Double targeting for Central Banks with two instruments: Interest rates and aggregate bank equity

Hans Gersbach 01 February 2010



The current crisis has placed a fundamental question at the centre of policy discussion: “Should monetary policy and banking regulation be conducted separately?” Opinions differ – see Adrian and Shin (2009), Goodhart (2008), and De Larosière et al. (2009).

  • Brunnermeier et al. (2009) argue that central banks should be tasked with macroprudential regulation.
  • De Grauwe (2007) argues that central banks should be responsible for the supervision of all institutions involved in the business of creating credit and liquidity.
  • Linking both policy areas directly, however, might endanger the exceptional success of many central banks in creating low and stable inflation of the kind observable during the last two decades (Gerlach et al. (2009)).

There is thus a pressing need to clarify the objectives and instruments of central banks and banking supervisory authorities, and also to inquire how they should ideally interact. Here I present a new framework aimed at such a clarification.

A new policy framework

Under this framework, monetary policy and the regulation of banks aim at stabilizing both inflation and the real economy. Stabilisation of the real economy consists in stabilising output fluctuations caused by macroeconomic shocks and by financial instability. In the latter case, stabilisation of output fluctuations is achieved by avoiding or reducing financial instability itself.

The central bank would have two instruments at its disposal:

(a) the short-term interest rate and

(b) the aggregate equity ratio of the banking sector defined as the ratio of total end-borrower lending (credit for non-financial firms, households, and governments) plus other non-bank assets to total equity in the banking sector. The aggregate equity ratio is the measure of the capital cushion of the banking sector.

As a consequence, there are two policy rules for the central bank: an interest rate rule and an aggregate equity ratio rule. The former is a traditional interest rate rule (see for example Gali (2008, Chapter 3)) that may include an additional variable capturing the current state of money and credit, as discussed below. The latter relates the required equity ratio of the banking system in the next period to the current aggregate equity ratio and to the state of money and credit. While it is impossible to find a fixed aggregate equity ratio rule, it will be essential that such a rule is as systematic, transparent and accountable as traditional monetary policy regimes.

The state of money and credit indicates how strongly consolidated and unconsolidated balance sheets of banks or financial intermediaries expand or contract in comparison with average growth. It is often useful to concentrate on sub-aggregates such as total credit to non-banks or total short-term debt liabilities of banks to non-banks and among banks themselves. The latter measures include both traditional monetary aggregates such as household deposits and other liabilities such as commercial papers and repurchase agreements which provide signals about the price of risk and other financial-market conditions (see Adrian and Shin (2009) for an analysis of the usefulness of broader monetary aggregates like these).1

All remaining activities for the regulation and supervision of banks are executed by separate and less independent bank-regulatory authorities. These authorities act under the aggregate equity ratio constraint set by the central bank. They determine bank-specific capital requirements that may require upward and downward adjustments of capital requirements, depending on whether a particular bank holds a high-risk or low-risk asset portfolio. Effectively, bank-specific capital requirements are determined by the banking-on-the-average approach examined in Gersbach and Hahn (2009). Those separate authorities also regulate shadow-banking, operate the deposit insurance scheme and may intervene to restructure or close banks.2

An illustration of the new policy framework

The framework enables a central bank to conduct flexible inflation targeting and to moderate booms and busts as a system regulator. Both the setting of the interest rate and of the aggregate equity ratios have to be chosen in such a way that they are mutually consistent. Here are some examples illustrating this point.

In a low-inflationary downturn, when banks have to write down equity as asset prices decline or credit losses occur, both aggregate capital requirements and short-term interest rates can be lowered to moderate the bust. After such a negative shock, the central bank can (and must) increase the required aggregate equity ratio when the liabilities (or assets) of the banking sector start growing strongly again, in order to increase the aggregate buffer of the banking system.

In boom periods, central banks can "lean against the wind" by using a combination of short-term interest rate increases and raising the required aggregate bank-equity ratios. For instance, in a boom with low inflation and rapid growth of the banking sector’s balance sheet, raising the aggregate equity ratio might be the primary vehicle for moderating the boom, putting a lower weight on interest rate hikes. If the boom is accompanied by higher inflation, increasing short-term interest rates can be used together with higher aggregate bank-equity requirements to moderate inflation and to prevent the build-up of excessive leverage in the entire banking sector, thus lowering the risk of a future banking crisis.

As a consequence, many of the drawbacks of Basel II (see Hellwig (2008)) can be avoided. For instance, regulatory capital in a boom is at least partially a buffer against negative macroeconomic shocks. Moreover, raising the aggregate equity ratio in booms can put a damper on the build-up of high leverage for many banks. This would curtail the vulnerabilities of the banking system. In addition, banking regulation authorities can ensure the soundness of individual banks. For instance, bank-specific capital requirements can be made dependent on the relative riskiness of banks’ asset portfolios.

