Banking Soundness and Monetary Policy

3 Banking Soundness: The Other Dimension of Monetary Policy

Charles Enoch, and J. Green
Published Date:
September 1997
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At the conclusion of the Sixth Seminar on Central Banking on “Frameworks for Monetary Stability: Policy Issues and Country Experiences” in March 1994, I remarked that the discussions had pointed “toward a critical area for central banking and monetary policy in the years ahead: the role of the monetary authority in fostering soundness and efficiency in financial markets.” In that context, I noted, “Besides posing serious challenges to monetary policy, deregulation and the opening of financial markets have brought the importance of supervision and prudential regulation to the forefront of monetary and financial management” and suggested that this subject might well lend itself as a theme for a forthcoming central banking seminar.1

Since then, bank and financial sector issues have attracted much attention, as made evident most recently by the specific reference in the September 29, 1996 Interim Committee’s declaration, Partnership for Sustainable Global Growth. This declaration included among its precepts the need to ensure “the soundness of banking systems through strong prudential regulation and supervision.”2 With the benefit of hindsight, it has been clearly appropriate to focus on the theme of banking soundness, and to set the issue in a global context given the growing interdependence of national economies. The widespread experience of banking crises in many countries over the past few years has made this topic of banking soundness even more relevant. Although the focus of this paper will be on banking soundness, this is not to deny importance to the broader setting of financial sectors—on the contrary, banking soundness typically reflects a country’s overall financial soundness.

Since the Sixth Central Banking Seminar was held in March 1994, much work has been done in the IMF and elsewhere in the banking and financial area. As far as the IMF is concerned, and as Stanley Fischer just outlined (Chapter 2), the main modalities of institutional involvement are surveillance, conditionality, and technical assistance. I would like to add to these three categories of activity the IMF’s contribution to operational research in this field, a recent example of which is contained in Bank Soundness and Macroeconomic Policy by Carl-Johan Lindgren, Gillian Garcia, and Matthew Saal, as well as a growing number of IMF Working Papers on banking sector-related subjects. But work is also under way on payments systems, on bank restructuring strategies, and more generally, on the identification of possible frameworks for sound banking, both at the individual country level and internationally.3

The contributions of financial institutions in general, and of banks in particular, to broader economic performance and welfare are well established in the literature, and have been summarized elsewhere. Instead, I would like to focus on bank soundness as a key component of two distinct but interdependent and fundamental dimensions of monetary policy: price stability—or similarly, exchange rate stability, although this is typically a more controversial aim, of course—which has been increasingly accepted as the primary macroeconomic goal of monetary policy; and a second set of goals, which until recently have been largely overlooked in the context of evaluations of monetary management in general.4 Those goals are microeconomic in nature, related as they are to the attainment of a competitive and efficient banking sector and a smoothly functioning payments system—in other words, to the existence of a sound banking system. This apparent neglect over this other set of objectives probably reflects their microeconomic and sectoral nature, that is, their focus on a single sector of the economy and on the behavior of individual agents within that sector. Traditionally, these objectives have been viewed mainly from a regulatory perspective, involving, as they do, issues of banking supervision and prudential regulation, deposit insurance schemes, and lender-of-last-resort responsibilities, aspects typically seen as separate from the broad aims of macroeconomic management. And yet, those aspects represent a legitimate policy undertaking because a sound financial system helps the monetary authority achieve its price stability objective and because a sound and stable banking system has public good qualities in its own right. For these reasons, all central banks have an interest in systemic bank soundness, even where the regulatory and supervisory responsibilities lie elsewhere.5

In this essay, I will examine the macroeconomic and microeconomic objectives of monetary management, their interconnections, and the related interdependencies of internal governance of financial institutions by their owners and managers and external governance by market forces and government intervention. To this end, I will first review the two dimensions of monetary policy and their interaction. I will then turn to a discussion of the question of the boundary between the public and private sectors—that is, the issue of how bank supervision can buttress market discipline, given the externalities that arise in the context of banking and the need to safeguard financial stability, an important public good. Next, I will focus on the practical limitations that confront policy measures aimed at banking soundness and will discuss some alternatives proposed in the recent literature, following which I will offer a few concluding remarks.

Key Aims of Monetary Management

In common with other policy areas, monetary policy management has a macroeconomic, as well as a microeconomic dimension. Attention must be paid to both if monetary policy objectives are to be not only attained but also maintained.

