Chapter 4 Understanding Financial Stability: Towards a Practical Framework
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Mr. Garry J. Schinasi
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SEM; central bank; certificate; fund; securities account; payment system; market stability; securities intermediary; TA activity; Securities; Hedge funds; Deposit insurance; Financial sector stability; Anti-money laundering and combating the financing of terrorism (AML/CFT); Global; Europe; North America; Sub-Saharan Africa; Central Asia; Western Europe; economic system; asset market turbulence; market volatility; market discipline; market-disciplining mechanism; Financial stability assessment; Systemic risk; Financial sector risk
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Abstract

Safeguarding financial stability is now widely recognized as an important part of maintaining macroeconomic and monetary stability and a key to the achievement of sustainable growth. Central banks in many advanced countries, as well as the International Monetary Fund, devote considerable resources to monitoring and assessing financial stability and to publishing financial stability reports. A casual reading of these publications would suggest that financial stability practitioners share some common understandings. To cite a few, it is more or less taken for granted that:

Safeguarding financial stability is now widely recognized as an important part of maintaining macroeconomic and monetary stability and a key to the achievement of sustainable growth. Central banks in many advanced countries, as well as the International Monetary Fund, devote considerable resources to monitoring and assessing financial stability and to publishing financial stability reports. A casual reading of these publications would suggest that financial stability practitioners share some common understandings. To cite a few, it is more or less taken for granted that:

  • finance is fundamentally different from other economic functions such as exchange, production, and resource allocation;

  • finance contributes to other economic functions and facilitates economic development, growth, efficiency, and ultimately social prosperity;

  • financial stability is an important social objective—a public good—even if it is not widely seen as being on a par with monetary stability;1

  • monetary and financial stability are closely related, if not inextricably intertwined, even though there is no consensus on why this is so.

There is also a growing academic literature on financial stability, much of it covering specific topics in considerable depth, and some of it providing rigorous anchors for debating substantive and policy issues. For example, there are extensive literatures on the special role and fragility of banks in finance, the costs and benefits of deposit insurance, and the causes, consequences, and remedies for bank failures. There are also new and growing literatures on market sources of financial fragility and systemic risk more generally (for example, see Allen, 2006).2

Despite considerable practical and intellectual progress in recent years, the discipline of financial stability analysis is still in a formative stage, compared to macroeconomic and monetary analysis. The various literatures taken together do not yet provide cohesive and practical approaches or tool kits for assessing financial stability, for analyzing systemic issues and controversies, and for designing policies to optimize the net social benefits of finance. In short, the discipline lacks a widely accepted and useful framework.

Nevertheless, the practice of assessing and safeguarding financial stability is ongoing. This chapter specifically addresses three questions.

  • Why have concerns about financial stability increased in recent decades?

  • What are the important conceptual challenges faced by policy makers in safeguarding financial stability?

  • What are the essential ingredients of a practical framework for safeguarding financial stability in real time, and the challenges in implementing such a framework?

Why Have Financial Stability Issues Recently Become Important?

Since the early 1990s, safeguarding financial stability has become an increasingly dominant objective in economic policymaking, as illustrated by the financial stability reports published by more than 50 central banks and several international financial institutions (including the IMF), as well as by the more prominent place given to financial stability in the organizational structures and mandates of many of these institutions.3

Recent Trends in Financial Systems

During the past several decades, significant structural changes in financial systems have been associated with the expansion, liberalization, and subsequent globalization of financial systems, all of which have increased the possibility of larger adverse consequences of financial instability on economic performance. The four major trends:

  • Expansion of financial systems relative to the real economy

  • Changes in the composition of financial systems

  • Increased integration of financial systems

  • Greater complexity of financial systems

Expansion of Financial Systems

Financial systems have expanded at a significantly higher pace than the real economy. In advanced economies, total financial assets now represent a multiple of annual economic production. Table 1 illustrates this expansion from 1970 to 2000 for a heterogeneous group of advanced economies with relatively mature financial systems. For example, while currency remained relatively steady as a percentage of GDP over the 30-year period, total assets in financial institutions grew from 110 percent of GDP in 1980 to 377 percent in 2000 in the United Kingdom, from 182 percent in 1980 to 353 percent in 2000 in Germany, and from 111 percent in 1980 to 257 percent in 2000 in the United States.

Table 1.

Development of Key Financial Aggregates (In percent of GDP)

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Note: Currency is coins and bank notes in circulation; M1, M2, M3, and M4 are national definitions. Total assets of financial institutions consist of total bank assets and (depending on data availability) assets of insurers, pension funds, and mutual funds. Equity is total stock market capitalization; bonds are total debt securities outstanding (government and corporate). Sources: Thomson Financial, International Monetary Fund, Bank for International Settlements, Merrill Lynch, Salomon Smith Barney, and various national sources.

The growth of assets in the equity and bond markets is just as phenomenal. While differences between countries reflect their more market or bank-oriented financial systems, most aggregates have increased. The broad measures of an economy’s total financial assets invariably involve some double counting due to claims between financial institutions, but even these mutual holdings are relevant for financial stability because they represent the links, interactions, and complexities in the financial system.

Changes in the Composition of Financial Systems

The process of financial expansion has been accompanied by changes in the composition of the financial system, with a declining share of monetary assets (aggregates), an increasing share of nonmonetary assets, and, by implication, greater leverage of the monetary base. The amount of currency relative to GDP has been broadly stable or decreased in all countries except Japan. In the United States, even the sizes of both M1 and M2 have fallen as financial innovation has progressed. For outlier Japan, the increasing importance of narrow money in the 1990s may be attributable to greater incentives to hold money due to the Japanese financial sector’s fragile state and enduring deflationary pressure.

The simple average expansion of the financial systems shown in Table 1 is illustrated in Figure 1, in which total assets of financial institutions are reflected by the triangle’s surface. Figure 1 shows rather dramatically that between 1970 and 2000 the size of these assets almost tripled relative to GDP. Note also how the average of the financial systems has become more highly leveraged, in the sense that the broader monetary and financial assets represent a much greater share of the triangle in 2000 than in 1970 relative to central bank money (or currency).

Figure 1.
Figure 1.

Composition of Key Financial Aggregates in 1970 and 2000

(In percent of GDP, average of the United States, Germany, the United Kingdom, Japan, France, Italy, Canada, and the Netherlands)

Source: Table 1.

Figure 2 shows the change in composition of the financial system over the past decades by expressing key financial aggregates as a percentage of their value in 1970 (all deflated by GDP). Clearly, the relative importance of monetary aggregates has decreased, while non-monetary components have increased rapidly.

Figure 2.
Figure 2.

Development of Key Financial Aggregates, 1970–2000

(Average for the United States, Japan, Germany, the United Kingdom, France, Italy, Canada, and the Netherlands, 1970=100)

Source: Table 1.

Increased Integration of Financial Systems

As a result of increasing cross-industry and cross-border integration, financial systems are more integrated, both nationally and internationally. Financial institutions now encompass a broader range of activities than that of a traditional bank, which takes deposits and extends loans. This is reflected in the rise in financial conglomerates, which provide a vast array of banking, underwriting, brokering, asset-management, and insurance products and/or services.4 In the 1990s, the number of mergers and acquisitions within the financial sector soared (Figure 3).

Figure 3.
Figure 3.

Financial Sector Mergers and Acquisitions, 1990-1999

(Number of M&As in G10 countries)

Source: Group of Ten, Consolidation of the Financial Sector (Basel, 2001).

