- Garry Schinasi
- Published Date:
- December 2005
© 2006 International Monetary Fund
All rights reserved.
Production: IMF Multimedia Services Division
Cover design: Lai Oy Louie
Cover photo: Bruno Budrovic, © Images.com/CORBIS
Schinasi, Garry J.
Safeguarding financial stability : theory and practice / Garry J. Schinasi — Washington, D.C.: International Monetary Fund, 2005.
Includes bibliographical references and index.
1. Finance. 2. Banks and banking, Central. 3. Risk. I. International Monetary Fund.
Disclaimer: The views expressed in this work are those of the author and do not necessarily represent those of the IMF or IMF policy.
Please send orders to:
International Monetary Fund, Publication Services
700 19th Street, NW
Washington, DC 20431 USA
Telephone: (202) 623-9730 Telefax: (202) 623-7201
I dedicate this book to my parents, Jack (deceased) and Josephine Schinasi.
Here’s what the experts are saying about
Safeguarding Financial Stability
Theory and Practice
By Garry J. Schinasi
“Safeguarding Financial Stability explicates why financial stability matters, what it means, and the challenges in securing it.... [It is] a thoughtful and thought-provoking volume that is a must read not just for central bankers but for all concerned with financial stability—and if you are not concerned about the latter, you soon will be!”
—Gerard Caprio, Jr., World Bank
“Garry Schinasi provides a unique and comprehensive framework for understanding financial stability and for assessing the risks posed by new financial instruments in increasingly unregulated markets in an increasingly globalized world. The channels of monetary policy management have changed tremendously, as anyone who follows the striking stability of long-term bond yields in the face of rising short-term interest rates will attest. The global business cycle is maturing, entering into a period of high financial risk, as discussed by Dr. Schinasi. Anyone who does not read this book today will regret not doing so, as the next financial shock and test of the stability of the global financial system is not long in coming.”
—Gail D. Fosler, The Conference Board
“The economic and institutional transformation of central banking that has taken place over the past four decades has been driven mainly by monetary policy issues. However, it has profoundly affected another historical mission of central banks—the preservation of financial stability. Financial stability is gradually emerging as a distinct policy function, requiring its own body of scholarship, not to be confused with monetary policy on the one side, and supervision on the other side, although it is related to both.
“Building an analytical approach and a policy paradigm consistent with this new setting as well as with the changing landscape of financial markets and institutions is one of the tasks of today’s research and policy agenda.
“Garry Schinasi takes us a big step forward in the fulfilment of this task. His book Safeguarding Financial Stability represents a brilliant attempt to provide solid and updated foundations to policies aiming at financial stability. The book is based on a thorough acquaintance with the literature, understanding of the real world, analytical skill, sense of the policy issues, familiarity with the diversity of country situations, and good judgement.
“The book can already be considered required reading for anyone interested in the subject of financial stability. Its clarity makes it accessible to practitioners as well as policymakers. At the same time, the book will stir debate and further research in academic circles.”
—Tommaso Padoa-Schioppa, European Central Bank
“…this is a great book. It synthesizes a large literature on financial stability,… and it fills in a number of crucial holes…. I think it will be remembered as the first concrete attempt to analyze, define, and move toward operationalizing assessment of financial stability.”
—R. Todd Smith, University of Alberta
- Part I: Foundations
- Part II: Toward a Framework for Financial Stability
- Part III: The Benefits and Challenges of Modern Finance
- 8 Challenges Posed by the Globalization of Finance and Risk
- 9 Systemic Challenges Posed by Greater Reliance on Over-the-Counter Derivatives Markets
- 10 The Market for Credit Risk Transfer Vehicles: How Well Is It Functioning and What Are the Future Challenges?