Price Stability

The ample literature on monetary policy and central banking has largely focused on the macroeconomic objective of stability in the value of the national currency, which is increasingly seen as equivalent to domestic price level stability.6 For example, in his recent review of modern central banking presented at the Tercentenary of the Bank of England, Stanley Fischer began with the observation that the “practice and theory of modern central banking revolve around the inflationary tendencies inherent in the conflict between the short- and long-run effects of monetary expansion….”7 While the review mentions bank supervision and its aim of stability of the financial system as one of a central bank’s functions and, indeed, one of the goals that central banks typically seek, its main theme is clearly a central bank’s responsibility for managing the supply of credit and money for purposes of price level discipline. In this sense, then, price stability has been at the center of monetary policy debate, while the microeconomic objective of a sound banking system was until very recently left in the background or overlooked.

This is not to say that microeconomic issues have been ignored in policy discussions and the academic literature. Quite the contrary, advances in the microeconomic foundations of monetary economics have been at the center of theoretical research. For example, the pioneering work on credibility by Finn Kydland and Edward Prescott (1977) underpins the heart the debate on central bank independence and the recent innovations in central bank institutional frameworks and their relevance for inflation targeting.8 Our understanding of the microeconomics of the banking industry has also evolved significantly over the past twenty years, particularly with respect to the role of asymmetric information and with discussions of the unique functions of banks in the financial sector.9 This said, though, their relevance in the context of debates about monetary policy objectives has paled relative to that granted to price level stability. The attention given to price stability has reflected a critical change in economic policy thinking during the last two decades, which is based on a broadening consensus that stable prices represent the best contribution monetary policy can make to the performance of the real economy.10 The consensus has been instrumental in helping bring about significant reductions in inflation rates in many countries.

Sound Banks and Price Stability

The attainment and maintenance of price stability, important though they are, do not exhaust the responsibilities of central banks; that is, even though they represent primary aims for the monetary authorities, they are not the only ones. It has long been recognized that appropriate macroeconomic policies are necessary to achieve balance in an economy, (a key element of which is price stability) but are not sufficient to maintain it unless supported by appropriate microeconomic conditions. Thus, policy prescriptions in general, including those developed at the IMF, increasingly incorporate structural measures aimed at improving microeconomic efficiency. Efforts to improve financial sector efficiency and soundness are often needed to support macroeconomic and monetary performance. There are, however, limits on what can be achieved through governmental policy action, and a central issue that deserves attention is that of achieving the best mix of official action and market forces to bring about a sound banking system. Such a system is typically defined as a sector made up of competitive and solvent banks, the maintenance of which can be considered a key microeconomic aim from the monetary policy stand-point. The overall microeconomic objective of a sound banking system is typically defined in terms of concepts such as solvency; however, as is the case with the macroeconomic goal of price stability, this concept involves some nuances.11 A most important question in this regard is how many vulnerable banks does it take to make a banking system unsound.12 The answer depends on the size of the banks in question as well as on the factors behind the individual bank’s fragility. If a single bank or several small banks become insolvent due to unrelated events, such as, for example, their own separate individual mismanagement, then chances are that the overall system will continue operating smoothly and that the payments system and the intermediation process will be unaffected. In this case, a policy response beyond letting normal procedures operate to ensure orderly exiting or to allow for changes in management and appropriate private recapitalization of the affected banks would not be needed. However, if the solvency problem is more widespread, either because a common factor has affected the bulk of the banks or because contagion has spread individual bank difficulties throughout the system, then a specific policy response to safeguard the system will most likely be in order.

The traditional macroeconomic aim of price stability is supported by appropriate microeconomic conditions in several ways. First of all, a sound banking system is typically needed for monetary policy signals to be appropriately transmitted throughout the economy.13 With vulnerable banks, the central bank’s expectations of the linkages between policy instruments and performance in the economy will become more uncertain than is generally the case, rendering increasingly difficult the process of setting appropriate policies. With growing problems in the banking sector, the effectiveness of policy instruments will diminish as banks become unable to respond to monetary policy signals through timely changes in their balance sheets. In addition, distortions in bank managers’ incentives on account of moral hazard and adverse selection risks will likely interfere with the transmission mechanism. They could also lead to inefficiencies in credit allocation and thus have additional negative implications for the real economy at large. On the other hand, when the banking system functions properly, the linkages between monetary policy instruments and economic performance will operate as generally expected in contributing both to policy effectiveness and efficiency.

A further constraint on macroeconomic management emanating from unsound bank positions is related to lender-of-last-resort interventions. In this case, the common policy tools, which involve changes in the central bank balance sheet, will affect the macroeconomic objective of price level stability as well as the microeconomic policy goals of safeguarding a banking system in distress. When monetary policy is rule based and aims at a particular path for monetary aggregates (or for the exchange rate), last-resort lending would be limited, if not explicitly prohibited, by the rule itself. Under more discretionary policy regimes, the monetary authority has more leeway to act as lender of last resort, but lending for microeconomic considerations could come at the expense of the desired macroeconomic policy path, particularly in situations where banking system problems are widespread and reflect insolvency more than mere illiquidity.

