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Article Excerpt
Financial stability in general has been a concern of public sector entities for many years. (1) But what is meant by macro-financial stability? Why is it important? Why is the term being used much more frequently? Can we measure it or model it for predictive purposes? What is the role of the central bank and other government agencies in bringing about financial stability? What are the implications for the private sector? What are the links to monetary stability?
As central banks continue to monitor and respond to tightened credit markets stemming from problems in the asset-backed commercial paper market, these questions are timely. Set against the financial crises of the last few decades and the challenges posed by such factors as the increased volume and complexity of financial transactions, they take on broader significance.
This paper examines these and other questions with a view to clarifying current challenges to financial stability and the roles that central banks, other public sector agencies and private sector entities can appropriately play in pursuing it. In the next sections of the Commentary, we look at the definition of macro-financial stability, then discuss why we should care about it. We examine the factors behind the increased attention being paid to macro-financial stability and focus on issues related to its measurement and modelling. Then we look at the role of central banks and other public agencies as they try to achieve and maintain financial stability, and discuss in more detail the activities of central banks in promoting macro-financial stability, including the publication of financial stability reports that address the potential issues affecting macro-financial stability. We discuss how the analysis of macro-financial stability could be used by the private sector; in particular, in what way financial stability reports can help the decision making of those working in financial institutions and financial markets. Finally, we focus on the possible links between monetary stability and financial stability, and offer some concluding remarks. (2)
What Is Macro-Financial Stability?
The issue of how financial stability should be defined has been the subject of debate for some years (3) and remains an open question. Unlike the definition of monetary stability, on which there seems to be broad agreement, a widely accepted definition of financial stability seems to be some way off. British economist and former Bank of England Monetary Policy Committee member Charles Goodhart (2004) wrote that, "There is currently no good way to define ... financial stability." Goodhart further noted that when a group of experts was asked to define the term, "the most persuasive responses were that it was just the absence of financial instability." The financial stability reports (FSRs) of some central banks offer a definition of the term, (4) while others do not give an explicit definition but describe the circumstances that can arise and cause concern. (5)
Andrew Crockett (2000), a former executive director of the Bank of England and former head of the Bank for International Settlements (BIS), argues that financial stability has two dimensions--micro-prudential and macro-prudential. He suggests that the macro-prudential objective is to "limit the costs to the economy from financial distress, including those that arise from any moral hazard induced by policies pursued [by governments or their agents]." This could be thought of as limiting systemic risk and would involve minimizing the likelihood, and the associated costs, of the failure of significant parts of the financial system.
The micro-prudential objective involves "the limiting of the likelihood of failure of individual institutions" (or limiting idiosyncratic risk). While one can argue that crises are the most readily identifiable aspect of financial instability, focusing on crises does not allow for different degrees of financial instability (6) or for changes in the source or nature of financial instability over time and in different countries.
So what is a good working definition of macro-financial stability? In spite of the absence of a generally accepted definition, there are some qualitative aspects that are common to most discussions and definitions. A stable financial system is one that is robust in the face of a reasonably wide range of adverse circumstances; that is, one that can efficiently provide its usual range of financial services when operating under significant stress.
Macro-financial instability typically involves such ideas as interrelationships or interdependencies, spillovers, systemic risk, domino effects, knock-on effects, system-wide consequences, financial sector and real sector interactions, financial system fragility or lack of robustness to shocks. Put differently, the main concerns involve the effects of a real or financial shock to the economy on a wide range of financial institutions and/or markets, and on the resulting macroeconomic outcomes. In the case of a real shock, the focus would be on its deleterious consequences for financial institutions and markets and the resulting amplification of the effects of the shock on the economy. In the case of a financial shock, such as the failure of a financial entity that had been a counterparty in many financial contracts, the concern would be that the unravelling of such contracts might have liquidity and credit implications for other financial institutions and possibly force some of them into default. Such outcomes could seriously affect the real economy.
