Financial Stability and Central Banks

A Global Perspective

Richard Brearley, Juliette Healey, Peter J N Sinclair, Charles Goodhart, David T. Llewellyn, Chang Shu

• Publisher: Routledge
• Year: 2001
• eBook ISBN: 9781134516353
• Topic: Business
• Subtopic: Business General
• Index: Business

An overview of present day thought on the very topical subject of financial stability and central banking. The papers, written by leading researchers, provide a highly informed account of contemporary policy issues and explore the legal, regulatory, managerial and economic issues that affect central banks.

1 Financial stability and central banks

An introduction

Peter Sinclair¹

1.1 Background

The collapse of a country’s payment and banking system is a terrible disaster. It would spell closure for many of its firms, ruin for many of its inhabitants. It is a prime responsibility for central banks to try to prevent and contain the financial crises that could precipitate such a calamity.

But financial stability is not the central bank’s sole concern—safeguarding the nation’s currency is at least as important a task. Nor is the central bank the only body with financial stability responsibilities. Finance ministries share this role, as do regulators and supervisors of financial firms, when housed outside the central bank.

Recent events remind us how crucial it is that the banking and payments system should be protected from risks and crises. The difficulties that beset Indonesia, South Korea and Thailand in 1997 are a vivid example. So too were the acute problems that confronted Russia in 1998, and the chronic financial malaise that underlay Japan’s macroeconomic underperformance throughout the 1990s. Even more dramatic was the banking and economic collapse in the United States and much of Europe in the 1930s.

Without trying to understand such phenomena, whenever and wherever they occur, we can have little hope of preventing their repetition. Sharing knowledge of different central banks’ experiences, and debating their implications in the never-ending search for improved monetary and financial policy, is undertaken in a variety of fora. One such is the Central Bank Governors’ Symposium, held annually in London since 1994. The Bank of England’s Centre for Central Banking Studies presents a set of papers to this annual Symposium.

The subject for the Central Bank Governors’ Symposium in June 2000 was ‘Financial Stability’. A written report was provided, Financial Stability and Central Banks. This contained six papers, each devoted to a different aspect of the subject. The present volume is a revised and expanded version of that report. Together with the report’s six chapters, it contains a chapter by Charles Goodhart (Chapter 3), a concluding note by Alastair Clark (Chapter 8), and a record of the discussion at the Symposium on 2 June. Section 2 of the present chapter presents a summary of the volume, and Section 3 poses twelve key questions about financial stability to which its contributors offer answers. Section 4 takes a brief look at the incidence of bank failure. Some aspects of the trade-off between safety and competition are examined in Section 5. Sections 6 and 7 identify certain links between financial stability policy and monetary policy, and some aspects of the character of the work of those charged with responsibility for financial stability policy. Section 8 concludes.

1.2 Summary of the volume

After his precis of the key points of other chapters in this volume, Peter Sinclair, in this chapter, presents a list of twelve questions about financial stability that he posed to the contributors before we began our work. He goes on to sketch what history tells us about the mortality probabilities of financial institutions. He emphasises the tendency of bank deaths to cluster, to vary over space and time, and to respond (somewhat weakly) to the character of the regulatory regime.

Despite undoubted advantages, liberalisation and intensified competition among banks have a worrying tendency to raise the frequency of failures. Reasons for this are discussed. Various linkages between monetary policy and financial stability policy are identified, linkages that point strongly to preserving the latter as a core function for the central bank, even if and where supervision and regulation are undertaken elsewhere.

Numerous and often conflicting pressures confront those charged with safeguarding the financial system, be they within or outside the central bank. They also face the misfortune of attracting blame when troubles arise, while appearing redundant in quieter periods. Their value in containing or preventing costly crises is not easy to quantify.

The extent and character of central banks’ involvement in safeguarding financial stability varies greatly from one country to another. It has also been subject to some radical recent changes. Establishing an up-to-date picture across a wide range of central banks is therefore particularly valuable. This is done in Chapter 2.