The relationship of sound banks to macroeconomic and monetary performance is bidirectional. Banks are “derivative” institutions in that their soundness and stability reflect those of the economy as a whole, and their own performance responds to macroeconomic policies. Awareness of this linkage might lead policymakers to respond to a problem in the banking system by deviating from their fundamental macroeconomic objective. For example, a tightening of liquidity called for by an overheating economy may not be implemented because of concern over the pressure that it may put on already weak banks by pushing up the costs of their funds.14 This problem can be all the more acute because one of the typical roles of banks is to transform maturities by holding shorter-term liabilities (deposits) against longer-term assets (loans). Without adequate hedging—which is not always available—banks are exposed to interest rate and liquidity risks. A policy tightening can cause depositors to demand higher returns or withdraw their funds, thereby placing pressure on bank earnings or liquidity. As we have seen in several cases over the last few years, a monetary tightening and the subsequent cooling of the economy can also have an impact on bank balance sheets by depressing loan values, since borrowers’ ability to repay is adversely affected. Avoidance of risks such as these may tempt policymakers to sacrifice their aim of macroeconomic balance for the sake of protecting vulnerable banks, particularly when there is a concern that doing otherwise will endanger the sector as a whole. Thus, there are interaction and feedback effects between bank soundness and macroeconomic policy choices. Conflicts between the aims of price stability and bank soundness may be more apparent than real in that they entail basically an intertemporal trade-off; this is the choice of price stability today, for example, strict pursuit of this goal without regard to its consequences for the banking sector, versus price stability tomorrow, or the specific concern for the macroeconomic consequences of a systemic banking failure. The former approach risks tomorrow’s stable price level in favor of today’s; the latter, in contrast, risks today’s for tomorrow’s.15

Global Capital Markets and Bank Soundness

Except for the few references made in passing to exchange rate stability, the above analysis is generally cast in terms of a closed economy but it can be readily extended to an open economy model. In this context, as is well known, capital inflows affect monetary conditions through changes in the exchange rate or the monetary base, or both. How—and the extent to which—these changes are transmitted to the real economy will depend on the health of the banking sector and the ability of banks to adjust their balance sheets promptly and efficiently. This argument follows the same line of reasoning outlined for a closed economy, regardless of whether or not capital flows are sterilized. An important extension in the global context is the recognition of the exchange rate as a price that can adjust—or if required, be adjusted.16 Thus, in a global setting, monetary policy can not only affect the price level and ultimately the real economy but through another channel, the exchange rate.17 In this context, the issue of banking system soundness need not be in itself of immediate importance to the extent that bank balance sheets and lending policies are not directly affected, although this is not very likely to occur in an environment open to international transactions. Even in that case, however, a sound banking system can become relevant because banks play a significant role in the provision of exchange services, which is typically the case in many countries. The parallel here to the closed economy model is the role of the banks in operating the domestic payments system. Such roles bring about positive externalities by facilitating trade—domestic and international respectively—and thus provide yet another justification for the central bank’s interest in sound banks. Finally, open capital markets can influence the incidence of monetary policy. Again, as fragility in the banking sector dampens bank responses to domestic policy signals, monetary policy is more likely to be affected by the exchange rate or the balance of payments (or both)—the latter having a direct impact on banks’ balance sheets and consequently on domestic price levels and interest rates.

An unsound banking system in an open economy can place constraints on macroeconomic policy options, just as was the case in a closed economy context. First, the central bank may be reluctant to allow an exchange rate depreciation that is needed for macroeconomic purposes when the adjustment would adversely affect weak banks. The concern here is typically that a depreciation could put direct pressure on banks with a foreign exchange asset/liability mismatch.18 Indirect pressure could also result from depreciation—triggered capital outflows and deposit withdrawals, or from a consequent reduction in the ability of bank customers to repay their foreign exchange loans. Second, as noted previously, when the monetary authority is committed to a fixed exchange rate, then the underlying monetary policy rule could constrain or proscribe lender-of-last-resort credit facilities. This would be most clearly the case in the context of a currency board arrangement, under which reserve money must be backed fully by foreign exchange reserves. Alternatively, if the monetary authority targets the exchange rate as part of a discretionary policy framework, it may be reluctant to offer lender-of-last-resort credit to weak banks, as the consequent increases in reserve money could jeopardize the attainment of the exchange objective. Actually, a general issue yet to be settled in this context is the feasibility or the constraints of a rule-based approach to monetary policy in a setting where monetary and banking activities are both progressively diversified and interconnected. And similarly, the jury is still out on the extent to which discretion in monetary management can be effective in such a setting.

