Journal Issue

Per Jacobsson Foundation Lecture: New directions needed for financial stability?

International Monetary Fund. External Relations Dept.
Published Date:
July 2004
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Per Jacobsson Lecture

Over the past 15 years, central banks have made enormous progress on the monetary policy front. But on the financial stability side, much remain: to be done, according to Professor Charles Goodhart of the London School of Economics and formerly of the Bank of England. Presenting a Per Jacobsson Foundation Lecture in Zurich, Switzerland, on June 27, to an audience mainly of governors and other central bank officials attending the Annual Meeting of the Bank for International Settlements (BIS), he argued that central banks will need to take some new directions if they are to make comparable progress on financial stability.

Central banks have two main responsibilities—monetary stability (meaning reasonable price stability) and financial stability. On the monetary side, Goodhart said, there has, in the past 15 years, been “enormous progress in operational success, practical procedures, and theoretical understanding.” But comparable progress on the financial stability side has proved more elusive. Indeed, even among experts, financial stability does not appear to be well defined, save as an absence of financial instability.

Goodhart began by noting that a number of central banks—those of China, Germany, Japan, and the United Kingdom, for example—are charged with maintaining systemic financial stability without having supervisory oversight of individual financial institutions. This separation of supervision from central bank responsibilities—together with the enhanced involvement of finance ministries and the greater role of the IMF and the World Bank—is making the procedures for reforming the international financial architecture “more messy and complicated.” Yet these changes are also, he said, making procedures “somewhat more ‘democratic’” than they were between 1974 and the late 1990s, when the private and informal Basel Committee of central bankers established “soft law” for the system.

What can be done to strengthen the financial stability side of central banking? Goodhart suggested that valuable benefits could be reaped from fresh approaches in four areas—research, linkages with fiscal policy, regulatory requirements, and accounting.

Modeling systemic stability

With regard to research, Goodhart pointed to a need for economic models of systemic financial stability and fragility, comparable to the macroeconomic models that underlie central bank analysis of, and decisions about, monetary policy. “We need to construct models of systemic stability, not just of individual bank probability of default.… A major problem is that almost all the quantitative techniques for risk measurement that have been devised apply to the individual (banking) institution, not to the banking system as a whole.. Almost by definition, such exercises relating to individual banks cannot cope with interactions, or contagious effects, between banks.”

A model suitable for analyzing and quantifying systemic financial stability must, Goodhart said, include incomplete financial markets (otherwise, the need for financial intermediaries does not arise); heterogeneous banks (otherwise, contagion cannot be considered); and, most important and most difficult, default, which must be endogenous—that is, explained by the model. “Most macro models effectively assume that there is never any default, with a transversality condition which implies that all debts are repaid by the final horizon. Such an assumption is totally out of place in any model of systemic risk,” he said. Goodhart went on to refer to research on models of default that he has been conducting with colleagues, drawing on the work of Martin Shubik of Yale University. “The ultimate aim of this exercise,” he noted, “is to try to lead the way toward a quantitative measure and model of systemic, aggregate financial stability that can complement the continuing risk measurements of individual institutions. If this can be done, it could start to provide an intellectual backstop to the more descriptive commentaries in financial stability reviews, and possibly allow for a more coherent unification of the various roles of a central bank in its financial stability remit.”

Fresh approaches are needed in research, linkages with fiscal policy, regulatory requirements, and accounting.

Reconsidering fiscal policy linkages

Goodhart argued that linkages with fiscal policy are “just as important and problematical” on the financial stability side as they are on the monetary policy side of central banking. Because banking crises often entail significant fiscal costs, their handling necessarily involves the relevant fiscal and political authorities. (He noted that losses from lender-of-last-resort operations that give rise to fiscal costs are more likely, the greater is the incentive for troubled commercial banks to use every other possible avenue of raising funds before approaching the authorities. This led him to wonder whether there might be an analogy here at the international level with national governments and the IMF.)

Goodhart saw no particular administrative problem with the fiscal policy link in the national context, although the need for crises to be handled, in effect, by a committee drawn from the central bank, supervisory authority, and finance ministry may add to coordination and operational difficulties. “The problems arise when the crisis has international dimensions,” he explained, since, in a globalized financial system, losses that occur in a bank in one country could effectively be passed through to the depositors or the fiscal authorities in another. “There is no mechanism in place to devise a generally acceptable sharing of burdens from international [banking] crises,” he observed.

These problems are most acute in three groups of countries:

  • those (such as the transition countries of eastern Europe) whose banks are mostly foreign owned and are therefore subject to supervisory decisions made by the banks’ home countries;

  • the United Kingdom, which has so many foreign banks and, as a major international financial center, is likely to feel the reverberations of any cross-border crisis; and

  • countries whose domestic banking systems are already largely interpenetrated, such as in the Scandinavian and the Benelux countries. “Since all three involve European countries, this is primarily a problem for the EU [European Union] to handle,” Goodhart said, “even aside from the concerns expressed by many about the differing domains of macro monetary and financial stability policies within the eurozone.” (In the euro area, monetary policy comes under the aegis of the European Central Bank, while financial stability policies remain under national control.)