After a brief historical review of the evolution of central banks, which have multiplied from ten in 1870 to nearly 180 today, Juliette Healey examines the current spectrum of financial stability activities of thirty-seven central banks across a range of economies, drawing on responses to a CCBS questionnaire. All but one of the thirty-seven deem the promotion of financial stability, and the stability of settlement and payments systems, as core elements in their mandates. While the wide variety of institutional arrangements suggests there is no single ‘optimal’ model, the responses may shed light on how an effective framework can be developed.

One topical issue is whether the efficiency of regulation and supervision of individual institutions may be influenced by the particular institutional structure in which they are conducted. Juliette Healey explores the issues that have prompted change in this area, the different ways in which authorities from industrial, transition and developing countries have responded, and what further changes might be expected and why. She also explores the principal arguments on whether a central bank should carry out regulation and supervision in addition to its monetary policy role. Evidence from the survey is included.

There is also a brief look at the correlation between the degree to which a central bank enjoys independence in its monetary policy, and the extent of its responsibility for prudential regulation and supervision. Taking a wider sample than the survey, of eighty-three (about half the world’s central banks), she finds a statistically significant negative association between independence and supervision: the greater a central bank’s autonomy in monetary policy, the less likely it is to conduct supervision and regulation. The chapter ends with some observations about establishing an effective regulatory institutional structure, and notes that not all current movement is towards integrated supervision outside the central bank: some central banks have expanded, or seem set to expand, their regulatory role. The institutional structure is a topic for lively debate; but there are few grounds for thinking that one structure is unambiguously better than another for all countries in all circumstances.

With the present facts summarised in Chapter 2, Chapter 3, by Charles Goodhart, carries forward the discussion about whether, in fact, it makes any difference where bank supervision occurs, and what its organizational structure is. The central bank would have to work closely with bank supervisors and regulators wherever they were located. The disappearance of boundaries between different kinds of financial institution, and the growth of multi-function financial firms, renders the old system of separate supervision for each obsolete. The growth of multi-country banks complicates supervision and implies that it is increasingly Finance Ministries, not the private sector, that fund any rescues of troubled firms.

Possible conflicts of interest, the need to amalgamate supervision, and concerns about excessive concentrations of power, might argue for taking supervision outside central banks, although the first of these three was not compelling by itself. The central bank’s Lender of Last Resort function argued in favour of keeping supervision inside the central bank, though perhaps less so when the Ministry of Finance also becomes involved in the resolution of banking crisis. Information flows point to the same conclusion. Supervisory data can assist monetary policy, for example. The central bank can choose what data to look at, and not just rely on information, however full and timely, passed on by another institution. Notwithstanding these points, the combination of blurred boundaries in financial markets (making separate supervisors for separate types of institution anachronistic) and the political disquiet about concentrating excessive power within the (increasingly independent) central bank point in favour of external supervision in many developed countries.

As far as developing and emerging countries are concerned, Charles Goodhart concludes, keeping (or integrating) banking supervision within the central banks has particular appeal: supervision would be better funded, better conducted, more dependable, and less open to outside pressures.

What matters is not regulation per se, David Llewellyn argues in Chapter 4, but the regulatory regime. This has seven key elements. Three relate primarily to regulated financial firms: how they govern themselves, how the market disciplines them, and the structure of incentives for staff and others within them. Then there are four elements for the regulators—the rules they set, how they monitor and supervise, their intervention, and their own accountability.

It is wrong to focus on just one element, such as monitoring and supervision. Tradeoffs and interactions between all seven elements need to be recognised. The optimum mix of the seven elements is liable to change over time and differ across firms. One promising concept is ‘contract regulation’. The regulator sets objectives and principles; the firm chooses how best to satisfy them, entering a contract with the regulator with penalties for infringements.

There is no single course of bank distress or crises. Strict, precise rules have numerous drawbacks. Regulation should reinforce discipline by the market, not replace or distort it. Market discipline is insufficient by itself (externalities, state-owned banks with soft budget constraints, restrictions on takeovers). A rules-based approach to intervention has merit, with a bias against (but no bar on) forbearance. Shareholder monitoring is an important adjunct to regulator supervision. Oversight by directors and senior management is crucial.