The dual and mutual interaction of macroeconomic and monetary policy with banking soundness observed in the domestic context, therefore, applies also in an open economy setting. Although they bring with them new opportunities for profit, open capital markets can also become potential sources of pressure on the banking system. For example, a rapid buildup in deposits stemming from capital inflows could potentially result in high-risk loans being added to the bank’s portfolio or could heighten risks by increasing currency or maturity mismatches, especially if the capital inflows are in short-term instruments. On the other hand, if the central bank attempts to sterilize those inflows, higher domestic interest rates could strain bank balance sheets. Intertemporal trade-offs similar to those described earlier in the context of a closed economy arise here in terms of exchange rate stability today versus tomorrow, of course.

Microeconomic Aspects of Bank Soundness

Banking soundness as a subject involves the following three aspects that reflect the role of banks in a modern market economy, all of which are of interest for central banks. Each of them has an element of a public good or gives rise to an externality that potentially calls for governmental oversight and intervention.

  • An efficient and stable payments system to facilitate transactions throughout the economy, and with money as a medium of exchange, to free economic transactions from barter. The payments system must be robust because agents will only use it if they believe that they will not lose value in the transaction process.

  • Intermediation between savers and investors to improve economic efficiency by helping to clear market for sources and uses of funds. Banks provide a valuable information service by screening investment projects and by bringing savers and investors together.

  • Financial market development, a process to which a sound banking system typically contributes. As uncertainty is reduced and confidence increases, other financial markets may develop, further increasing opportunities to match investable funds with commercial projects.

Besides the safeguard and promotion of the above institutions and processes, government oversight and intervention through appropriate regulation and supervision can also be justified on the more general grounds of the unique nature of information. Information is a pure public good in that its consumption by one person does not reduce the supply to another.19 In the domain of banking, information comes into play on both the asset and liability sides of the ledger. On the liability side, a deposit is in essence an exchange of money today for a promise of its return, with interest, in the future. The future payment involves risk that can be assessed with information on the deposit bank. On the asset side, a bank loan typically requires knowledge about the borrower and his ability to repay. Availability of information is not similar, however, and banks are normally better equipped and in a better position to elicit and assess information from their potential borrowers than depositors are to obtain and evaluate it from banks. Thus, even though ultimately information can rarely be kept secret—a depositor seeing his neighbors withdrawing funds from their bank will in some circumstances conclude that the bank is not a safe place to keep money—it does exhibit an asymmetry that calls for a role by government in the form of oversight on banks to compensate for it.

Boundary Between the Private and Public Sectors

For a long time, the economic literature has recognized the difficulty of drawing a proper boundary for government action and of describing the limits of economic policy.20 Indeed, the issue of the optimal degree of government involvement in the economy is likely to remain unsettled, if only because the question of where to lay the appropriate boundary between the public and private sectors is dynamic and varies among countries and within a country over time. It depends on several issues, among them social preferences for public services and the corresponding willingness to finance them, neither of which are time-invariant; on the interaction between the two sectors of the economy, in particular, on the impact of government on private decisions; and on technology and innovation. Tensions in the overall interaction between the public and the private sectors typically derive from governments’ tendency to exploit short-term policy trade-offs, with consequent adverse effects on credibility; but they also arise as a result of the private sector’s tendency to appropriate for itself the benefits but seek to shift the costs of its decisions to the public sector, that is, the general taxpayer.

Public sector involvement in banking is not exempt from these tensions. Globalization, innovation, and deregulation have clearly given impetus to reexamine the role of government in the banking and financial sector through regulation, supervision, and its ability to complement market forces. Public demands for deposit protection and concerns over how it should be structured and financed are clearly behind this impetus. The key questions, therefore, are the extent to which official banking supervision can be used to bolster market discipline, what the pitfalls to be avoided are, and which strategies are likely to offer the best results.

Rationale and Limits of Intervention

The textbook case for government involvement is made along three lines. First, on public goods grounds, such as national defense, clean air, and information. Goods of this nature should be provided collectively because all in society benefit and no one can be excluded from their consumption. Second, where conditions for a competitive equilibrium do not prevail, the associated market failure may justify government intervention in the form of corrective action to bring about an efficient outcome. And third, from the perspective of macroeconomic policy management, government intervention can be justified—or at least suggested—as a potential benefit to society as a whole. In this context, a stable economic environment can be considered a public good.

