This obstacle has to be removed. Let’s return to our bank and assume that nothing helps and that the situation goes from bad to worse. At some point, the bank will have to be declared “failing or likely to fail”, to use a bit of jargon. This is mostly done by the supervisors, and it is the most intrusive thing we can do. Declaring a bank “failing or likely to fail” has far-reaching consequences. It is a difficult decision which requires a delicate balancing act. As long as there is a reasonable chance of the bank recovering, a “failing or likely to fail” decision would put an undue financial burden on the shareholders. But if the decision is put off for too long, the costs of an imminent failure start to mount up. This would hurt creditors and depositors. In extreme cases, it might even become a threat to financial stability. So, the “failing or likely to fail” decision must neither be taken too early, nor too late. And in any case, it must be taken with great care. There are four general cases which call for a “failing or likely to fail” decision. Some of these cases are quite clear-cut and can be objectively assessed. Others are a bit less clear-cut – particularly when they refer to things that are likely to or might happen in the near future. Thus, there is some room for discretion when determining whether a bank is failing or likely to fail.
Most of the time, the best projection of asset prices at that horizon is for them to be broadly flat. Consequently, I suspect that our policy choices would not have been radically different had we been tasked with targeting an inflation measure that included a measure of owneroccupied housing costs. Finally, there is something of a logical error in moving from the indubitably correct observation that successful inflation targeting is insufficient to guarantee either macroeconomic stability or financial stability to the conclusion that monetary policy should in addition, or instead, be focussed on some other objective. There is a real danger in overburdening monetary policy if it is expected to achieve both price stability and financial stability simultaneously. With two objectives, one needs two independent means of achieving them. The assignment of instruments to targets then revolves around which instrument is most effective at achieving which objective. Though loose monetary policy, particularly in the United States during 2001–5, arguably contributed to the build-up of the financial imbalances, it was but one of many causes, including a plethora of failings within financial institutions. These include: inadequate care in the extension of loans to risky individuals, when those loans are then sold on; the inappropriate use of off-balance-sheet vehicles to circumvent capital requirements; reward packages that encouraged an undue focus on short-term returns; excessive complexity and opacity in some asset-backed securities; and distorted incentives facing ratings agencies.