There are two extreme views, both of them unsatisfactory. One says that banks should be told in detail what to do, watched continuously, and punished for any transgression. The other claims that supervision should be left to shareholder audit and internal monitoring, with the threat of takeover to punish inefficiency. It is far better, Llewellyn argues, to have complementary, flexible external regulation, possibly of the ‘contractual’ type. Llewellyn sees merit in the recommendations of the 1999 Basel Committee on Banking Supervision, which:

1. a emphasise internal risk analysis and control, and market discipline;
2. b suggest a role for market-based risk ratings; and
3. c strengthen the capital adequacy framework for supervision with extended, revised and improved systems of risk weighting.

Economic growth depends on an efficient financial system, Richard Brealey argues in Chapter 5. Particularly in developing countries, banks play a central role by providing liquidity services to savers and allocating capital to productive uses. Yet their ability to fulfil these functions has been hampered by widespread bank failure, which typically results from a decline in economic activity and sharp falls in asset prices and foreign exchange reserves.

Although banks are not the sole providers of capital, and therefore are not alone in suffering periodic losses, falls in asset prices are generally thought to have more serious consequences if they occur in the banking system rather than elsewhere in the economy. There are three reasons for this view. The first arises from banks’ role in the payments system. The second arises because banking crises may restrict credit and accentuate the fall in economic activity. The third comes from the fragility of bank deposits and the costs of monitoring bank solvency. These externalities provide the justification for bank regulation.

There are many ways to protect a bank against failure, but bank equity constitutes a general-purpose buffer against failure from any source. Thus capital requirements have played a central and increasing role in regulation. However, they are effective only if prompt corrective action is taken when capital is becoming exhausted. Capital requirements can trigger a credit crunch when constraints bind, but most G-10 banks, at least, now hold more than the statutory minimum. Riskier banks require more capital.

The international standard for bank capital was set by the Basel Accord. Because the values of bank assets do not evolve smoothly and cannot be observed continuously, banks with risky assets should hold more capital. An important contribution of the Accord was that, in computing capital ratios, the Accord made formal allowance for risk.

The Basel system of credit risk weightings suffers from two weaknesses. First, it focuses on the risk of individual loans and ignores the diversification of the loan portfolio. Second, it applies a broad bush treatment to the classification of loans. The proposed revisions to the Accord will tackle the second weakness, but the diversification problem may prove less tractable. This raises two issues. The first is the need to value bank assets at their true value, and the second is the appropriate level of bank capital. Decisions on the latter question depend on a better understanding of the cost of capital. Bank equity is commonly thought to be very costly, but the source of these costs is unclear.

Confidence in a bank can crumble quickly, and its failure can generate large external costs. This is why Glenn Hoggarth and Farouk Soussa argue, in Chapter 6, that central banks cannot ignore the threat to financial stability posed by a troubled bank.

The financial safety net of regulation, supervision and deposit insurance will prevent some crises and contain others. But the risk of failure cannot be wholly removed, not least because deposit insurance discourages depositor monitoring and the safest types of bank lending.

Honest brokering by the central bank can facilitate and co-ordinate a private sector rescue or takeover of a financial institution in distress. Private sector solutions may require central bank involvement, particularly when competition between financial institutions intensifies.

The central bank is lender of last resort, meeting regular liquidity needs for the market, and occasionally, and temporarily, providing discretionary emergency lending in response to exceptional strains. Inter-bank markets should satisfy normal liquidity demands of an individual bank, backed up by central bank lending on very rare occasions if and when these markets malfunction. While too high a price for official lending may induce gambling for resurrection, risking taxpayers’ funds is potentially very costly. Official emergency lending should be limited in size, highly infrequent, on tight terms, collateralised, and not mechanical. An element of ambiguity reduces moral hazard problems, especially when supported by other types of punishment for deficient management.