In these respects then, government involvement in the economy can be of benefit, but there can also be limitations and associated costs.21 In addition to the potential inefficiency of government activity, micro-economic analysis has shown that public involvement can distort private incentives. A classic example is the distortion to capital allocation and to labor decisions that may be caused by the structure of a tax system. More generally, moral hazard will tend to arise when there is uncertainty regarding the dividing line between private and public sector activities and responsibilities. The underlying prospect is that whenever discretionary policies allow for private risks to be shifted to the public sector, that is to the taxpayer, private agents will likely seize the opportunity and take on excess risk.22

Intervention in the Banking Sector and Moral Hazard

Because of its role in the payments and exchange systems and the positive externalities associated with financial intermediation, the services provided by a sound and stable banking sector are usually regarded as a public good. And as already pointed out, the asymmetry of information between banks and depositors and between banks and their borrowers can result in various forms of market failure. To these, we have to add the importance of bank soundness for monetary policy and macroeconomic management effectiveness. On all these grounds, some degree of government involvement is called for in the banking area, depending on public preferences and the scope for market failure that prevails in any given economy. As already noted, deregulation, globalization, and innovation have also given impetus to the reexamination of the role of government in the banking and financial sectors.

The traditional approaches to foster bank soundness combine deposit protection schemes, lender-of-last resort-facilities, and official supervision. All of them, however, are prone to giving rise to incentive problems and consequent moral hazard risks.23 Deposit insurance and lender-of-last resort support can limit the incentive of depositors and other creditors to monitor the performance and position of banks, to the extent that there are expectations that potential losses to depositors will be covered by the deposit insurance fund and that banks in distress will receive liquidity support from the central bank. Moreover, official oversight can have a similar effect if depositors and other bank creditors neglect assessing the situation, performance, and prospects of banks because they assume that official supervision is sufficient to ensure the health of the banking sector.

These drawbacks of the traditional approaches can be addressed in part through market discipline by undertaking measures to promote it, by devising regulatory and supervisory strategies that replicate as close as possible market forces. Deposit protection, for example, can be limited to safeguard small household accounts, so that beyond announced maximum caps, depositors will not be compensated; this will tend to shift the incentive to monitor banks back toward deposit holders.24 For such a shift to be effective, though, the rules governing deposit protection schemes and the line of demarcation between public and private responsibility, besides being absolutely clear, must be credible. Similarly, the norms for lender-of-last-resort activities are best spelled out with enough transparency in advance, so that stakeholders, including depositors, and other bank creditors, as well as bank managers and owners, do not operate under the assumption of anticipated support. The difficulty here is the bias toward intervention that accompanies situations where systemic repercussions appear likely. After all, monetary authorities can hardly be expected to wait and see whether ex post facto those systemic threats do or do not materialize. Yet, there is in this area also an argument for policy rules. Without clear rules, banks and the public at large may come to expect support to a weak banking system either through direct central bank lending or through an accommodative monetary policy stance.25

Addressing moral hazard through transparent and clear norms on the scope of central bank intervention to save failing banks entails setting constraints on such activities, even though a clear idea of an optimal intervention is difficult to obtain.26 But there are a few notions that can be stressed from the outset; for example, that prudential regulation and official supervision cannot prevent all bank failures. Nor should they, as such an attitude would perpetuate the operation of weak and inefficient institutions, thus exacerbating moral hazard. The appropriate strategy in this area is to combine official oversight with reliance on market discipline so as to provide appropriate incentives to depositors, creditors, bank managers, and shareholders. This combination will involve governmental efforts to support market forces in the provision of information to the public at large, both directly and more importantly, through the adoption of strict disclosure rules, such as those in effect in New Zealand.27

Here too there are questions regarding costs and effectiveness, particularly in settings where accounting standards and practices are deficient, or where market structures might preclude the operation of a firm exit policy. In principle, economic analysis can be used to appraise the trade-offs involved in the interaction of government with market forces. For example, the efficiency costs of full lender-of-last-resort support can be gauged against the gains of a more sound banking system. But experience demonstrates the difficulty of this endeavor. Indeed, the large number of banking sector problems over the past two decades underscores how much remains to be learned about the government’s role in this area and, more important, about ways in which official oversight can complement internal bank governance and support as well as replicate market forces.

Practical Limitations of Regulation and Supervision

Given the difficulties in establishing a clear boundary for public sector involvement and in avoiding the consequent risk of moral hazard in private sector behavior, it could be argued that the best course of action would be to rely exclusively on market discipline. However, for the reasons already described, governments have shied away from allowing market forces to become the only guide for financial market activities and the only determinant of their outcome. Instead, countries have generally established some form of official oversight of their banking systems. The challenge governments contend with on this issue is to continuously adapt their oversight frameworks to changing circumstances. At present, the evolution of modern financial systems are rendering that challenge even more difficult as the speed of innovation in financial transactions accelerates, as does the progressive integration of national economies into a global setting.

