Sources: Reuters EcoWin and the Riksbank  A simplified illustration of this can be provided by describing the banks’ lending rate as a function of the central bank’s policy rate plus an interest rate margin or spread:  itlending  it   t . The interest rate margin (  t ) is a function of the compensation taken by the banks for administrative costs and capital costs, risk premiums, the banks’ profit margins, and loan-tovalue and amortisation requirements. Loan-to-value and amortisation requirements are not directly visible in the interest rate applied to the customer, but, in order to illustrate their effects on an aggregated level, these can be recalculated in terms of interest relatively simply. When risk propensity fell during the financial crisis, the interest rate margin increased as a consequence of both higher risk premiums and lower loan-to-value ratios. This counteracted the cut in the policy rate. When central banks and governments subsequently adopted various measures to increase confidence on the markets, risk premiums fell in a similar way. The lending rate thus fell without a change in the policy rate being required. Now, it is not only during a crisis that there exists reason to consider the financial sector’s significance for the transmission mechanism. As I have just discussed, one of the consequences of a crisis is that the regulations of banks and other institutions will become more stringent. The intention of this is to reduce the socioeconomic costs that can result from banking.
It should be pointed out that the reason that a central bank may wish to lean against the wind does not have to be because it only wishes to safeguard financial stability. That may be the case, but it may also be a purely monetary policy decision. The bank may simply wish to attempt to avoid severe fluctuations in the real economy and inflation, even if these are not deemed to be associated with financial stability problems. Leaning against the wind is not a problem-free strategy. Three primary counterarguments have been put forth. 7 Firstly, the imbalance must be identified at a sufficiently early stage. Attempting to rectify the imbalance too late may be problematic as monetary policy acts with a time lag. If property prices fall steeply immediately following an increase of the policy rate by the central bank, the delayed effects of the interest rate increase will reinforce the negative effects on the economy of the falling property prices. Of course, one must also be sufficiently certain that an imbalance really is building up. If the upturn is being caused by fundamental factors, a higher interest rate would hinder growth unnecessarily. Secondly, one has to rely upon being able to deal with the property price increase through reasonable increases of the policy rate. One hypothesis is that the optimistic mood often prevailing during a boom in the property market means that significant increases of the policy rate are required to have an effect.