The Asymmetric Relationship of Central Banks to Market-Based Finance: Weighing Financial Stability Implications in the Light of Covid Events

Central banks today operate as the backstop of a fragile and volatile market-based financial system, as evidenced by the recent financial instability in the context of the Covid-crisis. This article investigates the genesis of this position, tracing it to an asymmetric program by central banks to prevent financial instability. Quick and resolute in moments of crises, this program is slow and hesitant, if not ineffective in moments of financial booms. This state of affairs is linked to the lacking control of central banks over the pro-cyclical behavior of non-bank financial institutions in the shadow banking sector, outcome of a fragmented system of governance which central banks share with market authorities. The Covid crisis and the subsequent large scale quantitative easing programs, undertaken to ensure the stability of this system of credit-intermediation, clarify the need for a fundamental re-regulation of this sector. If central banks are to continue to backstop this sector, as it looks likely to be the case, they need to request a substantial expansion of regulatory oversight and control. Absent such reforms, the de facto backstop will install moral hazard, inviting increased risk-taking in the sector.