Towards an Operational Framework for Financial Stability: "Fuzzy" Measurement and its Consequences

Over the last decade or so, addressing financial instability has become a policy priority. Despite the efforts made, policymakers are still a long way from developing a satisfactory operational framework. A major challenge complicating this task is the “fuzziness” with which financial (in)stability can be measured. We review the available measurement methodologies and point out several weaknesses. In particular, we caution against heavy reliance on the current generation of macro stress tests, arguing that they can lull policymakers into a false sense of security. Nonetheless, we argue that the “fuzziness” in measurement does not prevent further progress towards an operational framework, as long as it is appropriately accounted for. Crucial features of that framework include: strengthening the macroprudential orientation of financial regulation and supervision; addressing more systematically the procyclicality of the financial system; relying as far as possible on automatic stabilizers rather than discretion, thereby lessening the burden on the real-time measurement of financial stability risks; and setting up institutional arrangements that leverage the comparative expertise of the various authorities involved in safeguarding financial stability, not least financial supervisors and central banks.

The Globalisation of Inflation: The Growing Importance of Global Value Chains

Greater international economic interconnectedness over recent decades has been changing inflation dynamics. This paper presents evidence that the expansion of global value chains (GVCs), ie cross-border trade in intermediate goods and services, is an important channel through which global economic slack influences domestic inflation. In particular, we document the extent to which the growth in GVCs explains the established empirical correlation between global economic slack and national inflation rates, both across countries and over time. Accounting for the role of GVCs, we also find that the conventional trade-based measures of openness used in previous studies are poor proxies for this transmission channel. The results support the hypothesis that as GVCs expand, direct and indirect competition among economies increases, making domestic inflation more sensitive to the global output gap. This can affect the trade-offs that central banks face when managing inflation

The Anatomy of the Bond Market Turbulence of 1994

This paper examines the sharp rise in bond yield volatility across the major bond markets in 1994. The analysis covers thirteen industrialised countries and is largely based on OTC data for implied bond yield volatility. We conclude that the market’s own dynamics seem to provide a stronger explanation than variations in market participants’ apprehensions about economic fundamentals. We identify three market dynamics: downward markets increase volatility; volatility spills over from certain markets onto others; and it can rise in the wake of substantial withdrawals of foreign investments. We find more limited evidence that monetary or fiscal policies accounted for the rise in volatility, at least by our measures. Moreover, changing expectations about growth and inflation, while perhaps at work in particular countries, do not offer much of a general explanation

Monetary operations and the financial turmoil

Study comparing the central bank responses of Australia, Canada, the Eurozone, Japan, Switzerland, and the United States to the Global Financial Crisi

The Anatomy of the Bond Market Turbulence of 1994

According to Claudio E. V. Borio and Robert N. McCauley, "the bond market sell-off of 1994 has begun to show up on lists of market events against which risk management systems are judged." Examples of other such events are the 1987 stock market crash and the 1995 Kobe earthquake. However, there has been little analysis of the cause of the 1994 decline. Borio and McCauley fill the void by examining a number of factors that might explain the rise in volatility during that year. The authors investigate four types of one such factor, market dynamics: volatility persistence, relationships in the direction of market movements, foreign disinvestment, and volatility spillover effects from other markets. Borio and McCauley found that persistence had strong explanatory power. The implied bond volatility in two successive weeks accounted for 58 to 93 percent of the variance in volatility. They found "strong but not ubiquitous evidence" that a rise in bond yields led to higher volatility. In the United States and Canada they found no relationship between bond prices and volatility. In Japan, Sweden, and Spain, however, they found a symmetrical directional relationship, that is, increases or decreases in bond yields resulted in similar increases in volatility. In the remaining eight countries they studied, they found a partial directional relationship between volatility and bond prices, that is, volatility rose when bond yields rose, but did not respond when yields fell by a similar amount. The authors offer several possible explanations for the apparent directionality of volatility, including asymmetries in inflation risks and options trading strategies. Borio and McCauley found that international capital flows played a role in the rise in bond volatility in 1994, especially for European countries that experienced a sell-off of government bonds. The sell-off, the authors explain, reflects "the greater proclivity among foreign investors to leverage their holdings of bonds." The authors found that spillover effects were not a factor that could explain the general rise in bond market volatility. Borio and McCauley also investigate other factors that might contribute to bond market volatility. They find some evidence that uncertainties about monetary and fiscal policies were sources of volatility. Changing expectations and domestic economic factors (such as the inflation record or volatility in the money market), however, did not appear to explain volatility.