Some of these transactions involved different industries or countries, especially in Europe, where roughly half of the deals in this period were either cross-border, cross-industry, or both (Table 2). In addition, cooperation between financial institutions intensified through joint ventures and strategic alliances.5 The greater international orientation of financial systems is also reflected in the increasing size of cross-border transactions in bonds and equity relative to GDP (see Table 3). On this score, the amount of outstanding international debt securities surged over the past decades (Table 4).

Table 2.

Financial Sector Mergers and Acquisitions, 1991–1999 Distribution (percentages)

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Source: Group of Ten, supra Figure 3.
Table 3.

Cross-Border Transactions in Bonds and Equities (In percent of GDP)

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Sources: Bank for International Settlements and national balance of payments data. Note: Gross purchases and sales of securities between residents and nonresidents.

No breakdown in bonds and equities is available.

Table 4.

Outstanding International Debt Securities by Nationality of Issuer (percent of GDP)

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Sources: Bank for International Settlements, IMF, World Economic Outlook database.

Figure in 1970 column is from 1971.

Figure in 1970 column is from 1972.

Greater Complexity of Financial Systems

Financial systems have become more complex in terms of the intricacy of financial instruments, the diversity of activities, and the concomitant mobility of risks. Deregulation and liberalization created scope for financial innovation and enhanced the mobility of risks. In general, this greater complexity, especially the increase in risk transfers, has made it more difficult for market participants, supervisors, and policymakers alike to track the development of risks within the system and over time.

To further illustrate the globalization of finance, and the greater mobility of risks across global markets, Table 5 and Table 6 present the worldwide development and use of derivative instruments since the mid-1980s, for exchange-traded derivatives, and since the 1990s, for over-the-counter derivatives. Regarding exchange-traded derivatives, in nominal terms the total notional amounts outstanding have increased more than 60 times since the mid-1980s, while the number of derivative contracts traded has increased more than sevenfold. Regarding over-the-counter derivatives, the notional value of contracts increased from US$80 trillion at end-December 1998 to nearly US$285 trillion at end-December 2005—tripling of the notional value of contracts in 8 years. The gross market value (or replacement cost) of these contracts, which is a proxy for the credit-risk or counterparty exposures associated with the notional values, increased from around US$3 trillion at end-December 1998 to around US$9 trillion at end-December 2005, also a tripling. Note that the majority of derivative transactions were interest-rate contracts.

Table 5.

Exchange-Traded Derivative Financial Instruments: Notional Principal Amounts Outstanding and Annual Turnover

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Source: Bank for International Settlements
Table 6.

Global Over-the-Counter Derivatives Markets: Notional Amounts and Gross Market Values of Outstanding Contracts by Counterparty, Remaining Maturity, and Currency 1 (In billions of U.S. dollars)

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Source: Bank for International Settlements.

All figures are adjusted for double-counting. Notional amounts outstanding have been adjusted by halving positions vis-à-vis other reporting dealers. Gross market values have been calculated as the sum of the total gross positive market value of contracts and the absolute value of the gross negative market value of contracts with non-reporting counterparties.

Residual maturity.

Counting both currency sides of each foreign exchange transaction means that the currency breakdown sums to twice the aggregate.

Single-currency contracts only.

Adjustments for double-counting are estimated.

Risks and Vulnerabilities

The four trends discussed above reflect important advances in finance that have contributed substantially to economic efficiency, both nationally and internationally. They also have implications for the nature of financial risks and vulnerabilities and the potential impact of these risks and vulnerabilities on real economies, as well as implications for the role of policymakers in promoting financial stability. Consider financial system and market developments in the 1990s and early 2000s, a period during which global inflation pressures subsided and in many countries were eliminated. During this period, reflecting in part the above-mentioned trends, national financial systems around the world either experienced, or were exposed to, repeated episodes of unpleasant financial-market dynamics, including asset-price volatility and misalignments; volatile if not unsustainable financial and capital flows; extreme market turbulence, at times leading to concerns about potential systemic consequences; and a succession of costly country crises in 1994–95, 1997, 1998, 1999, and the early 2000s (Table 7). The experiences of, and fallout from, these financial stresses and strains occurred within both advanced countries with highly sophisticated financial markets and developing countries with financial systems of varying degrees of immaturity and dysfunction. As these developments were occurring, economic and financial policymakers became increasingly concerned that global financial stability was becoming more difficult to safeguard.

Table 7.

Market Turbulence and Crises in the 1990s and Early 2000s

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Source: G. Schinasi, Safeguarding Financial Stability: Theory and Practice (Washington, D.C.: International Monetary Fund, 2006).

These episodes were a rude awakening for some policy makers about the stability implications of these otherwise beneficial structural changes. It is not too dramatic to say that they were a wake-up call to many about the darker side of modern finance. Several lessons can be taken from these episodes, and three such episodes are representative of what can be learned: bond market turbulence in 1994; the Asian crises in 1997–98; and the Russian and Long-Term Capital Management (LTCM) hedge fund crises in the autumn of 1998.

The bond market turbulence of 1994 is an example of how a long-anticipated monetary policy change, which was delayed in part for financial system concerns, led to turbulence—not just in U.S. financial markets and in the deepest most liquid market for U.S. treasury securities but also in European and Asian markets. When the U.S. Federal Reserve System increased policy interest rates by 25 basis points on February 6, 1994, the long end of the U.S. treasury yield curve increased by more than 175 basis points, and Europe followed suit as well. This created significant turbulence in global financial markets for several weeks, and even posed, in the view of some, the risk of systemic financial consequences. The lesson is that monetary policy changes in one country can threaten financial stability in another, and in the extreme can cause a risk of systemic global financial consequences.

The Asian crises are an example of how exchange rate policies can lead to massive economic and financial disruptions in economies that had been seen as growth machines for close to a decade. At the time, these were seen as one crisis, but in actuality they were quite separate. What connected them was that once Thailand went into crisis, international investors understood that finance and financial stability is an economic fundamental factor that must be considered in international investment portfolio decisions. They hypothesized that if Thailand had a weak financial system and could grow fast, maybe other Asian economies had the same problem. When they paid attention to this, they decided that both Indonesia and South Korea had some of the same underlying weaknesses.

The combination of the Russian default and the collapse of the hedge fund LTCM demonstrated how a default by a country like Russia on a relatively small amount of debt ultimately became part of a scenario—one of credit-spread tightening and then liquidity runs—that not only led to the collapse of a relatively large hedge fund (although a small financial institution) but also threatened the systemic stability of some of the deepest, most liquid, and most efficient securities markets in the world, notably in the U.S. securities markets.

The bottom line is that there have been periods of structural changes that have created a new and ever-changing financial landscape that is not fully understood. The 1990s and early 2000s demonstrated clearly some of the characteristics of this new financial landscape and suggests that a more systematic approach to safeguarding financial stability is required.

The turbulence experienced during the 1990s and early 2000s raised, and continues to challenge us with, questions about the structure and nature of the existing regulatory and supervisory regimes around the world for addressing some of the problems that surfaced. Table 8 classifies the main public-policy issues and concerns raised by the turbulence during these decades. There are three broad areas where policy issues arise to varying degrees from cross-border banks, foreign exchange, and other global markets, and hedge funds: protecting investors and markets, dealing with safety-net issues and moral hazard, and assessing and mitigating cross-border and systemic risk. All three issues are important for banks generally, for cross-border banks in particular, and for global markets. Investor protection and safety-net issues are seen widely as not being relevant for hedge funds, while many, though not all, believe that hedge funds can pose systemic risk. The potential systemic risk associated with the collapse of the hedge fund LTCM is a case in point.

