This is partly because financial stability is a necessary condition for an effective monetary policy, but also because financial instability risks leading to major fluctuations in both the real economy and inflation. We should also take financial stability into account because part of the Riksbank’s assignment is to promote a safe and efficient payment system. Furthermore, in order to adapt monetary policy to the risk of future crises in the wake of financial imbalances we do not need to know that a crisis will actually occur, or exactly when, but we do need to know through what mechanisms or under what circumstances the probability of a crisis increases. Nor is it a case of a crisis being the most likely outcome but rather that the risk that something major can happen should make us focus our attention in that direction.6 If we learned anything from the financial crisis it was that there is every reason to take even less likely outcomes into account. The financial crisis has also reminded us that cleaning up after a crisis can entail huge costs and take a long time. Five years after the financial crisis began, for example, unemployment is still high in many of the countries that were hit hardest.7 With regard to household indebtedness it is obviously the case that monetary policy cannot do much about a high level of debt that in turn is due to high housing prices if these have structural causes, such as insufficient new construction, tax regulations, building regulations and so on.
With the banking sector in the euro area being an essential source of financing of the real economy, the integration of these markets plays an important role in the pass-through of monetary policy decisions to the lending rates of the banking sector. The financial crisis has challenged the stability and integration of European financial markets in an unprecedented way. It has thrown into reverse the steady integration seen since the inception of the euro. The causes for this were manifold. First, heterogeneous economic developments caused by financial and structural imbalances across euro area Member States led to outflows of funds from the countries that were perceived as more risky – in view of their large cumulated imbalances stemming from ample competitiveness gaps, high current account deficits and high private sector leverage – and led to inflows into countries with a safe-haven status. Second, imbalances in the banking sector arose from undue risk-taking, investment in opaque financial products and excessive leverage. This has caused some financial institutions to be cut off from wholesale funding markets and interbank funding. The seclusion of some financial institutions was also the result of the measures introduced by some Member States to ring-fence the domestic banking industry from foreign contagion. While this was an understandable response from regulators that had a domestic perspective in their institutional mandates, the consequence was a further fragmentation of financial markets. Third, in some countries, fiscal fragilities interacted with banking fragilities.