Internal Controls, Market Forces, and Prudential Regulation

The Barings incident in 1995 highlighted the practical limits of what can be expected from official oversight. But it also underscored the need for persistent vigilance and the adaptation of prudential norms and supervisory practices to ever-changing activities of financial institutions. Barings was a case where the standard procedure of separating back office and trading operations was not followed, and both internal and external auditors failed to signal the procedural violation. The resulting moral hazard occurred at the operational level (with the trader) rather than with management, although the firm’s compensation policies encouraged the problem. Nevertheless, Barings was not a case where the interests of management and the external supervisors deviated; both would have wanted to have caught the “rogue” trader. Although in this specific case it is clear there was a failure in internal control systems, a general inference can be drawn that as financial institutions and their incentive packages, as well as the services they offer become more complex, it becomes harder for internal and external oversight to control all risk factors. In other words, in today’s integrated world financial environment, it will be important to make clear to policymakers and the general public that even when appropriate, let alone when they are faulty, internal controls, market discipline, and regulation and supervision cannot prevent all bank failures.

Similarly, financial innovation presents new challenges to all parties, and raises the question of whether the risks associated with new financial instruments and operations need to be addressed through new approaches to promote bank soundness. Derivative trading, for example, is not inherently riskier than spot trading; the payoffs of derivatives depend, after all, on the underlying instruments. Still, derivatives are typically leveraged, and they allow traders to take excessive risks through large positions; they can also be used to evade monitoring systems, particularly where managers, auditors, and supervisors are less familiar than the traders with the markets and instruments. Thus, an important issue is that managers, investors, and regulators may all have difficulty in keeping up with new financial products and in understanding the risks they carry. Yet, as Alan Greenspan has pointed out (1997), “if it is technology that has imparted occasional stress to markets, technology can be employed to contain it.”

Globalization poses special problems as well. First, global competition is contributing to an evolution in banking that is moving toward a less clear distinction between universal and specialized banks and a blurring of the separation between banks and other financial intermediaries, such as security firms and insurance companies. Second, the complexity of banking activities and operations increase when they extend to the international arena, posing difficult challenges to bank managers, owners, and regulators in the fulfillment of their respective responsibilities. Finally, banks operating in several countries can “arbitrage” between regulatory frameworks by undertaking operations in locations where regulations are most favorable for them. Containing the scope for such arbitrage is an important task that requires international harmonization of national rules.

Policy Adaptations

Policy adaptations to address the growing challenges faced by regulators are evolving along several lines. First, internal governance measures can be taken that will enhance market discipline. Data publication and disclosure standards, such as those recently instituted by the IMF in the macroeconomic sphere, as well as those set out by International Accounting Standards (IAS) and the recent recommendations by the Basle Committee of Banking Supervision on disclosure of bank operations in derivatives, will raise the quality of bank governance, while at the same time help strengthen market discipline. The rationale here is that with increased and improved information, bank managers will perform more efficiently, and investors and depositors will be better able to monitor the institutions with which they deal.

Reinforcing certain prudential norms can both directly require banks to strengthen their financial position and also enhance incentives for bank owners and managers. For example, an increasing number of countries have adopted the Basle Committee capital adequacy standard, which not only calls on banks to maintain sufficient capital to cover potential losses, but also forces owners to put their own funds at stake, thus fostering their incentives to ensure banks are well operated. Acknowledgment of the role of market risk and the complexity of its measurement has led the Basle Committee to amend recently its 1988 Capital Adequacy Accord. The amendment recommends that banks be required to hold additional capital according to their exposure to market risk, which can be measured using either a standard or a proprietary model. This recommendation underscores the importance of appropriate statistical models to measure and monitor risk in financial institutions as a key support for the judgments that are critical for risk management.

Perhaps most important, a consensus is developing to give an increased emphasis to the need to ensure that internal governance and controls will not run counter to market discipline. This focus is justified because it is ultimately the responsibility of bank managers and owners to operate a sound bank and these parties are likely to understand their institutions’ operations best. It is now generally accepted that incentive structures must be set up to enhance internal controls.28 Since most breakdowns occur when agreed procedures are not properly followed or implemented, accountability is essential and managers should be responsible for failures in their internal controls systems. Indeed, adherence to procedures should be monitored by internal auditors, with positions within the organization that accord to them a considerable degree of independence in the corporate structure. External supervisors can then focus on monitoring these arrangements. Last, but not least, market forces must be allowed to play their role. Without them, internal governance and official oversight will not be sufficient. Market discipline, to have its expected effect on economic performance, will have to be allowed to identify inefficient banks as well as the corresponding shortcomings in official supervision.