Table 8.

Public Policy Issues and Concerns

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Source: G. Schinasi, “Causes and Conditions for Cross-Border Threats to Financial Stability,” remarks at the Federal Reserve Bank of Chicago conference, “Cross-Border Banking and National Regulation,” October 5-6, 2006 (in George G. Kaufman et al., eds., Cross-Border Banking and National Regulation (London: World Scientific Publishing Company, 2007)).

In view of the classification in Table 8, how are these risks and public-policy concerns addressed through financial policies? That is, to what extent are the tools of financial policies used to address these concerns? Table 9 is one (perhaps exaggerated) way of answering this question.

Table 9.

Oversight Regimes

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Source: Schinasi, supra Table 8.

As indicated in the column labeled “Cross-Border Institutions” in Table 9, large cross-border banking groups, including the large internationally active banks, are probably the most closely regulated and supervised organizations on the planet, and for good reasons:

  • These institutions pose financial risks for depositors, investors, markets, and even unrelated financial stakeholders because of their size, scope, complexity, and risk taking.

  • Some of them are intermediaries, investors, brokers, dealers, insurers, reinsurers, infrastructure owners and participants, all rolled up into a single complex institution.

  • The institutions are systemically important: all of them within their national systems, many of them regionally, and about twenty of them globally.

  • Protection, safety-net, and systemic risks issues are key pubic policy challenges.

  • Oversight occurs at the national level, through both market discipline and official involvement, and at the international level through committees and groups.

At the other extreme of regulation and supervision are hedge funds, as can be seen in the right-hand column of Table 9.

  • They are neither regulated nor supervised. Many of the financial instruments hedge funds use are not subject to securities regulation, and the markets in which they operate are, by and large, the least regulated and supervised. This is part of their investment strategy, and it defines the scope of their profit making.

  • Hedge funds are forbidden in some national jurisdictions. In jurisdictions where they are partially regulated, this is tantamount to being forbidden—given the global nature and fungibility of the hedge-fund business model.

  • Their market activities are subject to market surveillance just like other institutions, but this does not make transparent who is doing what, how they are doing it, and with whom they are doing it.

  • Investor protection is not an issue for most individual hedge funds, for they restrict their investor base to wealthy individuals and institutions willing to invest with relatively high minimum amounts.

  • Investor protection is becoming an issue with the advent of funds-of-hedge-funds that allow minimum investments of relatively small amounts less than US$100,000 or even less than US$50,000.

  • Probably beginning with the Asian crisis and then LTCM, and intensifying with the their tremendous growth over the past several years, hedge funds are increasingly being seen as potentially giving rise to concerns about systemic risk, a topic that is discussed later in the chapter.

Global markets fall in between being regulated and not being regulated or supervised. Examples of global markets are the FX markets and their associated derivatives markets (both exchange-traded and over-the-counter) and the G-3 fixed-income markets, as well as others associated with international financial centers (pound, Swiss franc, etc) as well as their associated derivatives markets. Dollar, euro, and yen government bonds are traded in a continuous global market, and the associated derivatives activities are also global.

Global markets are only indirectly regulated. They are subject to surveillance through private international networks and business-cooperation agreements, through information sharing by central banks and supervisory and regulatory authorities, and through official channels, committees, and working groups. Parts of these markets are linked to national clearance, settlement, and payments infrastructures, so they are also subject to surveillance through these channels. The risks they potentially pose are less of a concern to the extent that the major players in them—the large internationally active banks—are effectively supervised and market-disciplined by financial stakeholders.

Regarding infrastructure, the financial activities represented in the columns of Tables 8 and 9 all pass through the third transmission channel, or at least their balance sheet transactions involving securities trading. Large internationally active banks typically are major participants in domestic and international clearance, settlement, and payments infrastructures, both public and private, as well as the major trading exchanges. Many of them co-own parts of the national and international infrastructures and have a natural interest in their performance and viability. Incentives are to some extent aligned to achieve both private and collective net benefits.6 Increasingly, however, internationally active banks are becoming more heavily involved in over-the-counter transactions, which do not pass through these infrastructures. This poses systemic risk challenges.

In summary, financial structural changes have brought tremendous benefits for the world economy. But there is also a darker side of modern finance, as revealed in the experiences during the 1990s and early 2000s. The costs of these experiences have not been evenly distributed among emerging markets, developing countries, transition countries and mature markets. The United States was not spared, even though it has the deepest, most liquid markets in the world. Nor was Europe spared, and Japan certainly wasn’t spared. By and large, oversight regimes still have a national focus, so there are challenges for which the nationally oriented regimes are not keeping pace, such as financial innovation. Private finance can be likened to a greyhound running fast around a track, whereas regulation is more like a bloodhound slowly sniffing out the clues, not quite able to keep pace with the greyhound.

The Conceptual Challenges

The situation described above calls for a more systematic method for assessing the sources of financial risks and vulnerabilities. A more disciplined process is required, key concepts need to be defined as precisely as is practical, measures of the degree of financial stability or instability need to be developed, and there need to be internally consistent ways of adding this all up. The challenges of assessing risks and vulnerabilities in financial systems, as well as the likelihood of threats to financial stability can be likened to asking geophysicists to come up with reliable models for predicting earthquakes, with the obvious additional complexity that finance involves human trust, decisions, and fallibility (see Shubik (1999 and 2001).7 The assessment of risks and the identification of financial vulnerabilities require an analytical framework, for which there currently is no consensus.

The Financial Stability Challenge: A Balancing Act

There are many ways to characterize the challenges faced in achieving and maintaining financial stability. Moreover, the nature of the challenge will depend to some extent on the structure and maturity of the economic system being studied. For mature financial systems, the financial stability challenge can be characterized as maintaining the smooth functioning of the financial system and its ability to facilitate and support the efficient functioning and performance of the economy.

To achieve financial stability, it is necessary to have in place mechanisms designed to prevent financial problems from becoming systemic and/or threatening the stability of the financial and economic system, while maintaining (or not undermining) the economy’s ability to sustain growth and perform its other important functions.

For two reasons, the challenge is not necessarily to prevent all financial problems from arising:

  • First, it is not practical to expect that a dynamic and effective financial system would avoid instances of market volatility and turbulence, or that all financial institutions would be capable of perfectly managing the uncertainties and risks involved in providing financial services and enhancing financial stakeholder value.

  • Second, it would be undesirable to create and impose mechanisms that are overly protective of market stability or overly constraining of the risk taking of financial institutions. Constraints could be so intrusive and inhibiting that they could reduce the extent of risk taking to the point where economic efficiency is inhibited. Moreover, the mechanisms of protection or insurance could, if poorly designed and implemented, create the moral hazard of even greater risk taking.

An important aspect of the challenge of financial stability is maintaining the economy’s ability to sustain growth and perform its other important functions. But the challenge of financial stability analysis and policymaking is that maintenance of financial stability must be balanced against other and perhaps higher-priority objectives, such as economic efficiency. Finance is not an end in itself but plays a supporting role in improving the ability of the economic system to perform its functions.

The challenge of financial stability, therefore, is a balancing act. The likelihood of systemic problems could be limited in practice by designing a set of rules and regulations that restrict financial activities in such a way that the incidence or likelihood of destabilizing asset price volatility, asset market turbulence, or individual bank failures could be eliminated. But it is also likely that this type of ‘stability’ would be achieved at the expense of economic and financial efficiency.

