Over the past two decades, central banks have steadily become more powerful. Until the late 1980s, only the U.S. Federal Reserve, the German Bundesbank, and the Swiss National Bank were legally independent. With the surge in global inflation in the 1970s and 1980s, many central banks were given a clear mandate to tackle the problem. But low inflation does not guarantee financial stability, and now central banks face an additional challenge: preventing booms and busts in economic activity caused by large swings in asset prices. In a new Working Paper, Garry J. Schinasi, Advisor in the IMF’s International Capital Markets Department, takes a closer look at the evolving role of central banks in the quest for financial stability. He spoke with Christine Ebrahim-zadeh of the IMF Survey about his paper, which draws on the experiences of Europe, Japan, and the United States.

IMF Survey: Why are you looking at this issue now?

Schinasi: The role of central banks in ensuring financial market stability has been an important issue for some time. In the early 1980s, Paul Volcker—then Chair of the Board of Governors of the U.S. Federal Reserve System—told the U.S. Congress that the Federal Reserve System was, first, the ensurer of financial stability and, second, the manager of monetary stability. The timeliness of this issue has been confirmed by several recent events: the establishment of the European Economic and Monetary Union with centralized decision making about monetary policy and decentralized decision-making about financial system policy; the creation of an integrated financial supervisory authority in Japan; and the separation, in the United Kingdom, of banking supervision from the Bank of England.

IMF Survey: What do we mean by financial stability? Is it more than the absence of crises?

Schinasi: Financial stability should be defined in terms of the system’s ability to (1) facilitate an efficient allocation of economic resources—within an economy, across economic sectors, and over time—and to price and allocate economic and financial risks; (2) facilitate the effectiveness of other economic processes, such as wealth accumulation and economic growth, which are the source of social prosperity; and (3) perform key functions by responding to external shocks or a gradual buildup of imbalances through self-corrective mechanisms.

For at least three reasons, financial stability should be seen as occurring along a continuum. Financial systems are dynamic, first of all. What might constitute stability at one point in time might be more or less stable at some other time, depending on other dynamic aspects of the economic system, such as technological, political, and social developments. Second, financial stability is consistent with various combinations of the soundness of financial institutions, the condition of the financial markets, and the effectiveness of the various components of the financial infrastructure. And, finally, financial stability depends on participants’ confidence in the financial system and related infrastructure, such as the legal system.

IMF Survey: What are the implications, then, of looking at financial stability as a continuum?

Schinasi: Looking at financial stability in this way allows for the detection of potential difficulties according to their intensity, scope, and potential threat to systemic stability. One could, for example, think of problems in three categories:

• single institution or market problems not likely to have systemwide consequences for either the banking or financial system;

• problems that involve several relatively important institutions engaged in market activities with some nontrivial probability of spillovers and contagion to a subset of institutions and markets; and

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

Each category requires different diagnostic tools and policy responses, ranging from doing nothing, intensifying supervision or surveillance of a specific institution or market, to injecting liquidity into the markets to dissipate strains, and intervening in particular institutions.

IMF Survey: Do central banks have a natural role in ensuring financial stability?

Schinasi: They have several natural roles. First, the central bank is the only provider of the legal means of payment and of immediate liquidity. Only central banks can provide fiat money—that is, legal tender that has no intrinsic value but is universally accepted as a means of payment—and the finality of payment. And, since finance is intimately related to the value and stability of fiat money, there is a direct link between monetary and financial stability.

The second natural role for the central bank is to ensure the smooth functioning of the national payment system to avoid systemic risk. Traditionally, systemic risk has been viewed as the possibility that problems at one bank would spill over to others and lead to bottlenecks in payments, which could threaten the pace of economic activity. The payment system, being the core of the economy and the financial market, has been the subject of much discussion, policy, and reform. Through the efforts of the Group of 10, there now exist real-time gross payments settlement systems that try to prevent a failure at one institution from cascading through the payment system.

The third natural role is related to a central bank’s responsibility for monetary stability. The banking system is the vehicle through which monetary policy affects, in the first instance, the real economy. To the extent that the banking system is experiencing distress, it will be more difficult for the central bank to provide whatever liquidity it thinks is necessary to achieve its monetary objectives. For this reason alone, central banks have a natural interest in sound financial institutions and stable financial markets and in being in a position to influence corrective actions.

There is another explicit link between monetary stability and financial stability. When financial instability occurs, trust and confidence break down. When this happens, there is usually a rush to obtain liquidity—the most liquid asset being fiat money. This means that bank credit and the money supply begin to contract. If this process is allowed to continue, there is the potential for a sharp contraction in monetary aggregates—including bank money—that could ultimately lead to a decline in economic activity.