In general, price stability has been broadly recognized as the primary, if not the only, objective of monetary policy. Bank and banking system soundness, though also seen as important aims and therefore as matters of concern to central bankers, are relatively neglected goals. Partly because of the large incidence of banking problems, attitudes have recently changed, but also in reflection of the significant progress made in many countries in reducing their inflation to relatively low rates. Systemic bank soundness is now seen as a component of monetary management, as a complement to macroeconomic policy in general, and as a policy objective in its own right for the pursuit of economic balance and stability. To put it cryptically, sound money and sound banking go hand in hand.

How a sound banking system can be developed and sustained is therefore an important issue. Clearly, the ideal would be a market-based financial sector, in which private investors operate efficient banks and are accountable for their shortcomings. However, the presence of market failures combined with the public good characteristics and externalities stemming from the unique nature of banking activities does justify government intervention in the form of prudential regulation and supervision to bolster proper bank management, underpin market forces and correct for market failures, whenever these arise.

In today’s environment, deregulation, globalization, and product innovation are making the job of bank regulators and supervisors more complex. Prompted in part by the potential problems implied by these changes—not to mention the banking crises witnessed over the past few years—policymakers and researchers are now searching for explicit means to have supervision replicate market forces and to reinforce market discipline as well as to strengthen internal bank governance. These include accounting and disclosure norms to help depositors and investors assess bank efficiency and safety; a broadening of the range and scope of internationally accepted banking guidelines; and enhanced oversight of internal control processes. These means, combined with improved risk measurement methods through appropriate statistical models to guide bank management decisions and with incentive structures designed to contain excess risk taking, can go a long way toward fostering bank soundness.

But will all this be enough?29 It can hardly be denied, as a general proposition, that availability and disclosure of financial information are indeed relevant as ingredients toward banking efficiency, and all the more so in a setting of closely integrated international financial markets; actually, the case for the collection and broad dissemination of appropriate financial data is unassailable. Such data are as necessary for internal bank management as they are for the markets to be in a position to exercise discipline and for official supervisors to formulate their judgments. Similarly, the existence and broad observance within and across nations of proper prudential and supervisory norms as well as the pursuit of sound banking practices help provide a level playing field for banks, for market forces and for bank regulators, thus containing the margin for undue competitive wedges and the scope for regulatory arbitrage in search of a common denominator that may fall short of efficiency and equity requirements. And the introduction of adequate risk measurement techniques and efficient incentive structures will promote soundness and stability in banking.

This said, though, two important caveats must be made. One is that internal governance, official oversight, and market discipline will not be sufficient to eliminate the prospect of bank failures. All they can do is reduce their incidence and lower their probability. Another is that those three pillars of bank soundness will have to play their own role and cannot substitute for one another. When properly exercised, internal governance and external oversight combine with market forces to bring about efficiency in banking. In that sense, the whole is more than the sum of its three parts. As in many other areas of economic endeavor, in their functioning, the three elements exhibit aspects of substitutability as well as of complementarity. For example, market forces can and will compete with official oversight as a means to bring about proper bank governance. But official oversight, in promoting sound banking practices, provides market forces with useful guidance for the assessment of the appropriateness of bank management. And good bank governance eases the tasks of official oversight and bolsters market forces. Jointly, these three elements provide a key input toward the attainment of efficiency with stability in banking. The challenge here is to enhance their complementarity without impairing their substitutability, that is, their competitiveness. This will be, it hardly needs saying, a most difficult endeavor that entails striking an appropriate balance between the roles that bank governance, official oversight, and market discipline will be expected to play. This balance, which need be the same neither in all countries nor in a single country over time, is moving toward greater scope for market forces in the domain of banking supervision, a tendency similar to those that have developed in other areas of economic activity.


    Alexander, William E., and FrancescoCaramazza,1994, “Money Versus Credit: The Role of Banks in the Monetary Policy Transmission Process,” in Frameworks for Monetary Stability: Policy Issues and Country Experiences, ed. byTomás J.T.Baliñio and CarloCottarelli (Washington: International Monetary Fund).

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See Manuel Guitián (1994a).

Payments systems and bank restructuring are subjects of concern to central banks because of their importance for the maintenance or the resumption of the proper functioning of the domestic banking sector. Central banks play a key role in large value or interbank payments systems in their setting standards for controlling the risks they entail as well as in providing finality, certainty to payments and, when appropriate, liquidity to support the system. Such liquidity provision and the implementation of proper bank restructuring strategies are key components of the systemic responsibilities of central banks. See Alan Greenspan (1997).

Price stability is a key general economic policy goal itself; it can also be seen as a critical factor for securing the highest level living standards in the long run. This said, though, there is an ongoing debate on the relationship between monetary policy and short-term output stabilization and growth. For a recent examination of this relationship, see Guitián (1996a). The issue of exchange rate stability as a monetary policy goal has been discussed in Guitián (1994b).

