Inflation targeting and bank equity rules: Parallels and lessons

In the course of the last two decades, many central banks have adopted inflation targeting, i.e. they have specified numerical targets for inflation and committed themselves to reaching those targets in the medium term. Inflation targeting is considered best-practice monetary policymaking (for discussions of this monetary-policy strategy see Bernanke et al. 1999, Cecchetti 2006, Gersbach and Hahn 2006, Leiderman and Svensson 1995, Woodford 2008).

Regulatory authorities supervise private banks. One of their aims is to ensure that banks fulfil equity capital requirements. While at first sight inflation targeting and capital requirements seem to have little in common, we argue that there are some surprising parallels between them. These parallels may enable us to draw lessons for bank regulation from inflation targeting and vice versa.

• Numerical target values. The most obvious parallel is that, for both inflation targeting and bank equity capital requirements, there are numerical values that have to be met, i.e. an inflation target and a minimum capital requirement. However, while inflation targets are usually specified symmetrically, bank capital requirements specify only a minimum level of capital.
• High social costs of downward deviations. While upward deviations are only a concern in monetary policy, sharp downward deviations involve substantial welfare losses in both areas. Deflation is generally thought to impose substantial costs on society. Similarly, very low or even negative capital ratios represent a banking crisis, which involves high costs in terms of lost output, higher unemployment, and the fiscal burden imposed by bank bailouts and fiscal stimuli. The high costs of downward deviations are one reason why central banks target a strictly positive rate of inflation. It is doubtful whether current minimum capital requirements adequately address the social costs of banking crises.
• The right index. In both areas there is uncertainty about which index to use. In monetary policy, it is not entirely clear which basket is the right one. Is core inflation excluding volatile prices for energy and food an appropriate measure? Should the index perhaps even incorporate the prices of financial assets? With respect to banking regulation, it is uncertain how clear a distinction should be made (if at all) between loans and marketable assets. Moreover, the question of whether – and, if so, which – risk weights should be used to compute capital ratios is another contentious issue. In both areas, the indices are dogged by measurement problems. Separating quality improvements from pure price changes in price indices is a thorny issue, and determining the risk weights used for computing capital ratios is at least as challenging a problem.
• Flexible vs. strict rules. Early opponents of inflation targeting contended that a strict form of inflation targeting might lead to excessive output fluctuations. Advocates of this monetary policy strategy have responded by commending flexible inflation targeting, which implies that the target be reached gradually over a given period. Similarly, critics of bank minimum capital requirements have voiced the concern that strict requirements mean that one of the main purposes of regulatory bank capital, namely that of acting as a buffer against adverse shocks, is obviated by the fact that banks have to fulfil the requirement at all times (see Hellwig 2008). We will take up this point later.
• Commitment problems. It is commonly accepted that optimal monetary policy is not time-consistent. However, commitment problems may also arise in banking regulation. From an ex ante perspective, the strict enforcement of capital adequacy rules may be desirable to prevent banks from taking excessive risks. In a downturn, strict enforcement of these rules may not be optimal ex post. The following measures, amongst others, have been taken to deal with commitment problems related to central banking:
  • Rules. By committing to a particular rule such as inflation targeting, monetary targeting, or one of the several variants of fixed exchange-rate regimes, several central banks have successfully overcome the time-inconsistency problem.
  • Independence. Nowadays, most central banks are independent, as this shields them from political interference. If central bankers think in longer time horizons or are more conservative, this alleviates the time-inconsistency problem.

  Whether current banking regulation pays adequate attention to commitment problems is a question we take up in the next section.

• Looking ahead. According to Svensson (1997), inflation targeting implies inflation forecast targeting. The central bank uses its inflation forecast as an intermediate target. Similarly, risk weights used to compute capital requirements are also essentially forward-looking because they are based on estimates of future defaults.
• Reliance on sophisticated models. In both areas, there has been a trend towards a central role for complex models. With regard to inflation-targeting central banks, this need arose because the inflation forecast used as an intermediate target has to be computed. In bank regulation, complex risk models are used by large banks to compute the equity capital required.
• Transparency. Inflation targeting is generally accompanied by an increase in central-bank transparency, largely because inflation forecasts and the steps taken to arrive at them are made public. Generally, transparency is thought to enhance monetary policy efficiency (see Gersbach and Hahn 2009b for a critical assessment of the effectiveness of forward guidance). Accordingly, one of the cornerstones of Basel II is fostering transparency. The idea is that more transparency will induce tighter market discipline, which in turn is expected to bolster financial stability.
• International coordination. In monetary policy, it is occasionally advantageous to coordinate policy, for example to steer exchange rates in the direction desired. In Europe, many countries have opted for a very high degree of coordination, resulting in the Economic and Monetary Union. The need for international coordination is particularly strong in the field of bank regulation. A race to the bottom with regard to capital requirements can only be prevented by international agreements.

