I am very pleased to welcome you to the Seventh Seminar on Central Banking, organized by the IMF Institute (INS) and the Monetary and Exchange Affairs (MAE) Department. These biennial seminars have become a tradition, and we in the International Monetary Fund (Fund) benefit greatly from this opportunity to bring together senior central bankers and policymakers to exchange ideas and develop collective thinking on current issues.
The factors behind Mexico’s banking crisis should be identified in order to reach a clear diagnosis and, therefore, a clear prescription for handling problems of this sort or, better still, preventing future ones. With the benefit of hindsight, the origins of the crisis can be traced to a combination of factors that, although difficult to disentangle, contributed to the fragility of the banking sector.
Let me begin by discussing why, and in what senses, banks have been regarded as special. The term “bank,” historically and more than ever today, covers a multitude of sins. In practice it refers to a range of very different institutions that may, and do, within legal restraints, engage in a variety of different financial—and even some nonfinancial—activities whether on their own account or in an agency or advisory capacity. But banks have some key distinguishing characteristics in common. In particular they take unsecured deposits from the public at large.1
Earlier presentations have covered the questions of what makes banks special; banks’ central role in all financial systems; the forces of change in banking, such as innovation and liberalization; the features of such change, such as increases in the volume and complexity of transactions, the development of markets, globalization, and the blurring of institutional boundaries; and how market integration and globalization are taking place both functionally and geographically. These issues will not be repeated here; instead the objective will be to cover key issues for maintaining a sound banking system over time.
Recent financial and exchange rate crises have highlighted the potential for derivative products to have macroeconomic consequences and to obscure the meaning of capital account categories in balance of payments data. Although the existence of large off-balance sheet derivative positions will not necessarily trigger a financial crisis, derivatives can affect the magnitude and dynamics of a crisis. Sales of a weak currency by domestic institutions to meet margin calls against offshore derivative positions, the dynamic hedging of derivative positions, expanded opportunities for hedging and speculation, and the general unification of markets that derivatives permit certainly exacerbated both the turbulence in Europe’s exchange rate mechanism and Mexico’s peso crisis. Moreover, the increased opaqueness of the national balance sheet—even to authorities—brought about by cross-border derivative usage causes crises to evolve in unexpected directions, sometimes defying classical remedies.
Financial system reform in Poland started in the late 1980s with the devolution of its single administrative structure, typical for command economies, into one national savings institution and nine, regional, universal commercial banks. This new, two-tier banking system also comprises an independent central bank—the National Bank of Poland (NBP)—and about 90 universal banks, not to mention more than 1,500 small, local, cooperative banks. The NBP as a licensing and supervisory body sets requirements on the banks, including minimum capital requirements, staffing and projected operations, suitable premises, and acceptable articles of agreement.
Few would argue against the pivotal role of the banking industry in developing countries. The pioneering work of McKinnon and Shaw in the early 1970s clearly pointed this out by showing that financial deepening is needed to improve and sustain economic growth in developing countries.1 They observed that poor economic resilience against external shocks is due to shallow financial markets, or financial repression characterized by excessive regulation and control of interest rates and exchange rates. In this case, adjustment policies affecting the financial sector, particularly the banking sector, can bring about a more efficient allocation of funds, and the increased demand for investment can then be satisfied internally by the higher savings generated.
Banking soundness and the role of the market is a subject of particular relevance to New Zealand, given its adoption of a banking supervision approach that places considerable emphasis on the role of the market in promoting a sound financial system. Initially formalized in 1987, New Zealand’s approach to banking supervision was relatively orthodox between 1987 and the end of 1995. It involved minimum capital requirements (based on the Basle Accord); limits on the amount that banks could lend to individual customers and related parties; a limit on banks’ open foreign exchange positions; off-site monitoring of banks, using information provided privately to the central bank, the Reserve Bank of New Zealand; annual consultations with the senior management of banks; and a range of powers to enable the Reserve Bank to respond to bank distress or failure.
Liberalization and deregulation have freed competitive forces and opened financial markets the world over. Supported by sweeping technological progress these forces have generated an unprecedented growth of opportunities, brought forth a flow of financial innovation, increased the diversity of market participants, and boosted cross-border activities. But there is no denying that these positive developments also carry new risks of instability. They stem from the very dynamics and complexity of today’s financial markets, from the increased volatility of prices and interest rates resulting from the explosive growth of trading in innovative products, and from the tight linkages among markets that allow disturbances to spread quickly through the financial system. The heavy losses of some banks and the various market disturbances seen in recent years have highlighted some of the dangers facing today’s liberalized financial world.
It is quite naturally assumed nowadays that responsibility for monetary policy devolves upon the central bank. The question of who should be responsible for banking supervision, however, is much more controversial despite the historical backdrop concerning institutional responsibility. As Paul Volcker, former chairman of the Federal Reserve System, pointed out on the occasion of the one hundredth anniversary of the Banca d’ltalia, some central banks, like those of the United States and Italy, were “founded much more out of concern about banking stability than out of ideas about monetary policy as we know it today.”1