In Guitián (1993), the importance of these two interdependent monetary policy objectives is stressed, as is the relevance of a sound financial system for monetary control. Goldstein and Turner (1996) underline the ability that macroeconomic and financial policy have to complement each other. Goodhart and Schoenmaker (1993) look at the relationship between the two policy objectives, including the scope for a trade-off in their attainment. In this context, they examine the case for separating bank supervision responsibilities from the monetary policy activities of the central bank on the grounds of the possibility of conflict between the two policy objectives.

Such a view focuses on stability in the internal value of the currency. The external dimension of such stability, that is, the exchange rate, carries less support as an objective of domestic monetary policy; see Guitián (1994b) for further elaboration, Tommaso Padoa-Schioppa (1996) characterizes the modern evolution of monetary policy as a shift from discussions of the inflation-unemployment tradeoff and the choice of control instruments to the institutional aspects of central banking. The goal of price stability, while attributed to central banks as far back as some 200 years ago, was given added significance during the high inflation episodes in the 1970s.

See Fischer (1994); this paper contains an excellent survey of the current issues in monetary policy and central banking.

See Guitián (1995) for a discussion of the importance of central bank independence and Green (1996) for a review of inflation targeting and its policy implications. See also Persson and Tabellini (1994) for an excellent collection of articles on the economics of monetary policy and credibility.

See Fama (1985) for further elaboration.

The scope of the consensus is broader, encompassing the role of government and the limitations of policy. For a brief review of this subject see Guitián (1996a).

For the macroeconomic objective, one nuance revolves around the practical definition and measurement of price stability. Federal Reserve Chairman Greenspan has defined price stability as the inflation rate that has no impact on private decisions and he has recently elaborated on the ambiguity that presently surrounds the notion of prices; see Greenspan (1997). See also Fischer (1996) for a summary of research on desired rates of inflation and Sarel (1996).

See Gonzalez-Hermosillo (1996) for a discussion of bank unsoundness and systemic vulnerability.

See Alexander and Caramazza (1994). See also Lindgren, Garcia, and Saal (1996) for a more detailed review of the macroeconomic consequences on bank unsoundness. Johnston and Pazarbaşioĝlu (1995) provide evidence linking banking fragility to low economic growth.

This is the essence of the case for separation of supervisory from monetary management responsibilities.

There are moral hazard risks in either approach. One relates to the credibility to be attached to a monetary policy that neglects banking sector conditions; the other relates to the consequences for inflationary expectations of a short-term departure from inflation targets.

This analysis depends on the exchange regime that prevails in the economy. Under a fixed rate regime, capital flows will affect the central bank’s balance sheet and by definition, there would be no impact on the exchange rate. See Guitián (1973 and 1974c). For an examination of capital account liberalization issues, see Peter Quirk and others (1995).

This assumes that the exchange rate is also an objective of monetary policy—that is, that exchange policy is in the domain of the central bank. See Cottarelli (1994) for a discussion of this point in the context of central bank independence.

Gonzalez-Hermosillo (1996) discusses the links between foreign exchange and bank soundness.

See Stiglitz (1992) for elaboration on this point.

See, for example, John Stuart Mill’s Principles of Political Economy (1965), In Guitián (1997), I have discussed the issues of the scope of government and the limits of economic policy in a more general context.

In the area of macroeconomic management, growing doubts have arisen on the government’s capability to steer the economy in a predetermined direction. Those doubts have been brought about by empirical evidence to the contrary as well as by developments in rational expectations and credibility theory, all of which led to reduced expectations on the government’s ability to ensure the achievement of macroeconomic objectives.

As pointed out in Guitián (1997), there are serious fiscal considerations whenever the public sector takes on private risks.

In a recent speech, Greenspan (1997) describes these risks as those that reflect the wedge created when decision makers collect the benefits but do not bear the full costs of their actions.

See for elaboration, Garcia (1997).

There are complex issues at stake here, and often it is argued that constructive ambiguity is a better principle than transparency to follow in the exercise of lender-of-last-resort responsibilities. Such exercise always calls for an important measure of judgment, which some believe means “keeping the market guessing,” and others think requires providing the market with “clear guidance.”

This would be equivalent to ascertaining an optimal level of bank soundness. Greenspan (1988) addresses the issue in terms of the social benefits of risk. See also Rivlin (1996).

See Nicholl (1996) and Brash (1997) for descriptions of New Zealand’s supervisory arrangements and new disclosure regime for commercial banks.

See Goodhart (1996) for further elaboration.

For a discussion of certain aspects of these questions see Guitián (1996b).

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