There are four lessons to be learned from these parallels.

• Flexible bank-equity targeting. It is generally recognised that strict inflation targets would lead to excessive output variation, so inflation targeting has to be flexible. Current equity capital requirements are very strict – the same capital ratio has to be fulfilled in both boom periods and dramatic economic downturns. The resulting cutback in lending also leads to undesirable output disruptions. Accordingly, it would seem plausible to introduce more flexible rules reducing the required level of capital in a downturn. Flexible rules of this kind have been proposed by Gersbach (2009) and formally analysed by Gersbach and Hahn (2009a).
• Cautious use of sophisticated models. One of the reasons for the current crisis is the excessive predilection for risk models that despite their sophistication fail to capture realistic economic patterns like movements in real estate prices, which lead to strong positive correlations in subprime mortgage defaults. This may also be a warning to inflation-targeting central banks, where complex DSGE models play a crucial role in inflation forecasting and, by extension, monetary policy. Excessive infatuation with colourful diagrams displaying probability distributions may make policymakers lose sight of the deficiencies of the underlying models, which may, for example, be unable to provide adequate, in-depth descriptions of asset markets (see Sims 2008) or financial institutions with separate balance sheets.
• Insufficient levels of regulatory capital. We have noted that, among other things, high social losses caused by downward deviations have induced central banks to target positive levels of inflation. Because social losses are highly asymmetric with regard to bank regulation, it seems reasonable to ask whether the levels of equity thought to be sufficient prior to the current crisis really are adequate. In the light of recent evidence, requiring higher levels of bank equity would seem to make sense.
• Making regulatory capture difficult. Another approach to making banking regulation more flexible would be to endow the regulatory authorities with more discretionary leeway. However, due to commitment problems, this solution would only be advisable if regulatory authorities were independent of politicians. Even then the danger of regulatory capture is severe. Flexible bank-equity targeting with a low degree of discretion on the part of the regulatory agency appears to be the better solution.

Bernanke, Ben S., Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen (1999). Inflation Targeting. Princeton University Press.

Blum, Jürg and Martin Hellwig (1995). The macroeconomic implications of capital adequacy requirements for banks, European Economic Review, 39:739-749,.

Cecchetti. Stephen (2006). “What is inflation targeting?” VoxEU.org, 1 July.

Gersbach, Hans (2009). “Banking on the average: A new way to regulate banks”. VoxEU.org, 16 February.

Gersbach, Hans and Volker Hahn (2006). Signalling and commitment: Monetary versus inflation targeting, Macroeconomic Dynamics, 10:595-624.

Gersbach, Hans and Volker Hahn (2009a). Banking-on-the-average rules. CER-ETH working paper 09/107.

Gersbach, Hans and Volker Hahn (2009b). Forward guidance for monetary policy: Is it Desirable?, in Designing Central Banks, David Mayes, Geoffrey E. Wood (eds.), Routledge.

Hellwig, Martin (2008). Systemic risk in the financial sector: An analysis of the subprime mortgage financial crisis, Preprints of the Max Planck Institute for Research on Collective Goods, Bonn, 2008/43.

Leiderman, Leonardo and Lars E. O. Svensson (1995). Inflation Targets. CEPR, London, 1995.

Sims, Christopher A. (2009). Inflation expectations, uncertainty and monetary policy, BIS Working Paper 275,

Svensson, Lars E. O. (1997). Inflation forecast targeting: Implementing and monitoring inflation targets. European Economic Review, 41:1111–1146, 1997.

Woodford, Michael (2008). The Fed’s enhanced communication strategy: Stealth inflation targeting? VoxEU.org, 8 January.