- 11 Systemic Implications of the Financial Market Activities of Insurance and Reinsurance Companies
- 12 Ongoing National and Global Challenges
- About the Author
- List of Tables
- 1.1 Changes in Key Financial Aggregates
- 1.2 Distribution of Financial Sector Mergers and Acquisitions, 1991–1999
- 1.3 Cross-Border Transactions in Bonds and Equities
- 1.4 Outstanding International Debt Securities by Nationality of Issuer
- 1.5 Exchange-Traded Derivative Financial Instruments: Notional Principal Amounts Outstanding and Annual Turnover
- 1.6 Market Turbulence and Crises in the 1990s and Early 2000s
- 2.1 Finance as a Temporary Exchange of Services
- 2.2 Relative Values of Services
- 3.1 Typology of Benefits from Goods, Based on Characteristics of the Goods
- 6.1 Source of Risk to Financial Stability
- 6.2 IMF Financial Soundness Indicators: Core and Encouraged
- 6.3 Policy Instruments for Financial Stability
- 8.1 Cross-Border Transactions in Bonds and Equities
- 8.2 International Equity Issues by Selected Industrial and Developing Countries and Regions
- 8.3 Outstanding International Debt Securities by Nationality of Issuer for Selected Industrial and Developing Countries and Regions
- 8.4 Major Industrial Countries: Bank Deposits of Commercial Banks
- 8.5 Major Industrial Countries: Bank Loans of Commercial Banks
- 8.6 Major Industrial Countries: Tradable Securities Holdings of Commercial Banks Assets
- 8.7 Major Industrial Countries: Financial Assets of Institutional Investors
- 9.1 Top 20 Derivatives Dealers in 2004 and Their Corresponding Ranks in 2003
- 9.2 Global Over-the-Counter Derivatives Markets: Notional Amounts and Gross Market Values of Outstanding Contracts by Counterparty, Remaining Maturity, and Currency
- 11.1 Life Insurance: Premium Growth Rates
- 11.2 Profitability Decomposition of Major Nonlife Insurance Markets
- List of Figures
- 1.1 Composition of Key Financial Aggregates in 1970 and 2000
- 1.2 Growth of Key Financial Assets, 1970–2004
- 1.3 Financial Sector Mergers and Acquisitions, 1990–1999
- 2.1 Evolution of Modern Finance
- 4.1 Private Demand and Supply Equal to Social Demand and Supply
- 4.2 Private Marginal Benefit Below Social Marginal Benefit
- 4.3 Private Marginal Cost Below Social Marginal Cost
- 4.4 Stable Disequilibrium
- 6.1 Stylized View of Factors Affecting Financial System Performance
- 6.2 Framework for Maintaining Financial System Stability
- 9.1 Structure of OTC Derivatives Markets, End-December 2003
- 10.1 Global Credit Derivatives Market Size and Structure
- 10.2 Key Characteristics of Credit Derivatives Markets
- 10.3 Spread Between Credit Derivatives Premium and Underlying Bond Spread
- 11.1 Shares of Total Financial Assets of Institutional Investors and Banks: United States and Japan
- 11.2 Shares of Total Financial Assets of Institutional Investors and Banks: Selected Euro Area Countries and the United Kingdom
- 11.3 Holdings of Financial Securities by Insurance Companies and Banks
- 11.4 Holdings of Securities Relative to Market Size
- 11.5 United States: Corporate and Foreign Bonds
- 11.6 Balance Sheet Assets of Insurance Companies: United States and Japan
- 11.7 Balance Sheet Assets of Insurance Companies: Selected Euro Area Countries and the United Kingdom
- 11.8 Global Insurance Industry Results
- 11.9 Nonlife Insurance: Combined Ratios in the Industrial Countries
- List of Boxes
- 3.1 Prisoner’s Dilemma
- 3.2 Sources of Market Failure in Finance
- 3.3 Samuelson’s Store of Value as a “Social Contrivance” Providing a Public Good
- 6.1 Remedial Action: Dutch Housing Market Boom in the 1990s
- 6.2 Crisis Resolution: Terrorist Attacks on September 11, 2001
- 9.1 The Role of OTC Currency Options in the Dollar-Yen Market
- 9.2 Long-Term Capital Management and Turbulence in Global Financial Markets
- 9.3 The Role of Derivatives in Crises in Emerging Markets
- 9.4 Sources of Legal Uncertainty in the U.S. Regulatory Environment
- 10.1 Financial Implications of Enron’s Bankruptcy
This book was written because I could not find one like it in bookstores or in central bank libraries. In effect, it fills a gap—albeit imperfectly—in the existing policy, academic, and commercial literatures on financial stability issues.
The motivation for undertaking this project came to me in early 2003, after having spent nearly 10 years engaging in international capital market surveillance—first in the IMF’s Research Department (both as Deputy Chief and Chief of the Capital Market and Financial Studies Division) and then in the newly created International Capital Markets Department (as Chief of the Financial Markets Stability Division). Part of the challenge of the job was to understand the implications of structural changes in finance (including financial institutions, markets, and infrastructures), which required talking to market participants and the relevant authorities (including central banks and supervisory authorities). The job always entailed keeping management and colleagues well informed about capital market developments, prospects, issues, and most important, sources of risks and vulnerabilities.
The time spent searching for potential risks and vulnerabilities (or “potholes” as we called them) in the international monetary and financial system, especially in the more mature markets, challenged my colleagues and me to search continuously for new ways of understanding how calm market conditions can lead to turbulence, why changes in market sentiment often occur without much warning, and how the private and official sectors can adapt and learn to prevent and better cope with financial difficulties and crises. By mid-2003 I felt it was time to step back from the events as they were occurring and to reflect more systematically—and with less pressure—on what kind of framework would advance the understanding of financial stability issues, how to communicate the importance of these issues, and how to encourage and energize a greater focus on optimizing the benefits of finance for societies at large.