This reasoning leads to the impression, if not conclusion, that there is an ex ante trade-off between achieving, on the one hand, economic and financial efficiency and on the other economic and financial stability. That is, if one is concerned solely with stability, then it may be possible to achieve and maintain it by trading off some efficiency.

The possibility of an ex ante trade-off can be illustrated by narrowing the definitions of stability and efficiency. Consider a market for a good whose price is sensitive to incoming information, a characteristic of many asset markets. In principle one could limit the variability of the asset price by imposing restrictions in the market that would inhibit the ability of traders to price-in every small piece of information. But from a trader’s and investor’s perspective, such restrictions would inhibit the efficiency of the market’s ability to price and allocate resources in the presence of uncertainty.

On the other hand, it is possible to try to maintain efficiency, and even enhance it, while still allowing the financial system room to innovate, evolve, and better support the economic system. If the cost of doing so is greater asset price volatility or capital flow volatility, it is up to society to choose a point along this continuum of trade-offs.

Some have characterized the difference between the American financial system and the European financial system as choices of different points along this trade-off continuum. The American system is more market-oriented in that the financing of both household and corporate activities is accomplished more through markets than in Europe, where there is much greater reliance on bank funding and less reliance on tradable securities (although this is changing in Europe). While one might argue that the American system of finance has led to greater economic productivity and efficiency, this greater efficiency is accompanied by greater asset market volatility and turbulence, and a greater propensity to financial stress.

From a broader perspective, the challenge of achieving and maintaining financial stability goes well beyond the stability of asset prices, or prices generally. This is not to say that authorities, and central banks in particular, should not be concerned with asset price volatility, and price volatility more generally, because they determine the value of money. Instead, the challenge of financial stability is broader than, and in fact encompasses, the need to limit the impact of price instability on the functioning of the overall financial system. In fact, if the financial system is stable, it will be able to tolerate higher levels of asset price volatility as well as other financial problems, including weaknesses in financial institutions.

At the highest level of generality, one can see that the challenge of financial stability is to create a framework for managing the risk of a system-wide problem, or what is known as systemic financial risk. But what is systemic risk, and how should we think of it? That is the subject of the next section.

The Required Conceptual Elements of a Framework

A framework for financial stability can best be understood as a set of definitions, concepts, and organizing principles that impose discipline on the analysis of a financial system. Such a framework is not merely and academic exercise but a practical tool for early identification of risks and vulnerabilities that might threaten the maintenance of stability.

An effective framework would have to meet three important standards:

  • There must be rigorous definitions and understandings of key concepts, such as what is meant by the terms financial system, financial stability and instability, and systemic, just to name a few.

  • To be most useful for monitoring and policy, the framework’s concepts and definitions ultimately must be either directly measurable or correlated with measures. In other words, the concepts and definitions must have useful and policy-relevant empirical counterparts; they must match the real world.

  • The set of definitions, concepts, and organizing principles along with their empirical counterparts must serve the purpose of ensuring internal consistency in the identification of sources of risks and vulnerabilities and in the design and implementation of policies aimed at resolving difficulties should they emerge.

Defining Key Concepts

It is important to define the relevant concepts, especially what is meant by the terms financial system, financial stability and instability, and systemic risk.

Financial System

Broadly, the financial system can be seen as being comprised of three separate but closely related components. First, there are financial intermediaries that pool funds and risks and then allocate them to their competing uses. Today financial institutions are providing a growing range of services, not just the traditional banking services of taking deposits and making loans. Insurance companies, pension funds, hedge funds, and financial-nonfinancial hybrids (such as General Electric) supply a range of financial services. Second, there are financial markets that directly match savers and investors—for example, through the issuance and sale of bonds or equities directly to investors. Third, there is the financial infrastructure, comprised of both privately and publicly owned and operated institutions—such as clearance, payment, and settlements systems for financial transactions—as well as monetary, legal, accounting, regulatory, supervisory, and surveillance infrastructures.8

Notably, both private and public persons participate in financial markets and in vital components of the financial infrastructure. Governments borrow in markets, hedge risks, operate through markets to conduct monetary policy and maintain monetary stability, and own and operate payments and settlement systems. Accordingly, the term financial system encompasses the monetary system with its official understandings, agreements, conventions, and institutions, as well as the processes, institutions, and conventions of private financial activities.9 Any analysis of how the financial system works and how well it is performing its key functions requires an understanding of these components.

From this definition, one could reasonably expect that considerations of financial stability and monetary stability are related in some meaningful ways. These relationships will become more transparent in what follows.

Financial Stability and Instability

There is as yet no widespread agreement on a useful working definition of financial stability. Some authors define financial instability instead of stability,10 while others prefer to define the problem in terms of managing systemic risk rather than as maintaining or safeguarding financial stability.11 Consistent with some aspects of these alternative definitions, Schinasi (2004b and 2006a) proposes and analyzes a definition of financial stability that has three important characteristics.

  • First, the financial system is efficiently and smoothly facilitating the inter-temporal allocation of resources from savers to investors and the allocation of economic resources generally.

  • Second, forward-looking financial risks are being assessed and priced reasonably accurately, and they are also being relatively well managed.

  • Third, the financial system is in such condition that it can comfortably, if not smoothly, absorb financial and real economic surprises and shocks.

If any one or a combination of these characteristics is not maintained, it is likely that the financial system is moving in the direction of becoming less stable and at some point might exhibit instability. For example, inefficiencies in the allocation of capital or shortcomings in the pricing of risk can, by laying the foundations for imbalances and vulnerabilities, compromise future financial system stability.

All three of these aspects of the definition can and do entail both endogenous and exogenous elements. For example, surprises that can impinge on financial stability can emanate both from within and from outside the financial system. Moreover, the inter-temporal and forward-looking aspects of this particular way of defining financial stability serve to emphasize that threats to financial stability arise not only from shocks or surprises but also from the possibility of disorderly adjustments of imbalances that have built endogenously over a period of time—because, for example, expectations of future returns were misperceived and therefore mispriced.12

There are several important implications of defining financial stability in this way.

First, judgments about the performance of the financial system entail an evaluation of how well the financial system is facilitating economic resource allocation, the savings and investment process, and ultimately economic growth. There are two-way linkages; the real economy can be positively or negatively affected by the financial system, and the performance of the financial system can be affected by the performance of the real economy. A framework useful for assessing financial stability must pay attention to these linkages.

Disturbances in financial markets or at individual financial institutions need not be considered threats to financial stability if they are not expected to damage economic activity at large. In fact, the incidental closing of a minor financial institution, a rise in asset-price volatility, and sharp and even turbulent corrections in financial markets may be the result of competitive forces, the efficient incorporation of new information, and the economic system’s self-correcting and self-disciplining mechanisms. By implication, in the absence of contagion and the high likelihood of systemic effects, such developments may be viewed as welcome—if not healthy—from a financial stability perspective. Just as in Schumpeterian business cycles, where the adoption of new technologies and recessions have both constructive and destructive implications, a certain amount of instability can be tolerated from time to time because it may encourage long-term financial system efficiency.13

Second, financial stability is a broad concept, encompassing the different aspects of the financial system—infrastructure, institutions, and markets. Because of the interlinkages between these components, expectations of disturbances in any one component can affect overall stability, requiring a systemic perspective. Consistent with the definition of the financial system, at any given time, stability or instability could be the result of either private institutions and actions, or official institutions and actions, or both simultaneously and/or iteratively.