Current trends to larger, conglomerate and global banks complicate crisis prevention and management practices. This is recognised, in part, in the current Basel proposals that place an increased emphasis on the need for market discipline and supervision of banks’ management systems and controls, rather than formulaic capital standards. The importance of timely information sharing and cooperation between central banks and (bank and non-bank) supervisors within and across countries is also recognised. These may, however, need to be enhanced in the future.

International capital movements may damage output, and employment or wages, in the source country, and profit incomes and competitiveness in their destination. Despite these drawbacks, Peter Sinclair and Chang Shu argue, in Chapter 7, that they should in principle increase national income in both countries. International capital migration also provides valuable opportunities for smoothing consumption, diversifying risk and intertemporal trade; and despite the problems they pose for central banks, they accommodate imbalances in the current account of the balance of payments. The presumption of positive net effects on social welfare constitutes a general case against capital controls.

Temporary controls may be helpful in crises, however. From many standpoints inflow controls are preferable to outflow controls, and both tend to outrank the blunt instrument of prohibition. Currency crises may stem from fundamentals (such as inconsistencies between exchange rate and macroeconomic policies), but information disparities and asymmetries, together with mimicry by imperfectly informed investors, play important roles. While this may justify intervention, capital controls have not prevented crises, and their anticipation may provoke them.

A survey of the evidence and literature on capital controls reveals several general insights. First, they tend to be most effective under sound macroeconomic policies. Further, their impact diminishes rapidly, as agents learn how to bypass them. Next, their ability to insulate the domestic economy from financial developments abroad is qualified, and comes at the price of costly distortions. Finally, they are no alternative to wise prudential regulation and prompt corrective action.

The final contribution to this volume, by Alastair Clark, concludes by selecting a group of important policy questions for special scrutiny.

1.3 Twelve questions about financial stability

All contributors to the volume were shown a list of questions about financial stability, which the author of this chapter drew up before we embarked upon our work. Twelve questions came to the fore as our research progressed. Here they are:

1. Can or should central banks have responsibility for financial stability, if regulation of financial firms has passed to another authority? Or is it best to split prudential regulation from business-conduct or consumerprotection regulation, with the former remaining with central banks?
2. Can we learn anything (yet) from the experience of countries where central bank responsibilities (no longer) include bank regulation? Is there (so far) any discernible difference in stability between those countries and others?
3. How could we attempt to measure the (marginal) benefits and costs of central bank actions to promote financial stability? How could we tell if a central bank was doing too much or too little in this regard? What in principle determines the optimum level and character of financial protection by a central bank?
4. Why can’t the financial system ‘look after itself—or are there parts of it that can or could?
5. Is ‘financial protection’ a strict public good, that the market would underprovide, if left to itself, or not provide at all?
6. Does public financial protection make private sector actors significantly more careless, and if so does this matter? Is there a satisfactory and workable practical distinction between systemic and asystemic risk?
7. What are the precise differences, boundaries, and overlaps between monetary policy and operations on the one side, and policy or operations to promote financial stability on the other?
8. In financial markets, is there a trade off between safety and competition? If there is, what determines the ideal point of balance between the two?
9. Does evidence suggest that financial instability is mainly a cause or mainly a consequence of business cycle fluctuations, to the extent that the two are correlated at all?
10. How should a central bank decide when to pull the plug on a troubled financial institution, as opposed to aw...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Charts
• Tables
• Contributors
• Foreword
• Acknowledgements
• 1 Financial stability and central banks
• 2 Financial stability and the central bank
• 3 The organisational structure of banking supervision
• 4 Alternative approaches to regulation and corporate governance in financial firms
• 5 Bank capital requirements and the control of bank failure
• 6 Crisis management, lender of last resort and the changing nature of the banking industry
• 7 International capital movements and the international dimension to financial crises
• 8 Some concluding comments
• Appendix 1 Minutes of the Bank of England’s 7th Central Bank Governors’ Symposium 2 June 2000
• Appendix 2 Central Bank Governors’ Symposium participants
• References