There is a growing call for central banks to consider financial vulnerabilities when formulating monetary policy. As financial conditions ease, such as through interest rate cuts, the risk of financial instability increases, necessitating its inclusion in policy decisions.
Tobias Adrian, Director of the International Monetary Fund's (IMF) Monetary and Capital Markets Department, stated during the '2026 BOK International Conference' held at the Bank of Korea in Jung-gu, Seoul, that "traditional monetary policy has focused solely on stabilizing prices and output gaps, while financial stability has been regarded as the domain of macroprudential policy."
Adrian noted that the expansion of leverage in the financial system and changes in risk appetite among financial intermediaries can amplify asset prices and economic fluctuations, adding that macroprudential policies alone cannot fully mitigate these amplification effects.
The global financial crisis was triggered by weaknesses in the U.S. housing market, which spread throughout the financial system via structured financial products and high leverage among financial institutions. During that time, financial institutions excessively invested in structured financial products based on mortgage loans, significantly increasing leverage and accumulating risks across the financial system.
In a low-interest-rate environment with eased financial conditions, investments in risky assets increased, and leverage built up, yet monetary policy at the time failed to adequately reflect these accumulated financial vulnerabilities. Ultimately, as housing prices fell, the value of derivatives plummeted, leading to the collapse of major investment banks like Lehman Brothers, which triggered a credit crunch worldwide.
Adrian pointed out that when financial conditions ease, leverage among financial intermediaries increases, which may improve the economy in the short term but also raises the risk of a severe economic downturn in the future. He explained that "central bank interest rate adjustments affect the funding costs and risk levels of financial institutions, which in turn influence the scale of lending and investment, impacting the real economy, including consumption and production."
He also emphasized the concept of 'Growth-at-Risk,' stating that while the upside risk to GDP growth remains relatively unchanged during periods of eased financial conditions, the downside risk significantly increases. He explained that vulnerabilities accumulate during good times, ultimately leading to low growth and high volatility.
Regarding the nature of optimal monetary policy, he stated, "While soundness policies can mitigate tail risks, they do not eliminate the procyclicality of financial institution leverage. Incorporating financial vulnerabilities into monetary policy is necessary not only for financial stability but also to achieve inflation targets."
During the conference, a question arose about whether applying optimal monetary policy guidelines could be perceived as the central bank bursting market bubbles, especially as the KOSPI index recently surpassed 8,500. Adrian responded, "While the market may interpret it as a signal to deflate bubbles, that is not the essence of the policy. The key is to reduce the risks of long-term economic downturns and increased volatility due to accumulated financial vulnerabilities."
* This article has been translated by AI.
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