Third, financial stability not only implies that the financial system adequately fulfills its role in allocating resources, transforming and managing risks, mobilizing savings, and facilitating wealth accumulation and growth, but also that within this system the system of payments throughout the economy functions smoothly (across official and private, retail and wholesale, and formal and informal payment mechanisms). This requires that money—both central bank money and its close substitute, derivative monies (such as demand deposits and other bank accounts)—adequately fulfills its role as a means of payment and unit of account and, when appropriate, as a short-term store of value. In other words, financial stability and what is usually regarded as a vital part of monetary stability overlap to a large extent. 14

Fourth, financial stability requires the absence of financial crises and the ability of the financial system to limit and deal with the emergence of imbalances before they constitute a threat to stability. In a well-functioning and stable financial system, this occurs in part through self-corrective, market-disciplining mechanisms that create resilience and that endogenously prevent problems from festering and growing into system-wide risks. In this respect, there may be a policy choice between allowing market mechanisms to work to resolve potential difficulties and intervening quickly and effectively—through liquidity injections via markets, for example—to restore risk taking and/or to restore stability. Thus financial stability entails both preventive and remedial dimensions.

Finally, but not least important, financial stability can be thought of as occurring along a continuum, reflecting different possible combinations of conditions of the financial system’s constituent parts. An analogy is the health of an organism, which also occurs along a continuum. A healthy organism can usually reach for a greater level of health and well-being, and the range of what is normal is broad and multi-dimensional. In addition, not all states of illness are significant, systemic, or life-threatening, and some illnesses, even temporarily serious ones, allow the organism to continue to function reasonably productively and return to a state of health without permanent damage. One implication of viewing financial stability in this way is that maintaining financial stability does not necessarily require that each part of the financial system operates persistently at peak performance; it is consistent with the financial system operating on a “spare tire” from time to time.15

The concept of a financial-stability continuum is relevant because finance fundamentally involves uncertainty, is dynamic (meaning both inter-temporal and innovative), and is composed of many interlinked and evolutionary elements (infrastructure, institutions, markets). Accordingly, financial stability is expectations-based, dynamic, and dependent on many parts of the system working reasonably well. What might represent stability at one time might be more stable or less stable at some other time, depending on other aspects of the economic system, such as technological, political, and social developments. Moreover, financial stability can be seen as being consistent with various combinations of the conditions of its constituent parts, such as the soundness of financial institutions, financial markets conditions, and effectiveness of the various components of the financial infrastructure.

Systemic Risk

According to the G-10 Report on financial consolidation and risk:

Systemic financial risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainly about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy. Systemic risk events can be sudden and unexpected, or the likelihood of their occurrence can build up through time in the absence of appropriate policy responses. The adverse real economic effects from systemic problems are generally seen as arising from disruptions to the payment system, to credit flows, and from the destruction of asset values.”16

The G-10 study notes that this definition encompasses much of what is in the literature but it is stricter in two respects. One is that the negative externalities of a systemic event must have the potential to adversely affect the real economy; that is, to be a systemic event, a financial event must have the potential to affect the real economy. The second is that the potential impact on the real economy occurs with relatively high probability. The emphasis on real effects reflects the view that it is the output of real goods and services and the accompanying employment implications that are the primary concern of economic policymakers. “In this definition, a financial disruption that does not have a high probability of causing a significant disruption of real economic activity is not a systemic risk event.” 17

Taken together, a good understanding of what is meant by financial stability and what is meant by financial instability can serve to define boundaries around the scope of the analysis. The safeguarding of financial stability should not be understood as a zero tolerance of bank failures or of an avoidance of market volatility, but that it should avoid financial disruptions that lead to real economic costs.18

Toward a Practical Framework for Assessing Financial Stability

With working definitions of the financial system, financial stability, and systemic risk in hand, it becomes possible to discuss the key role that financial stability assessments play in safeguarding financial stability. The core objectives of a framework for safeguarding financial stability are the prevention and resolution of systemic financial problems. That is, safeguarding financial stability fundamentally requires a framework to prevent problems from occurring and to resolve problems if prevention fails.

A key to prevention is the early identification of risks to stability and of potential sources of vulnerability in the financial system before they lead to unsustainable and potentially damaging imbalances and consequences. For example, weaknesses and vulnerabilities could exist in any of the components of the financial system—institutions, markets, infrastructure—and could entail all three simultaneously. Along with identifying potential sources of risks and vulnerabilities, it is also desirable to attempt to calibrate their intensity and potential for (or probability of) leading to financial-system problems and possible systemic effects. Financial stability assessments are a key part of prevention.

The key to resolution is to have mechanisms in place and policy tools available to remedy situations in which the financial system seems to be in the early stages of moving towards instability. Such tools would include, for example, moral suasion and intensified supervision and/or market surveillance. Should remedial measures fail, or undetected endogenous factors or unanticipated exogenous factors lead to instability, tools should be available for resolving problems and instabilities quickly and with minimum spillovers and contagion, either to the financial system or the economy. Such tools would include emergency liquidity assistance.

Figure 4 represents a schematic that might be considered as a reasonable model for such a framework for prevention and resolution. Both prevention and resolution of financial difficulties are part of the framework (although resolution is well beyond the scope of this chapter and is not discussed).19

Figure 4.
Figure 4.

Framework for Maintaining Financial System Stability

Source: Schinasi, supra Table 7; A. Houben, J. Kakes, and G. Schinasi, “Framework for Safeguarding Financial Stability,” IMF Working Paper 04/101 (Washington, DC: July 2004).

In order to prevent problems from occurring or becoming significant enough to pose a risk to financial stability, it would be desirable to have a continuous process of information gathering, technical analysis, monitoring, and assessment. Because of the linkages between the real economy and the financial system, and also the various components of the financial system, this continuous process would be most useful if it encompassed economic and financial dimensions as well as institutional knowledge about institutions, markets, and the financial infrastructure. In effect, the process needs to be comprehensive and analytical (see the top bar in Figure 4). Note that ongoing and more fundamental research into the changing structure of the financial system and its changing linkages to the real economy, as well as the further development of measurement techniques for detecting growing imbalances and calibrating risks and vulnerabilities, are vital for keeping this important monitoring phase up to date.

The process entails information gathering about, and monitoring of, the macroeconomy (and at times microeconomic aspects as well) and the various aspects of the financial system through supervisory, regulatory, and surveillance mechanisms. Each of the financial-system monitoring components could entail both macro- and micro-prudential characteristics. For example, in gathering information about and monitoring individual institutions, the supervisory process could be aided by knowledge about where the economy is along the business and credit cycles and how markets have been performing overall. This is important because the macroeconomy and markets provide the background against which the operational performance of individual institutions should be assessed. Likewise, an assessment of the condition of financial markets could be different depending on whether the major institutions operating in the markets were well-capitalized and profitable, or not. This is another way of observing that there are tradeoffs, even in the assessment process, in safeguarding financial stability.

The reason for gathering information, analyzing it, and continuously monitoring the various components of, and influences on, the financial system is to enable systematic and periodic assessments of whether the financial system is performing its main functions well enough to be judged to be within a corridor of financial stability along the continuum discussed earlier. Such an assessment could lead to three conclusions, each of them having quite different implications for action (see the middle bar in Figure 4 labeled assessment and the arrows). The financial system can be judged to be in a zone or corridor of financial stability, as approaching a boundary of stability/instability, or outside a zone or corridor of stability. Within the third category, the financial system could be further judged to be in a position in which self-corrective processes and mechanisms are judged to be likely to move the system back toward the corridor of stability or alternatively to need prompt remedial and even emergency measures to reverse the instability.20

One could also develop a delineation of financial conditions and potential difficulties according to their intensity, scope, and potential threat to systemic stability. For example, potential financial difficulties can be thought of as falling into one of the following fairly broad categories:

  • difficulties in a single institution or market not likely to have system-wide consequences for either the banking or financial system;

  • difficulties that involve several relatively important institutions involved in market activities with some nontrivial probability of spillovers and contagion to other institutions and markets; and

  • problems likely to spread to a significant number and types of financial institutions and across usually unrelated markets for managing liquidity needs, such as forward, interbank, and equity markets.