Given the aim of establishing a common European financial system, it might seem a logical step to shift both the fiscal competence to deal with banking crises and the banking supervisory function to the federal EU level. Moving only the fiscal function would cause too much moral hazard, Goodhart said, while moving only the supervisory function would be unacceptable to national treasuries, which usually want control over what they are paying for.

But Goodhart doubted that it will prove possible in the foreseeable future to move the fiscal function for crisis resolution to the EU level. And absent such a shift, “calls for transfers of supervisory functions to a central, European body are, in my view, nugatory and little more than whistling in the wind. That, alas, brings us back to the question of how to share out the burden of rescues when the relevant public authorities are national but the financial system is international.” In these circumstances, he argued, the European Central Bank should be encouraged to adopt the role of arbiter in handling financial crises that have international overlaps in the euro area and there is disagreement and deadlock among the national bodies.

A holistic approach to regulation

The increasing complexity of the financial system also calls for a “holistic approach to financial regulation” that extends beyond risk-related capital requirements, Goodhart emphasized. He likened devising good financial regulation to the labors of Sisyphus: the difficulties are not just that financial innovation and interactions between the supervised and the supervisors will continuously require regulations to be updated, “though this, too, will happen, and Basel II will be succeeded in due course by Basel III.” There are also so many aspects of risk that no one set of negotiations can, or will, fully take on board all of them.

Basel II—the new capital adequacy framework issued by the BIS—focuses on the application of capital to credit risk and other operational risks, Goodhart noted, but numerous other facets of risk management need attention—notably liquidity, the pricing of risk via interest rate margins, and devising a structure of incentives to “encourage bankers (and, for that matter, also supervisors) to abide by the various standards and requirements that may have been promulgated.”

Over the previous 40 years, the attention of regulators had swung from concerns about liquidity, with requirements for various cash and liquidity ratios, to a focused concentration on capital requirements. In Goodhart’s view “this pendulum has swung far too far ….It is arguable,” he observed, “that the case for externally imposed liquid asset ratios is actually much stronger than the case for externally imposed risk-related capital adequacy ratios.” Banks’ maintenance of liquid assets protects the system as a whole from damaging fluctuations in asset prices. In fact, much of the benefit of any bank’s holding more liquid assets accrues to other banks, while the negative effect on profitability is almost entirely internalized; thus, there will be an incentive for banks to hold less than the socially optimal amount of liquid assets. Moreover, banks’ holdings of liquid assets protect not only other commercial banks but also the monetary authorities and help them to maintain systemic stability.

Goodhart also argued for more attention to interest margins, suggesting that one approach to countering procyclicality in the financial system would be to have regulatory requirements, including for capital and liquidity, vary inversely with margins. Thus, “when risk margins fell during booms, relative to the historical norm, aggregate required ratios would rise, and vice versa.”

With regard to incentives and sanctions, Goodhart observed that there is “an apparently irresistible temptation among regulators to focus solely on what banks should desirably do, and issue regulations and suggested standards and codes of conduct” (including those promoted by the IMF) that exemplify such good behavior. But more difficult and more important, he said, is to work out what sanctions to apply—sanctions to “give bite and backup” to standards, codes, and other regulatory requirements.

Accounting choices

Finally, Goodhart turned to an accounting issue. Should banking data always be presented on a current market value basis, or is it sometimes desirable to present data on a historic cost basis or apply some other device to smooth the data? Europeans tend to argue that, because markets can be volatile, using current market value data will exacerbate financial instability. For example, in a financial panic, when asset values shrink dramatically, the capital ratios of banks—if based on current market valuations—will contract sharply, too. Bank lending will consequently decline at a time when continuing, indeed additional, loans are desirable from a macro viewpoint.

Until recently, Goodhart said, he had defended the use of smoothing devices to adjust banking data, but “market innovations and the trend of thought” had now led him to believe that “their day is done.” These devices, he argued, are usually nontransparent and subject to manipulation; reduce the availability of information, including early warnings of impending problems in financial institutions; and are likely to lead to a misallocation of investable funds. Moreover, with the advent of securitization and credit default derivatives, market valuations of loans are now more readily available.

So if accounts, ratings, and valuations are all to be based on current market values, how will volatility in the system be restrained? Goodhart lent his support to a proposal—made by several economists at the BIS—to adjust regulatory ratios to the rate of change of a key systemic factor—for example, GDP growth or house price inflation.

With these recommended new directions, Goodhart hoped, the progress that central banks have made since the late 1980s in their understanding and conduct of monetary policy will be replicated in the next 15 years in their other main area of responsibility.

The full text of the lecture is available at

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