Financial DominanceTwelfth Paolo Baffi Lecture

The Twelfth Baffi Lecture addresses the issue of financial dominance, i.e. the tendency of the financial system, in the absence of  appropriate regulation, to accumulate an insufficient quantity of capital and to make public intervention necessary to absorb its financial losses (including by recapitalizing financial intermediaries). This tendency stems from the crucial role that the financial system plays in allocating financial resources to productive enterprises – a role that central banks try to protect. When a shock hits the economy, the financial system can amplify the negative effects: banks are forced to reduce their lending to businesses to counter the deterioration of their own balance sheets. This reduction, however, causes a further deterioration of the economy, which can trigger a negative spiral. Under these conditions, the central banks need to intervene by reducing interest rates (with conventional and unconventional measures) to improve economic conditions and help to ‘fix’ banks' balance sheets.

The financial system, which is aware of the need for monetary policy action in the event of negative shocks, can therefore show a tendency to hold little capital on their balance sheets in order to minimize their losses and maximize the involvement of the central bank. This trend must be countered ex ante with appropriate macroprudential policies that set appropriate capital requirements for banks and that help reduce the riskiness of their portfolios.