I am among the ones who think that the interest rate is often too blunt a tool to deal with financial stability issues, especially when they have clear sources that can be addressed more directly, since the policy rate affects every sector of the economy. Furthermore, under some circumstances the required movement in the policy rate for financial stability purposes may be in conflict with the price stability mandate. Assuming that such tradeoff is absent, that reasonable movements in the policy rate are expected to be useful to deal with financial stability concerns, and that there are no better tools at hand, it may be reasonable to rely on it as a tool for financial stability. However, in many situations at least one of these conditions would not hold and other options would prove more efficient. For instance, more often than not financial stability concerns are related to specific segments of financial intermediation. Concerns about rapid growth in credit to the housing sector can be tamed by changes in loan-to-value or debt-toincome ratios, for example. Dynamic provisions related to general or specific forms of credit may also help banks maintain a solid position through the financial cycle, and discretional changes to reserve requirements may also help rein in rapid bank credit expansion. Of course, all these measures are not cost free and their use must properly consider these costs against specific financial stability concerns.
The financial soundness of a central bank, the usual lender of last resort in a country, is an important firewall for trouble in the financial system. While a central bank may count with the help of the sovereign, this channel may be a source of concern when sovereign themselves are facing problems, and it also raises some worries about the ability of the central bank to maintain its independence. There are also those who argue that, since the liabilities of central banks can be arbitrarily created, the financial position of a central bank shouldn’t matter. But this argument forgets that doing so may endanger the achievement of the inflation targets that many central banks have taken as their operational goals, affecting their reputation and independence. 2  4  Céspedes et al. 2012. BIS central bankers’ speeches  In 1982, as the debt crisis spread through Latin America, the Chilean financial system, which had channeled substantial foreign-currency-denominated syndicated loans, became largely insolvent. Under these conditions, the government engineered a massive rescue operation through the central bank where several of the most important banks became nationalized and others disappeared, after their assets were absorbed by other institutions. This intervention prevented an even larger collapse of activity than the one we ended up experiencing. The manner in which it was implemented, where shareholder equity was fully diluted and institutions assumed a subordinated debt to the central bank that took a long time to repay, helped maintain the rescue’s moral hazard concerns at bay.