Before actually reaching the decision to take a one year sabbatical from the IMF, I challenged myself to produce an outline of a study on financial stability issues that I was fairly certain I could write, if given sufficient free time. Instead, I produced an outline of a book that I wanted to read, but which I was uncertain I was capable of writing. I will leave it to the reader to decide whether the outcome was worth the effort. My only hope in publishing this study is that practitioners—that is, those who safeguard financial stability—will be motivated to think about these issues in a new and more productive way and that the relevant professions will be encouraged to develop useful, policy-oriented frameworks for achieving and maintaining national and international financial stability.
This study was researched and partly written during a one-year sabbatical from the International Monetary Fund (IMF). I gratefully acknowledge the IMF’s generous financial support under its Independent Study Leave Program.
I also gratefully acknowledge the support and encouragement of the European Central Bank (ECB) and De Nederlandsche Bank (DNB) while visiting them in 2003 and 2004, and would like to thank especially Tommaso Padoa-Schioppa, Mauro Grande, and John Fell at ECB and Henk Brouwer, Jan Brockmeijer, Aerdt Houben, and Jan Kakes at DNB.
Chapters 2, 3, 5, and 6 are based, in part, on material researched and presented in various drafts of several papers (which were later revised and repackaged and issued as IMF Working Papers WP/04/101, WP/04/120, and WP/04/187). These and other related papers benefited from discussions with, and comments from, many colleagues both within and outside the IMF. These include Bill Alexander, Ivan Alves, Michael Bordo, Burkhard Drees, Christine Cumming, Udaibir Das, Phil Davis, Charlie Kramer, Myron Kwast, John Fell, Bob Flood, Andy Haldane, Aerdt Houben, Jan Kakes, Russell Kincaid, Donald Mathieson, Leena Mörttinen, Tommaso Padoa-Schioppa, Lars Pedersen, Eric Peree, and James R. White. I also received useful comments during seminars at ECB, DNB, the European Investment Bank, the University of Hong Kong, and from other IMF colleagues during the review process for IMF working papers.
The chapters presented in Part III of this study are based, at least in part, on material that was originally cowritten with IMF colleagues and published in various editions of the IMF’s International Capital Markets—Developments, Prospects and Key Policy Issues during 1995–2001, and Global Financial Stability Report during 2002–2003. I would like to acknowledge the following coauthors for their contributions to this earlier work and the more recent manifestations of it presented in this study: Charlie Kramer (Chapters 9, 10, and 11); Burkhard Drees (Chapter 9); Todd Smith (Chapter 10); Peter Breuer (Chapter 11); and Oksana Khadarina provided essential assistance in preparing the quantitative part of Chapter 8. I am also grateful to my coauthors Aerdt Houben and Jan Kakes (of DNB) for allowing me to use material from our joint IMF Working Paper WP04/101 and DNB Occasional Paper, “Toward a Framework for Safeguarding Financial Stability,” which we jointly researched, brainstormed, and drafted during a four-month period ending in mid-February 2004, and which makes up part of Chapter 6. I am grateful to my coauthor John Fell for allowing me to use material from our joint paper, “Assessing Financial Stability: Exploring the Boundaries of Analysis,” published in a special financial-stability edition of National Institute Economic Review (April 2005). I am especially grateful to John Fell for providing a fertile environment at ECB for the early stages of my work and for his persistent encouragement to complete this project. In all other instances in which I use material drawn from the work of colleagues both within and outside the IMF it is acknowledged in footnotes. I am grateful to Oksana Khadarina for untiring efforts in producing and updating the tables and charts and also to Yoon Kim for assisting in a part of this effort. Special thanks to Margo and Tom Vuicich for providing a sunny environment for thinking and writing part of this study.
Thanks are due also to Jeanette Morrison, Anne Logue, and Sherrie Brown for their editorial and publishing expertise. I am particularly grateful to Sean M. Culhane for providing expert professional advice and encouragement during each phase of the editorial and production process.
I owe thanks to Michael Mussa (IMF Economic Counsellor and Director of Research, 1993–2001) and David Folkerts-Landau (Assistant Director of Research until 1998) for providing me with the opportunity to be a part of the IMF’s international capital markets surveillance team in 1994–95.
Finally, I thank Katherine, Jack, and Sarah for their loving support throughout these and many other efforts.
alternative risk transfer
collateralized debt obligation
credit default swaps
Commodity Futures Trading Commission
Continuous Linked Settlement
Employee Retirement Income Security Act
Financial Sector Assessment Program
gross domestic product
guaranteed investment contracts
ruble-denominated discount instrument
Hong Kong Monetary Authority
International Association of Insurance Supervision
International Swaps and Derivatives Association
London Inter-Bank Offer Rate
Long-Term Capital Management
nondeliverable forward (market)
Office of the Comptroller of the Currency
ruble-denominated coupon bonds
over the counter
Special Administrative Region (Hong Kong)
Securities and Exchange Commission
special purpose vehicle
Trans-European Automated Real-Time Gross Settlement Express Transfer System