As long as the banking system was – or at least appeared to be – sound, as central bankers we did not need to worry too much about what happened elsewhere in the financial system or the condition of the corporate sector or the structure of household balance sheets. But this is no longer true, if it ever was. I have already mentioned the role of the corporate sector in the Asian financial crises of a decade ago. The fact that it was the corporate sector rather than the banking sector that had assumed foreign exchange risk ultimately didn’t matter from the point of financial system stability. The effects were the same – or possibly were greater as the corporate sector was less well able to handle the risks than the banking sector might have been. From a macro prudential policy perspective this means that we must pay attention to conditions in the corporate sector and the soundness of corporate balance sheets. And given that so many banks in Asia have followed those in the rest of the world in looking to develop their consumer credit business, the condition of household finances is also important to understand from a financial system stability perspective. In addition, the experience of the last decade has also taught us that non-bank financial intermediaries matter for the soundness of financial systems. For example, there is plenty of evidence that insurance companies have been major sellers of credit derivatives. This passes credit risk from the banking system to the insurance sector.
11  Mervyn King, the former governor of the Bank of England, has used a closely-related means of illustrating why monetary policy should give consideration to financial imbalances, where he instead uses the so-called Taylor curve – a curve that illustrates a central bank’s trade-off between stabilising inflation around an inflation target and stabilising the real economy (GDP, unemployment, employment and so on) around a long-run sustainable level. See King (2012). 12  This reasoning is thus based on the notion that risks linked to financial imbalances can be taken into consideration in monetary policy by incorporating their effects in the longer-run forecasts for inflation and the real economy (for instance, measured in terms of GDP). There are also arguments in favour of the central bank having the stabilisation of financial imbalances as an explicit objective for monetary policy. The financial frictions that give rise to the imbalances could, for instance, entail welfare costs for society, over and above the effects on inflation and GDP, which the central bank may have reason to counteract directly, see for instance, Cúrdia and Woodford (2009). Monetary policy would then have three factors to weigh against one another: stabilisation of inflation around the target, stabilisation of GDP around a sustainable level and stabilisation of some relevant measure of financial imbalances. Regardless of the theoretical argument, this way of including financial imbalances in the deliberations could have practical benefits, for instance by reducing the need to incorporate the risks in the forecasts for inflation and GDP.