Introduction

Anxieties about central banks' interventions in financial markets often arise during periods of crisis. Extraordinary measures may trigger controversies when existing policy solutions are difficult to translate across institutional landscapes. The European Central Bank's (ECB's) decision to initiate the Securities Market Programme in May 2010, as governments in the Eurozone's peripheries faced increasing borrowing costs, offers an interesting example. The strongest opposition, mostly although not exclusively voiced by German policymakers (including the German representatives on the ECB Governing Council), warned that purchases of government bonds are ill-advised on legal, political, and economic grounds, contravening the Maastricht Treaty prohibition of public debt monetization, reducing the urgency for fiscal adjustments and distorting financial markets (Belke 2010; Weidmann 2012). According to this account, interventions in sovereign bond markets cement the view that the ECB is the only institution that can effectively contain a crisis, turning the central bank into a “whipping boy” for political elites hesitant to engage with the structural problems underpinning the euro crisis. In turn, the ECB attributed its interventions to legitimate concerns with stabilizing disrupted markets segments crucial to the transmission of monetary policy signals rather than as attempts to ease governments' financing conditions. It simultaneously reaffirmed commitment to its constitutional mandate, price stability, and a rapid unwinding of extraordinary crisis measures that would allow the return to the pre-crisis policy framework (ECB 2010a; Trichet 2009). Two years later, the ECB went further, and announced that it would do whatever it takes through the Outright Monetary Transactions program, a commitment to buy government bonds in order to stabilize the European financial system.

Theoretical accounts of central banks' presence in financial markets distinguish between normal and crisis periods. During “normal” times, interventions occur in one market, the interbank market, where banks trade liquidity to enforce model-guided policy decisions (Allen et al. 2008). Under the efficient market hypothesis, steering the interbank rate allows central banks to influence broader financing conditions in the economy. In contrast, the theoretical foundations of crisis interventions are less straightforward. Central banks may resort to non-standard interventions once policy interest rates have been lowered to zero (Bernanke and Reinhart 2004).

Background and Key Themes

Since the collapse of Lehman Brothers, central banks and regulatory authorities in general have been confronted with difficult questions. The global financial crisis made apparent that the analytical models of the Great Moderation period failed to capture the changing nature of financial intermediation and the complex business models of transnational banks operating across different jurisdictions. In turn, despite few theoretical certainties with which to draw upon, central banks have played key roles in responding to the crisis and in trying to devise more adequate modes of regulation and intervention. First, in the immediate aftermath of the crisis, it was the central bank governors of Basel Committee member countries that amended the existing Basel II rules and methodologies for capital adequacy. Second, it was the Financial Stability Board, with much the same country membership as the Basel Committee and with central bank governors gathered around the negotiating table, which identified principles and guidelines for the resolution of distressed banks. And last but not least, it was the central banks that replaced conventional tools with new instruments and practices that extend their mandate and blur the traditional separation from private financial markets. For the past five years, central banks have intervened in both public and private debt markets, taking on functions of market makers or dealers of last resort. In this book, we propose to explore these developments and set them in the context of the European crisis.

The most comprehensive national regulatory response to the crisis came from the USA, where the Dodd–Frank Act specifically aimed at regulating the business models of banks by removing the risky proprietary trading from the investment banking activities in bank conglomerates and moving over-the-counter derivatives trading to the exchanges. The Vickers Report in the UK, too, aimed at separating investment banking from the retail banking activities of universal banks, but in a less clear way, by proposing the ring fencing of retail from investment banking. Such ring fencing would involve different capital-adequacy rules for retail and investment banking activities within the same bank holding company.

This book has its origin in a conference held in the Axelborg Hall in Copenhagen last year. Axelborg Hall, built in 1920, was the second largest secular building in Copenhagen at the time, surpassed only by Parliament. The Danish Cooperative Bank, for which Axelborg was originally built, went bankrupt in 1925, only five years later. But the building itself survived and now boasts a colorful history of nearly one hundred years of different owners and tenants, with banking by far the dominant theme. It seemed the perfect venue for a conference on central banking at a crossroads.

However, as esteemed speakers and eager participants arrived to the venue on the morning of 29 January last year, Axelborg Hall lay shrouded in darkness, as did indeed the entire building and a few blocks around it. Helped only by the dim light of a few candles, Professor Charles Goodhart delivered his opening talk masterfully to an audience of several hundred, most of whom could perhaps hear but not see much. Halfway through Goodhart's talk, the lights came back on. And from there, it was smooth sailing.

A generous reading of post-crisis central banking would say that an exceptionally difficult situation was handled just as masterfully. Out of a dark and dangerous event, came a stronger mode of central banking, reinvented and with new resilience. Others will say that in the world of central banking, darkness is still the order of the day, as we chase systemic risk and try to tame phenomena of which we still have only insufficient understanding.

The contributions in this book fall between these two poles, perhaps with a slight bias towards a worried take on the trajectory of central banking in recent years. While a certain measure of concern may be shared by all contributors, the approaches taken and conclusions reached by different authors vary considerably. This was a defining feature of the talks given at the conference too, in which many (but not all) of the chapters originate.