Problems occurring within each of these categories would require different diagnostic tools and policy responses, ranging from doing nothing to intensifying supervision or surveillance of a specific institution or market, to liquidity injections into the markets to dissipate strains, or to interventions into particular institutions.

Challenges in Implementing a Framework

While the categories of possible assessments may be easy to discuss in principle, they are difficult to identify in actual practice. How, for example, should the boundary of stability be defined and measured? When does a small, isolated problem threaten to become a systemic one? There would also seem to be a bias toward being prudent and overreaching in identifying both potential sources of risks and vulnerability, and in overestimating their likelihood and importance. Thus it would be useful to establish ground rules or guidelines for applying discipline to the continuous process of information gathering, analysis, and monitoring—and, most importantly, for identifying sources of risks and vulnerabilities. A check list of questions for identifying risks and vulnerabilities and for assessing where they lie along the stability spectrum could include the following:21

  • Is the process systematic?

  • Are the risks identified plausible?

  • Are the identified risks systemically relevant?

  • Can linkages and channels of transmission (or contagion) be identified?

  • Have risks and linkages been cross-checked?

  • Has the identification of risks and the assessment been consistent over time?

In practice, the process of assessing financial stability entails a systematic identification and analysis of the sources of risk and vulnerability that could impinge on stability in the circumstances in which the assessment is being made. For example, consider the comprehensive list of sources of risks in Table 10. An operationally significant distinction is made between endogenous sources of risk that are present within the financial system and exogenous sources of risk that might emanate from outside the realm of finance.

Table 10.

Sources of Risk to Financial Stability

article image
Source: Schinasi and Houben, Kakes, and Schinasi, supra Figure 4.

In keeping with the broad definition of the financial system outlined above, endogenous sources of risk can arise in financial institutions, financial markets, or the infrastructures, or in any combination of the three. For instance, credit, market, or liquidity risks may be present in financial institutions which, if they materialize, could hamper the process of reallocating financial resources between savers and investors. Financial markets can be a source of endogenous risk not only because they offer alternative sources of finance to nonfinancial sectors but also because they entail systemic linkages between financial institutions, and more directly between savers and investors. Financial infrastructures are also an important endogenous source of risk, in part because they entail linkages between market participants as well, but also because they provide the institutional framework in which financial institutions and markets operate.

Outside the financial system, the macroeconomic environment can be an exogenous source of risk for financial stability because it directly influences the ability of economic and financial actors (households, companies, and even the government) to honor their financial obligations. Financial stability assessments should entail a systematic and periodic process of monitoring of each of these sources of risks, both individually and collectively, by taking account of cross-sector and also cross-border linkages. This process should satisfy at least the list of questions above.

There are also formidable measurement and modeling challenges in the ability to assess the strength and robustness of the various risks, to calibrate their plausibility and importance, or to appraise quantitatively the potential costs should the risks materialize. In actual practice, many shortcuts and qualitative judgments must be made in order to produce an overall assessment.

For most macroeconomic or monetary policy objectives (for example, unemployment, external or budgetary equilibrium, price inflation) there are widely accepted measurable indicators that define, and measure deviations from, the objective, even if still subject to methodological and analytical debate, even controversy. In the fields of both macroeconomics and monetary economics, it took each of the disciplines some 20–30 years of practice, trial, and error, measurement and modeling development, and fundamental research to achieve these indicators. As noted earlier, financial stability analysis is still in its early stage of development. Thus there is as yet no widely accepted set of measurable indicators of financial stability that can be monitored and assessed over time. In part, this reflects the multifaceted nature of financial stability, as it relates to both the stability and resilience of financial institutions, and to the smooth functioning of financial markets and settlement systems over time.22 Moreover, these diverse factors need to be weighed in terms of their potential ultimate influence on real economic activity. But it also reflects the relatively young age of the discipline of assessing financial stability. Because measurement is not highly developed yet, it is reasonable to see the current practice of making financial stability assessments more as an art form than as a rigorous scientific discipline.

Challenges in measuring financial system stability reach well beyond the challenges of measuring the degree of stability in each individual sub-component of the financial system. Financial stability requires that the constituent components of the system—financial institutions, markets, and infrastructures—are jointly stable. Weaknesses and vulnerabilities in one component may or may not compromise the stability of the system as a whole, depending on size and linkages, including the degree and effectiveness of risk-sharing between different components. Moreover, as different parts of the system perform different tasks, there are challenges to aggregating information across the system. For example, in diversified financial systems, where both financial institutions and markets are important providers of finance, there is no commonly accepted way of aggregating information on the degree of stability in both the banking system and financial markets to form an overall assessment of system stability. If the banking system is functioning well but, at the same time, there are signs of strains in financial markets, the overall assessment of financial system stability is likely to be ex ante ambiguous, particularly if the respective shares of the two components as providers of finance are similar. The more complex and sophisticated a financial system, the more complex is the task of measuring overall stability in a precise way.

Financial stability assessments carry a higher degree of uncertainty than ordinarily associated with forecasts based on macroeconometric models. This is because there are four formidable practical challenges to measuring, modeling, and assessing the consequences of rare events:

  • If past crises were prevented or tackled by policy actions, assessments of the likely costs of a selected scenario, based on simulations drawn from historical data-sets, will likely prove to be biased unless sufficient account is taken of policy reactions. It is doubtful that past policy responses to episodes of financial stress could be summarized by a mechanical reaction function, particularly if the authorities were mindful of avoiding the moral hazards that typically follow from predictable behavior. Moreover, even in cases that did not lead to policy responses, the frequency of crises in historical data-sets may be too low to facilitate precision in estimating the likely “policy neutral” consequences of a stylized scenario.

  • Confidence intervals around the expected output losses associated with the materialization of a specified scenario may be neither well-defined statistically nor defined at all. For instance, simulations based on historical episodes tend to be founded on statistical relationships that reflect the central tendency of probability distributions, rather than the tails. Moreover, for hypothetical scenarios that have not occurred in the past, it may not be possible to compute a confidence interval around the simulation because the events themselves may be subject to Knightian uncertainty—or unquantifiable risk.23

  • Most macroeconometric models used for stress-testing tend to be built on the basis of log-linear relationships. For simulations, this means that a doubling of the size of a shock will result in a proportionate change in the effect. In reality, however, it can never be excluded that in situations of financial stress, unpredictable nonlinearities may surface—due, for instance, to threshold effects.

  • As witnessed during the near collapse of Long Term Capital Management in 1998, unexpected linkages may surface during crises, such as correlations between financial markets that ordinarily tend to be uncorrelated. Given such uncertainties, the real economic costs associated with a particular scenario could well prove to be larger than those predicted by an empirical model. Such considerations would suggest that the output of any stress-testing exercise should only be viewed as indicative of how, or if, the financial system would endure adverse disturbances. In order to avoid complacency, this calls for a high degree of caution and judgment in forming financial assessments.

