The world of presumed stable monetary and financial conditions was severely shaken by the recent global financial crisis. And with that, the separation in some quarters of financial supervision and monetary policy that reigned supreme over the past decades might also be coming to the end.

Before the crisis, the policy paradigm used to look like this: central banks around the world would focus on inflation-targeting and on setting interest rates, while financial regulation would be left to specialized, ad hoc agencies. Central banks’ primary role would be enough to maintain price stability and economic growth. On their side, financial regulators, through so-called “microprudential” rules, would ensure the soundness of financial institutions and protect depositors.

We all know what happened to this picture. The crisis tested the limits of both financial regulation and monetary policy acting individually. The existing regulations were insufficient to contain the spillover effects of the collapse of financial institutions to the rest of the economy. Now, in the wake of the Great Recession, there’s an increasing recognition of the need for macroprudential regulation to ensure the stability of the financial system as a whole and to mitigate risks to the real economy.

In fact, prudential regulation and monetary policy are complementary. Neither one can replace the other on its own. The combined use of both tends to be more effective than a standalone implementation of either.

read more