Central banks often have taken a rather narrow and more practical approach to promoting financial stability by focusing on systemic risk. Systemic risk reflects the interdependencies among participants in the financial system, from the classic contagion effects arising from the failure of a single bank that then spread to other banks (often through clearing and settlement systems that are poorly risk-proofed) to cases where a significant number of financial system participants are dependent on a single piece of financial infrastructure or where they have a common exposure to a single risk factor.
For central banks, systemic risk is generally seen as a form of market failure. Each financial system participant is primarily focused on the set of risks that affect its own risk profile and that are within its control. Each participant will tend to under invest in the mitigation of systemic risk, or even free-ride on the efforts of others. Thus, dealing with systemic risk is in society's best interest, and since the private sector does not have the appropriate incentives to address it appropriately, the public sector clearly has a role to play. One of the principal roles of central banks in this area has been to act as lender of last resort to avoid the unnecessary winding up of solvent, but illiquid, banks. This critical function can prevent financial panics arising from runs on banks.
More recently, many central banks have been involved in the operation of, or at least the oversight of, clearing and settlement arrangements in payments and, sometimes, securities and foreign exchange. In this context, central banks have focused on the introduction of appropriate risk-proofing arrangements in those clearing and settlement systems that handle values large enough to generate systemic risk.
Finally, central banks have also acted as advisers to governments with respect to the enactment of laws governing the three key elements of the financial sector--financial institutions, financial markets, and clearing and settlement systems-bringing a system-wide perspective to this activity.
Why Does Financial Stability Matter?
Why do we care about maintaining financial stability? Clearly, there are compelling reasons. Significant financial instability can result in lost output. It can lead to a misallocation of resources across different uses and across time. The financial system can be a source of instability or it can transmit (and possibly amplify) problems from one part of the financial system to other parts of the system, or to the economy more generally. Often the combination of an economic shock and a weak financial system can give rise to much worse outcomes than would be expected from an assessment of each of these areas separately.
Furthermore, macro-financial instability can seriously impair the lending of funds from ultimate savers to ultimate borrowers, resulting in a sharp reduction in the ability of the financial system to allocate credit. "The resulting impact on economic activity can be severe and long lasting and undermine the effectiveness of traditional macroeconomic policy tools such as monetary and fiscal levers." (7)
The last few decades have been particularly notable because of the frequency and the size of episodes of financial instability. Not only has the magnitude of crises apparently increased, but so has the speed with which they develop. Advances in technology have facilitated the real-time marking-to-market of positions, leading to a shortening of the time frame for decision making in the management of portfolio positions. Certain trading strategies use real-time data and often assume adequate market liquidity in all circumstances. When market liquidity becomes significantly impaired, these strategies can generate self-fulfilling outcomes as asset positions are continuously adjusted to limit losses in response to price movements that were induced by earlier changes in asset positions. The result: significantly greater volatility in prices than would be warranted by the fundamentals.
Related to this point is the fact that, in the past, financial stress has usually involved financial institutions, particularly banks, to a very significant degree. With a much wider range of entities currently participating in financial systems, financial stress can now involve more, and more varied entities, potentially making crisis management more difficult than in the past. (8) Furthermore, because there is greater integration among these entities, both domestically and internationally, it is possible that a financial system will transmit and amplify shocks more quickly and more broadly than used to be the case, rather than act as a shock absorber. (9)
It is important to emphasize that the concern about macro-financial stability does not refer to usual or even unusual movements of asset prices as markets adjust to shocks, and prices move to a new equilibrium. Indeed, financial stability is not the absence of volatility or of sharp adjustments in financial prices and quantities, which can be an important part of price discovery or quantity adjustment in a sound financial system. Rather, the concern about macro-financial instability refers to developments that have the potential to have major impacts on the economy through the destruction or serious weakening of the whole or large parts of the financial sector.
In this context, it is important that central banks and other public agencies responsible for macro-financial stability should avoid taking full responsibility for all problems in particular segments of financial markets or with particular participants. To be excessively...
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