IMF Survey: What authority or tools does a central bank need to execute this role effectively?

Schinasi: Most of them already have some of what they need, such as an intimate knowledge of the major institutions and oversight of the national payments system. What seems to be lacking in many cases, however, is a clear mandate for ensuring financial stability. In particular, they need to be able to independently obtain information about the soundness of their main private counterparts—the major financial institutions—in part to be prudent but also to understand financial market conditions, especially during periods of stress.

The European Central Bank (ECB) is a case in point. This newly created central bank, which is supranational, manages the one currency of 12 countries. In many ways, the German Bundesbank was the model for the ECB, both in statute and in practice. The Bundesbank, as it existed prior to the creation of the euro zone, could be characterized as a central bank based on a narrow concept of central banking. It had a single objective—the stability of the deutsche mark, which, in domestic terms, meant price stability. In practice, the Bundesbank was a de facto bank supervisor as well, even though there was a separate Federal Supervisory Office. The Bundesbank was responsible for collecting all of the information required for good banking supervision, and it provided that information to the Federal Supervisory Office, which legally was the supervisor. The Bundesbank had a very direct and central role in banking supervision.

By contrast, the ECB’s mandate is to ensure price stability. It has a small role in ensuring financial stability, and this role is effectively confined to ensuring the smooth functioning of the TARGET payment system (the settlement system for the euro) and not the financial system per se. Most of the authority for banking supervision is delegated to the 12 national European central banks. The U.S. Federal Reserve, on the other hand, is a broadly conceived central bank with several mandates, including the responsibility to regulate and supervise key sectors of the financial markets, both domestic and international. The U.K. system is somewhere in between. The Bank of England plays the role of lender of last resort in ensuring financial stability, but it no longer has a mandate for banking supervision.

IMF Survey: How far have central banks actually gone in safeguarding financial stability?

Schinasi: Let me answer with three examples. The first is the collapse of the Barings Bank in the United Kingdom in 1995. In that case, the Bank of England, along with other official bodies, including the U.K. Treasury, decided that Barings was not systemically important. It was, at best, a medium-sized bank, and it was not central to the U.K. payment system. The Bank of England, because it still had a supervisory role at the time, apparently understood the relationship Barings had with the U.K. and other European counterparts. Over a weekend, it was able to decide that Barings could be allowed to fail. If a ready and able buyer had taken over Barings during the weekend, the Bank of England probably would have been very happy. In this case, the central bank’s financial stability role was to decide how important this institution was for the U.K. and European financial systems, and it decided it was not important enough to save.

The second example is the U.S. Federal Reserve’s involvement, in 1998, in coordinating a private rescue of Long-Term Capital Management (LTCM), a $4 billion hedge fund on the brink of failure. There appear to be two main reasons why the Federal Reserve coordinated the private rescue and reduced interest rates (in three separate moves totaling 75 basis points) simultaneously. One was for financial stability; certainly, although the fund was relatively small by U.S. standards, there was tremendous turbulence in the deepest and most liquid markets in the world. The other reason is that there was a real threat to future monetary stability in that if risk taking were not restored to at least a normal level, even small, thriving businesses would not have been able to receive the credit they needed to conduct their day-to-day business. This would have been a threat to monetary stability.

A third example is the Hong Kong Monetary Authority’s intervention in support of the equity markets during the Asian crisis in 1997. One possible reason for the intervention was to establish financial stability in the face of attacks on currencies, sometimes through the equity markets. The second reason was for monetary stability. The Hong Kong economy was likely to be subject to a widespread systemic problem if the equity market collapsed.

IMF Survey: Can any further steps be taken to make central banks more effective?

Schinasi: One thing that can be done is to rationalize specific mandates for financial stability. Some countries do that more than in others. The extreme would be the ECB, where it’s clear from the Maastricht Treaty that it has very limited direct oversight of financial stability except insofar as it affects the TARGET payment system. That leaves some gaps of surveillance, and perhaps even regulation and supervision, in the center of the still integrating pan-European markets and European banking systems. To give the ECB a central role in ensuring financial stability or in banking supervision would require opening up the Maastricht Treaty. So, a greater and more transparent specification of the mandates across the European System of Central Banks and a better alignment of other supervisory and regulatory bodies’ mandates with financial stability would help. This requires a more clearly defined framework for thinking about financial stability issues and a better working definition of financial stability—if not along the lines I mentioned earlier, then some other mutually agreed definition.