In order to advance the practice of financial stability assessment from what is essentially an art towards a science, progress is necessary on at least three fronts: data, models, and understanding of linkages. A priority for data gathering must be microeconomic balance-sheet data covering financial institutions, households, and firms. While a picture of the aggregate risks borne within each of these sectors can be useful for financial stability analysis, far more important is an understanding of the way in which the risks are distributed across sectors and especially whether or not concentrations or pockets of vulnerabilities can be pinpointed. In mature economies, the availability and comprehensiveness of such data is rather mixed, particularly for the household sector.

There are two areas where more and better analytical research on financial stability modeling appears necessary: (1) models for identifying risks and vulnerabilities and (2) models for assessing the consequences of adverse disturbances.24 Concerning the identification of risks, the literature suggests that it is doubtful that models will ever be capable of predicting crises, particularly with precise timing. Nevertheless, this should not stand in the way of developing models for assessing vulnerabilities. Even simple single-indicator approaches can be useful for gauging risks to financial stability,25 and current work holds promise for the development of more comprehensive frameworks for pinpointing the sets of variables26 and the conditions that raise the likelihood of financial stress.27 As for the prediction of crises, it cannot be excluded that drawing on the intellectual advances made in other disciplines in the modeling of complex and discontinuous processes—such as the prediction of earthquakes—may offer insights for financial stability assessment.

Conclusion

This chapter has explored the various challenges in safeguarding financial stability, which have become more important over the past three decades. There are formidable conceptual challenges in defining financial stability and in analyzing it. From the perspective of assessing the performance of financial systems, and their likelihood of encountering difficulties, those who work in the financial-stability “discipline”—if it can as yet be labeled as such—do not yet know how to integrate knowledge and information about financial institutions and financial markets. Nor do they know how to conceptualize usefully and model empirically the important systemic linkages between financial processes and the real economic processes that finance is designed to facilitate. In short, the discipline lacks a widely accepted framework.

The challenges that lie ahead for financial stability analysis concern both measurement and theory. The challenges are formidable, in part because financial stability assessments must not only take stock of disturbances as they emerge but also identify and examine the vulnerabilities that could lead to such disturbances occurring in the future. A forward-looking approach is required in order to identify the potential build-up of financial imbalances and to account for the transmission lags in policy instruments. The real difficulty is that financial crises are inherently difficult, if not impossible, to predict, in part because of contagion effects and likely nonlinearities in both the build-up of imbalances and their transmission to the real economy. In addition, financial stability risks often reflect the far-reaching consequences of unlikely events. This implies that the focus of the attention is not the mean, median or mode of possible outcomes but the entire distribution of outcomes, in particular the “left tail.”

While many conceptual and methodological challenges lie ahead, it is important to acknowledge that significant progress has been made in recent years. Even though there is no obvious framework for summarizing developments in financial stability in a single quantitative measure, a growing number of central banks around the world are making financial stability assessments and publishing financial stability reports, many of them based on a broad and forward-looking conception of financial stability.

The three major challenges to financial stability—the globalization of finance, the increasing use of sophisticated instruments, and the entrance of new large participants in global markets—lead, separately and collectively, to the strong conclusion that further and continuous reforms are desirable and should be aimed at striking a better balance between relying on market discipline and relying on official or private-collective action. In some countries—most of them advanced countries with mature markets—a rebalancing toward greater reliance on market discipline is desirable. In other countries—many with poorly developed markets—strong efforts need to be made to improve the financial infrastructure through private-collective and government expenditures and commitments, and to target the role of government to enhance the effectiveness and efficiency of market mechanisms for finance.

Reforms in seven areas would go a long way in improving the prospects for safeguarding financial stability where it presently exists, and in promoting it where it is yet to be achieved:

  • Improve internal governance at the board-of-directors level, management and risk controls, and the alignment of incentives of board, management, and staff by realigning private incentives within all financial institutions.

  • Reduce moral hazard and other adverse incentives by reevaluating and reforming existing regulatory incentives and their consistency with private market incentives.

  • Improve market discipline and strengthen private-collective and official surveillance and supervision by enhancing financial transparency through disclosure by a wide range of financial and nonfinancial entities.

  • Reduce informational asymmetries and the tendency toward adverse selection by improving financial market transparency.

  • Reduce, and if possible eliminate, legal uncertainties where laws are still ambiguous (such as with close-out procedures for credit derivatives and other complex structured financial instruments) by introducing new legislation developed in a coordinated fashion by private financial industry, official, and legislative representatives.

  • Improve the ability to monitor, assess, and safeguard financial stability, and to restore it when this fails by aggressively developing and implementing comprehensive and appropriately targeted frameworks, analytical tools, and the necessary data and information.

  • Reduce opportunities for international regulatory arbitrage, and eliminate international gaps of information and analyses by enhancing international cooperation and coordination in financial-system regulation, surveillance, and supervision.

The complexity of the challenges and the rapidity and creativity with which new financial instruments are developed and disseminated require a systemic approach to safeguarding financial stability. The financial system, working within the context of the broader economic, social, and political systems, affects the performance of the economy and well-being of society. In turn, those systems must operate hand in hand to safeguard the stability of the financial system, and the constellation of tools they provide must be used to ensure economic stability.

Ultimately, the goal is to maintain financial stability so that the financial system is capable of performing its three key functions: the intertemporal allocation of resources from savers to investors and the allocation of economic resources generally; the assessment, pricing, and allocation of forward-looking financial risks; and the absorption of financial and real economic shocks and surprises.

1

See James Tobin, “Money as a Social Institution and Public Good,” in J. Eatwell, M. Milgate, and P. Newman, eds., The New Palgrave Dictionary of Money and Finance (London: Macmillan, 1992).

2

See F. Allen, “Modeling Financial Stability,” National Institute Economic Review, Vol. 192 (April 2005).

3

See O. Oosterloo, J. de Haan, and R. Jong-A-Pin, “Financial Stability Reviews: A first Empirical Analysis,” paper presented at the Federal Reserve Bank of Chicago Conference, “International Financial Instability: Cross-Border Banking and National Regulation,” October 5, 2006.

4

See various issues of the IMF’s International Capital Markets and Group of Ten, Consolidation of the Financial Sector (Basel, 2001).

5

Van der Zwet discusses this blurring of distinctions between financial sectors and across countries, including by looking at variables such as the share of financial institutions’ cross-border and cross-sector revenues. See A.van der Zwet, “The Blurring of Dinstinctions between Financial Sectors: Fact or Fiction,” Occasional Studies No. 2 (Amsterdam: De Nederlandsche Bank, 2003).

6

The phrase “to some extent” needs to be emphasized. Consider, for example, that the G-10 central banks decide to get out of the business of providing clearance, settlement, and payment services on foreign-exchange transactions—as might have been considered years ago when they challenged private institutions to eliminate Herstatt risk, the risk of losses of principal on foreign-exchange transactions owing to time-zone differences. If this decision were taken, the major international banks would have the incentive to organize fully the clearance, settlement, and payment on FX transactions. But if this were to happen, this private organization could become too big to fail or even to liquidate in a timely manner without global systemic consequences.

7

Martin Shubik, Theory of Money and Financial Institutions (Cambridge, MA: MIT Press, 1999).

8

On the role of the legal system see, for example, R. Levine, “Law, Finance and Economic Growth,” Journal of Financial Intermediation, Vol. 8 (1999), at 8–35; M. Leahy, S. Schich, G. Wehinger, F. Pelgrin, and T. Thorgeirsson, “Contributions of Financial Systems to Growth in OECD Countries,” OECD Working Paper No. 280 (Paris, 2001); T. Beck, A. Demirgüç-Kunt, and R. Levine, “Bank Concentration and Crises,” NBER Working Paper No. 9921 (Cambridge, MA: NBER, 2003).

