightagainstinflation–so-calledfinancialdominance. Weexaminewhetherprudentialpolicycanincreasemonetarypolicy’sroomformanoeuvre.Basedonfivedecadesofdataforadvancedandemergingmarketeconomies,weexploretheconditionsunderwhichmonetarytighteningmayusherinstressandwhetherprudentialtighteningreducesthelikelihoodofsuchanoutcome.Wecontributetotheliteraturebyanalysingprudentialtighteningspecificallyinthecontextofmonetarytighteningepisodesandbyconsideringvariousindicatorsofstress.2 Wefindthatprudentialpolicytighteninghelpstopreventfinancialdominance.Suchmeasuresareespeciallyhelpfulwhenmonetarytighteningtakesplaceagainstthebackgroundofstronginflationarypressures,whichwouldinduceamoreintensetightening,orhigherprivatedebt.Thesearealsotwokeyfeaturesoftoday’smacro-financialbackdrop. 1TheauthorsthankStijnClaessens,MathiasDrehmann,LeonardoGambacorta,AaronMehrotra,BenoîtMojon,PhurichaiRungcharoenkitkul,HyunSongShinandNikolaTarashevforhelpfulcommentsanddiscussions.TheviewsexpressedinthisarticlearethoseoftheauthorsanddonotnecessarilyreflectthoseoftheBankforInternationalSettlements. 2Previousstudiesoftheinteractionofmonetaryandmacroprudentialpoliciesfocusmostlyonitseffectsoncredit,housepricesorgrowthbutnotonfinancialstress(egBrunoetal(2017),Ceruttietal(2017),GambacortaandMurcia(2020),KimandMehrotra(2019),KuttnerandShim(2016)orAraujoetal(2020)forasurvey).Afewrecentstudiesseparatelyanalysetheeffectsofmacroprudentialormonetarypolicyonfinancialstress(egFernandez-Gallardo(2023),Nakatani(2020),Schularicketal(2021)).Toourknowledge,wearethefirsttostudytheeffectsoftheinteractionbetweenthetwopoliciesonfinancialstress. Keytakeaways Monetarypolicytighteningismorelikelytousherinfinancialstressdowntheroadwhenratehikesoccuramidhighprivatedebtlevelsorstronginflationarypressures. Prudentialpolicytightening–whetheraheadoforduringamonetarytightening–helpstoreducethelikelihoodoffinancialstress. Thisprovidescentralbankswithmoreroomformanoeuvreintheirfightagainstinflation–itreduces“financialdominance”. Theremainderofthisspecialfeatureproceedsasfollows.Thefirstsectionidentifiespastmonetarytighteningepisodes.Italsoanalysestheoddsoffinancialstressduringsuchepisodesandwhethertheseoddsarehigherwhenthemacroeconomicenvironmentiscomparablewiththecurrentone(Graph1).Thesecondsectionanalysestheimpactofprudentialmeasuresontheoddsoffinancialstress,withafocusonwhethertheirimpactvariesiftheyaretakenbeforeorduringmonetarytightening.Thefinalsectiondrawsthepolicyimplications. Monetarypolicytighteningandfinancialstress Toexplorethelinkbetweenmonetarypolicytighteningandfinancialstressunderconditionsthatmayshedlightoncurrentchallenges,weproceedintwosteps.First,weconstructadatasetofmonetarytighteningandfinancialstressepisodes.Second,weexaminewhetheramonetarytighteningepisodeismorelikelytobefollowedbyfinancialstressifittakesplaceinanenvironmentofhighprivatedebtorstronginflationarypressures. Thedataset:identifyingmonetarytighteningandfinancialdistress Wefocusonmonetarytighteningepisodesinvolvingamaterialandsustainedincreaseinthepolicyrate.Importantly,tochooseepisodesthataremorerelevantatthecurrentjuncture,weseektoisolatethosemeanttoquell–possiblyincipient– Historicallyhighdebtlevelsandinflationincreasesin2021–221Graph1 A.Privatecredit-to-GDPB.InflationC.Changeininflation3 1970–80 1980–90 0 100 200 300 1990–20192 Pre-GFC2 –5 0 5 10 15 20 5 0 –5 –10 Jul2021–Jun2022 %%%pts 1Boxplotsshowmedians,interquartilerangesandfifth–95thpercentiles.Seetechnicalannexfordetails.2Excludespre-GFC=2003– 07.3Year-on-yearinflationrateminusitstwo-yearlag.Sources:WorldBank;BIS;authors’calculations. inflationarypressuresandexcludethosedrivenbyotherfactors.Inparticular,weexcludesharphikesinresponsetocurrencydepreciationsorsuddencapitalflowreversals,possiblyduringfinancialcrises.Anepisodestartsinthemonthofthefirstpolicyratehike,endswhenthepolicyratepeaks,andfeaturesincreasesoveratleastfourconsecutivemonths.3 Thechoiceofsampleperiodfortheanalysisraisesaquandary.Ontheoneh