This policy framework provides an answer to how macroprudential and microprudential supervision can be organised in such a way that they are mutually consistent (e.g. Borio (2003)). Our suggestion to make capital charges countercyclical shares the spirit of Brunnermeier et al. (2009), who suggest using above-average growth of credit and leverage, and the mismatch in the maturity of assets and liabilities to adjust capital adequacy requirements over the cycle.

Of course, it will never be possible to distinguish precisely between a boom fuelled by high total factor productivity growth and one that cannot be justified on fundamental grounds. Moreover, constraining bank expansion during euphoric upswings can induce disintermediation to less controlled channels. These considerations reinforce the need for the consistency of interest-rate and aggregate-equity policies when they are used jointly, to lean – strongly or gently – against the wind.

Moreover, there are two alternative institutional arrangements for implementing the rules. Either bank regulation and supervision authorities take care of both macroprudential and microprudential activities, or they are executed in two different institutions and separated from the central bank. Such arrangements would shield central banks from pressure by interest groups when equity ratios have to be raised. But they would only be viable if aggregate equity rules allow little discretion on the part of the regulatory agencies.

This principle of targeting aggregate equity could also be applied to liquidity requirements if targeting aggregate bank equity does not make such requirements superfluous. Moreover, if the downturn is severe and is associated with banking instability, further unconventional measures may be necessary, such as emergency liquidity assistance, guarantees, recapitalisation of banks, or restructuring and liquidation of individual banks. The framework proposed here aims at minimising the likelihood of such events.

The formal framework

The formal resource for examining this new policy framework could be a combination of the leading models for flexible inflation targeting with its microfoundation (Woodford (2003)) and flexible bank equity targeting, as suggested by Gersbach (2009) and Gersbach and Hahn (2009), plus the balance sheet model for the banking sector outlined by Shin (2009).3


The current proposal aims at separating the responsibilities and instruments regarding capital requirements and bank supervision. The proposal places a substantial burden on the shoulders of central banks with regard to inflation and financial stability. Together with current events, the function of central banks as a lender of last resort indicates that this burden cannot be avoided. Accordingly, it makes good sense to equip the central bank with two instruments (short-term interest rates and aggregate equity ratios of the banking system) to help them bear this burden, while leaving detailed bank regulation and supervision activities to separate authorities.


1 Moreover, other components of systemic risk such as inter-connectivity and derived network risk can be included to describe the state of the economy.

2 It should be noted, however, that the central bank has to keep its monopoly as a lender of last resort. Hence, liquidity support to the banking sector beyond what would be possible through government bonds can only be provided by the central bank.

3 A first attempt is available upon request.


Adrian, Tobias and Hyun Song Shin (2009), "Money, Liquidity and Monetary Policy", forthcoming in American Economic Review Papers and Proceedings.

Borio, Claudio (2003), “Towards a Macroprudential Framework for Financial Supervision and Regulation?”, BIS Working Paper 128.

Brunnermeier, Markus, Andrew Crocket, Charles Goodhart, Avinash D. Persaud and Hyun Shin, The Fundamental Principles of Financial Regulation, Geneva Reports on the World Economy 11, ICMB and CEPR, Geneva and London, 2009.

De Grauwe, Paul (2007), “There is more to central banking than inflation targeting”,, 14 November.

De Larosière, Jacques, Leszek Balcerowicz, Otmar Issing, Rainer Masera, Callum McCarthy, Lars Nyberg, José Pérez and Onno Ruding (2009), Report by the High-Level Group on Financial Supervision in the EU, 25 February.

Gali Jordi (2008), Monetary Policy, Inflation. and the Business Cycle, Princeton University Press, Princeton, NJ.

Gerlach, Stefan, Alberto Giovannini, Cédric Tille and José Viñals (2009), Are the Golden Days of Banking Over? The Crisis and the Challenges, Geneva Reports on the World Economy, 10.

Gersbach, Hans (2009), “Banking on the Average: A New Way to Regulate Banks”,, 16 February.

Gersbach, Hans and Volker Hahn (2009),“Banking-on-the-average Rules”, CER-ETH Working Paper 09/107.

Goodhart, Charles A.E, (2008), “Central Banks' Function to Maintain Financial Stability: An Uncompleted Task”,, 24 June.

Hellwig, Martin (2008), “Systemic Risk in the Financial Sector: An Analysis of the Subprime Mortgage Financial Crisis”, Jelle Zijlstra Lecture at the Free University of Amsterdam.

Shin, Hyun Song (2009), "Securitisation and Financial Stability'', Economic Journal, 119, 309-332, 2009.

Svensson, Lars E. O. (1997), "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets", European Economic Review, 41:1111–1146.

Woodford, Michael (2003), Interest and Prices: Foundations of a Theory of Monetary Policy, Princeton University Press, Princeton, NJ.



Topics:  Monetary policy

Tags:  Central Banks, financial regulation, equity ratio

Professor at CER-ETH - Center of Economic Research at ETH Zurich and CEPR Research Fellow


CEPR Policy Research