9

This particular formulation is an adaptation of “international financial system” in Edwin Truman, Inflation Targeting in the World Economy (Washington, D. C.: Institute for International Economics, 2003).

10

See, e.g., the definitions in the following: J. Chant, “Financial Stability as a Policy Goal,” in J. Chant, A. Lai, M. Illing, and F. Daniel, eds., Essays on Financial Stability, Bank of Canada Technical Report No. 95 (Ottawa, 2003); A. Crockett, “The Theory and Practice of Financial Stability,” De Economist, Vol. 144, No. 4 (1996); Deutsche Bundesbank, “Report on the stability of the German financial system,” Monthly Report (Frankfurt, December 2003); W.F. Duisenberg, “The Contribution of the Euro to Financial Stability,” in Globalization of Financial Markets and Financial Stability—Challenges for Europe (Baden-Baden, 2001); R. Ferguson, “Should Financial Stability Be An Explicit Central Bank Objective?” (Washington, D.C.: Federal Reserve Board of Governors, 2002); M. Foot, “What is ‘Financial Stability’ and How Do We Get It?” The Roy Bridge Memorial Lecture (London: Financial Services Authority, 2003); A. Large, “Financial Stability: Maintaining Confidence in a Complex World,” Financial Stability Review (2003), at 170–74 (London: Bank of England); F.S. Mishkin, “Global Financial Instability: Framework, Events, Issues,” Journal of Economic Perspectives, Vol. 13, No. 4 (1999); Norwegian Central Bank, 2003, Financial Stability Review, Vol. 1 (2003); T. Padoa-Schioppa, “Central Banks and Financial Stability: Exploring a Land in Between,” in V. Gaspar, P. Hartmann, O. Sleijpen, eds., The Transformation of the European Financial System (Frankfurt: European Central Bank, 2003); A.J. Schwartz, “Real and Pseudo-Financial Crises,” in F. Capie and G.E. Woods, eds., Financial Crises and the World Banking System (New York: St Martin’s, 1986); and A.H.E.M. Wellink, “Current Issues in Central Banking,” speech at the Central Bank of Aruba, Oranjestad, Aruba, 2002. All of these definitions are surveyed in G. Schinasi, “Defining Financial Stability,” IMF Working Paper 04/187 (Washington D.C.: International Monetary Fund, 2004) and G. Schinasi, Safeguarding Financial Stability: Theory and Practice (Washington, D.C.: International Monetary Fund, 2006). A typology of instability is developed in E.P. Davis, “A Typology of Financial Instability,” Financial Stability Report, No. 2 (Wenen: Oesterreichische Nationalbank, 2002).

11

From a policy perspective, a positive approach focusing on financial stability is more useful than a negative one focusing on financial instability. See Garry Schinasi, Safeguarding Financial Stability: Theory and Practice (Washington, D.C.: International Monetary Fund, 2006.

12

That financial stability should not be thought of simply as a static concept of shock absorption capacity has been emphasized by others. See, for example, H.M. Minsky, Inflation, Recession and Economic Policy (Wheatsheaf, Sussex: MIT Press, 1982) and C.P. Kindleberger, Manias, Panics and Crashes (Cambridge: Cambridge University Press, 1996).

13

See J. Schumpeter, The Theory of Economic Development (Cambridge, MA: Harvard University Press, 1934.

14

On the role of central banks in financial stability, see T. Padoa-Schioppa, “Central Banks and Financial Stability: Exploring a Land in Between,” in V. Gaspar, P. Hartmann, O. Sleijpen, eds., The Transformation of the European Financial System (Frankfurt: European Central Bank, 2003) and G. Schinasi, “Responsibility of Central Banks for Stability in Financial Markets,” IMF Working Paper 03/121 (2003).

15

See A. Greenspan, “Do Efficient Markets Mitigate Financial Crises?” Speech delivered before the 1999 Financial Markets Conference of the Federal Reserve Bank of Atlanta.

16

Group of Ten, Consolidation of the Financial Sector (Basel: Group of Ten, 2001).

17

Id.

18

For papers that focus on aspects of systemic risk, see D. Hoelscher, and Marc Quintyn, “A Framework for Managing Systemic Banking Crises,” IMF Occasional Paper (forthcoming) and M. Summer, “Banking Regulation and Systemic Risk,” Open Economies Review, Vol. 14 (2003), at 43–70.

19

For a brief discussion of the resolution phase, see Schinasi, Safeguarding Financial Stability, supra note 11, at 114–118. Also see the conference papers discussed at the Federal Reserve Bank of Chicago conference, “International Financial Instability: Cross-Border Banking and National Regulation,” which deal in part with the challenges in resolving cross-border banking problems in a world in which regulation and supervision are nationally oriented. See D.D. Evanoff, G.G. Kaufman, and J.R. LaBrosse, eds., International Financial Instability: Global Banking and National Regulation, (World Scientific Publishing Company, 2007).

20

As Kindleberger puts it, “markets work well, on the whole, and can normally be relied upon to decide the allocation of resources and, within limits, the distribution of income, but that occasionally markets will be overwhelmed and need help.” See Kindleberger, Manias, Panics and Crashes, supra note 12.

21

These ideas are developed in detail in J. Fell and G. Schinasi, “Assessing Financial Stability: Exploring the Boundaries of Analysis,” National Institute Economic Review, Vol. 192 (April 2005).

22

Sets of indicators have been developed, and are widely used, for assessing the soundness of banking institutions. See, for example, the IMF Soundness Indicators, both core and encouraged sets, in International Monetary Fund/World Bank, Analytical Tools of the Financial Sector Assessment Program (Washington D.C., 2003); and International Monetary Fund/World Bank, Compilation Guide on Financial Soundness Indicators (Washington D.C., 2004).

23

See F.H. Knight, Risk, Uncertainty, and Profit (Cambridge, MA: The Riverside Press, 1921).

24

For an overview of early warning systems used by some G-10 authorities, see R. Sahajwala and P. van den Berg, “Supervisory risk assessment and early warning systems,” Basel Committee on Banking Supervision Working Paper No. 4 (2000). On the use of financial market indicators, see M. Persson and M. Blåvarg, “The Use of Market Indicators in Financial Stability Analysis,” Economic Review (Sveriges Riksbank, 2003), at 5–28.

25

See J. Campbell and R. Shiller, “Valuation Ratios and the Long-Run Stock Market Outlook: An Update,” NBER Working Paper No. 8221 (Cambridge, Massachusetts: NBER, 2001).

26

International Monetary Fund, Compilation Guide on Financial Soundness Indicators (Washington D.C., 2004).

27

O.C. Aspachs, C. Goodhart, M. Segoviano, D. Tsomocos, and L. Zicchino, “Searching for a Metric for Financial Stability,” paper presented at the U.S. FDIC’s 6th Annual Bank Research Conference, September 13-15, 2006.

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Cover Current Developments in Monetary and Financial Law, Vol. 5
Current Developments in Monetary and Financial Law, Vol. 5
Author:
International Monetary Fund
ISBN:
9781589067738
Publication Date:
06 Nov 2008
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781589067738.072
Pages:
668
Figure 1.

Composition of Key Financial Aggregates in 1970 and 2000
Figure 2.

Development of Key Financial Aggregates, 1970–2000
Figure 3.

Financial Sector Mergers and Acquisitions, 1990-1999
Figure 4.

Framework for Maintaining Financial System Stability