Challenges to Central Banking in the Context of Financial Crisis

By Syed Zahid Ahmad,

After global financial crisis the central banks around the world are facing unprecedented challenges to provide stability in financial sector along with needs to offset the side effects of bailouts and stimuli packages. Latest challenges are different from earlier ones because by now the liberalized capital account has more shares in money stocks whereas central bank’s regulatory access to international market has not increased to that level. So, it is high time that besides identifying the root causes and remedial measures for the financial crisis, we should find best possible practices for future and also develop enhanced coordination and cooperation at international level.

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It is prudent that global financial crisis occurred due to unmanageable extravagant practice of shifting the financial risks through instruments like Credit Default Swaps (CDS) derivatives instead of sharing the risks by the investors. Attempts by financial sector champions to evaluate financial risks involved with monetary instruments like credit and mortgaged assets and thereafter trading those risky instruments caused the collapse of highly developed credit market. They failed to read the total risks generated in the market by their own trades of risky instruments. Central banks were mere spectators in the market.

Ideally ‘Money’ is meant to measure value of goods and services so as to facilitate economic transactions. Value of money or risk of monetary instruments cannot be measured by any monetary instrument itself. With development of monetary systems, various financial products have been invented, but allowing trade of financial products like mortgaged asset and credit risks etc. started building risky tower which was bound to collapse after a certain period of time.

There were alarms before financial crisis but was not noticed. Before financial crisis, the growth rate of financial institutions was higher than other industries and trades. That was an alarm for central banks. Unfortunately the theory of debt finance taught us that higher credit GDP ratio is sign for developed financial market and thus the central banks failed to read the financial risks associated with higher credit GDP ratio.

The central banks are supposed to be in line with the local governments to stabilize financial sector and stimulate the economy. For central banks of developed countries like US and UK etc. the major challenge is to restore stability in the financial sector with bail out packages, while the major challenge for central banks like Reserve Bank of India is to manage the impact of stimuli besides offsetting impact of voluminous capital account transactions. It is not easy to be banker of a government who need more finance to bail out financial institutions or to stimulate the economy because the debt burdens may go beyond capacity of the banker. While financing government debts adds pressure upon banks, the shortage of credits for private sector increases inflationary pressure on the economy.

After failure of CDS instruments, the central banks should think to promote a system where financial risks could be shared among stakeholders instead of selling the risks to others because risks beyond capacity cannot be borne. If Lehman Brothers fails to tackle the financial risks, the central banks should draw a lesson that risks cannot be shifted but has to be borne by anyone. If risks are not being born by investors, at last the losses have to be born by the tax payers. So, it is better that financial risks may born by investors.

Another important lapse by central banks is that they did not monitor appreciation of real estate prices with increased flow of credits to real estate compared to other sectors. If real estate prices increases in accordance with growth in financial sector, keeping other sectors below, the situation alarms for crisis.

There should not be short cut method to offset the financial crisis. The central banking may be protected from challenges if we properly answer the following questions:

1. While giants like Lehman Brothers failed to deal with financial crisis, how safe to rely upon credit rating agencies and to allow trade of instruments like CDS derivatives?

2. Have central banks drawn any lesson from the sub prime crisis to fix a maximum limit for credit flow to real estate so that in future appreciation of real estate prices may not be dangerous for the economy?

3. Is there any desired rate of interest to keep economy free from inflation?

4. What bank credits to GDP ratio would be ideal for sustainable economic growth?

5. How to reduce debt burden of central government when they would be in more need of financial resources to bail out financial institutions and to stimulate the economy?

6. Have central bank thought about fixing limit of interest over deposits to GDP ratio?

7. After financial crisis what should be ideal mechanism to determine the currency exchange rates for different countries?

8. Should US dollar be continued as standard international currency when debt finances are alarming at US economy?

9. How to maintain stability in stock market prices with boom in capital inflow for emerging countries like India?

10. How to ensure adequate and affordable credits for private sector when government needs more resources to finance welfare schemes or to stimulate the economy?

11. What should be priority based industries / trades to attain maximum possible inclusive growth with available resources in developing country like India?

12. What total consumption to GDP ratio is desirable for sustainable economic growth?

13. What Reserve Bank of India has done to ensure financial inclusion of such Muslims who face religious hindrances due to interest based banking mechanism?

14. What proportion of GDP should be considered as ideal for Gross Capital Formation?

15. It has been observed that in recent past growth of Islamic Finance has been fairly good as compared to interest based finances. Should Islamic financial instruments be considered as better alternatives to CDS for economic growth?

16. It has been observed that broad money in proportion to GDP has increasing multifold during last 50 to 60 years. Does it not pose any threat on monetary regulation for central banks to keep inflation under control?

17. Do Islamic banking poses any threat to conventional approach of central banking when it is observed that interest based instruments are creating inflation and debt burdens?

18. Does RBI find scope of sovereign Islamic bonds to raise financial resources for infrastructure development in India?

19. Though RBI succeeded to protect banks during financial crisis, but has so far failed in controlling the inflation. Is RBI not finding any monetary reasons for higher inflation?

20. What RBI is doing when we are observing excess of bank credits for investment than planned target and banks are facing short of credits for private sector?