Handbook of Safeguarding Global Financial Stability

Political, Social, Cultural, and Economic Theories and Models

,

• Publisher: Academic Press
• Year: 2012
• ISBN:
  9780123978783
• Topic: Economía
• Subtopic: Economía internacional

Political and social forces exert pressure on our globalized economy in many forms, from formal and informal policies to financial theories and technical models. Our efforts to shape and direct these forces to preserve financial stability reveal much about the ways we perceive the financial economy. The Handbook of Safeguarding Global Financial Stability examines our political economy, particularly the ways in which these forces inhabit our institutions, strategies, and tactics. As economies expand and contract, these forces also determine the ways we supervise and regulate. This high-level examination of the global political economy includes articles about specific countries, crises, and international systems as well as broad articles about major concepts and trends.

• Substantial articles by top scholars sets this volume apart from other information sources
• Diverse international perspectives result in new opportunities for analysis and research
• Rapidly developing subjects will interest readers well into the future

III

Safeguarding Global Financial Stability

Chapter 25 Safeguarding Global Financial Stability, Overview

Chapter 26 Resolution of Banking Crises

Chapter 27 Advantages and Drawbacks of Bonus Payments in the Financial Sector

Chapter 28 Central Banks Role in Financial Stability

Chapter 29 Organization, Supervision and Resolution of Cross-border Banking

Chapter 30 Dynamic Provisioning to Reduce Procyclicality in Spain

Chapter 31 Varieties of European Crises

Chapter 32 The Financial Sector Assessment Program

Chapter 33 Financial Sector Forum/Board

Chapter 34 Financial Stability and Inflation Targeting

Chapter 35 Financial Supervision in the EU

Chapter 36 Groups

Chapter 37 Market Structures and Market Abuse**This chapter was completed as of 31 December 2011.

Chapter 38 Development and Evolution of International Financial Architecture

Chapter 39 On the Role of the Basel Committee, the Basel Rules, and Banks’ Incentives

Chapter 40 International Monetary Fund

Chapter 41 Innovations in Lender of Last Resort Policy in Europe

Chapter 42 Micro and Macro Prudential Regulation

Chapter 43 Role and Scope of Regulation and Supervision

Chapter 44 Independence and Accountability of Regulatory Agencies

Chapter 45 Institutional Structures of Regulation

Chapter 46 Organizations of International Co-operation in Standard-Setting and Regulation

Chapter 47 Prevention of Systemic Crises

Chapter 48 Lines of Defense Against Systemic Crises

Chapter 25

Safeguarding Global Financial Stability, Overview

J.R. Barth^{*,, †,, ‡}, D.G. Mayes^§ and M.W. Taylor^‖

^*Auburn University, Auburn, AL, USA

^†Milken Institute, Santa Monica, CA, USA

^‡Wharton Financial Institutions Center, Philadelphia, PA, USA

^§University of Auckland, Auckland, New Zealand

^‖Bank of International Settlements

Outline

Financial Stability

Establishing and Maintaining Financial Stability

Crisis Management and Avoidance

Global Approaches

Other Issues

References

Financial Stability

Tommaso Padoa-Schioppa once remarked that a concern with financial stability was part of the ‘genetic code’ of central banks (Padoa-Schioppa, 2004). Similarly, Charles Goodhart’s monograph on the Evolution of Central Banks (Goodhart, 1988) emphasized that the function of safeguarding financial stability had historically been the primary purpose of central banks. Yet, for several decades prior to the financial crisis of 2007–08, the financial stability function of central banks remained in abeyance, as their core focus was increasingly on the manipulation of short-term interest rates in pursuit of the goal of price stability. The pursuit of inflation targeting and the adoption of quantifiable goals for price stability reinforced this trend. By contrast, financial stability was seen as at best a subsidiary aim of policy that would be attained as an inevitable consequence of achieving a central bank’s price stability objective.

This is not to suggest that financial stability was completely neglected during this entire period. From the mid-1990s onward, central banks did establish specific departments labeled ‘financial stability’ that had responsibility for producing detailed assessments of financial sector vulnerabilities, often published in the form of Financial Stability Reports. However, these departments – and the central banks in which they were located – often lacked specific tools with which to back their analyses with policy actions. This situation did not prevent the emergence of a fruitful academic and policy debate on how financial stability was to be defined and measured, but it did result in the relative neglect of the stability of the financial sector as an explicit objective of policy.

A further factor reinforcing this state of affairs was the fashion of removing responsibility for banking supervision from central banks and handing it over to a single financial services regulator. These unified regulatory agencies tended to focus on microprudential regulation at the level of the individual firm. With central banks increasingly focused on the price stability objective, financial stability was too often left to fall between the institutional gaps – as was arguably the case in the United Kingdom in the run-up to the global financial crisis that began to emerge fully in 2007.

Since the financial crisis, however, the pursuit of financial stability has been restored to its place as a core central-banking function. There has been a renewed emphasis on macroprudential analysis and tools, while new decision-making mechanisms (such as the Financial Stability Oversight Council in the United States, the United Kingdom’s Financial Policy Committee, and the European Systemic Risk Board) have been established. Nonetheless, important issues remain to be addressed.

First, while the banking sector has been traditionally viewed as the primary source of potential financial instability, many believe the chain of collapse that ran through the financial system in 2007–08 following the bursting of the housing bubble in the United States originated in the nonbank sector and then spread to the banks. It can, of course, be argued that the severity of the crisis was a consequence of the fact that the soundness of the banking system was itself brought into question. Nonetheless, many consider that the immediate trigger of the worst part of the global crisis was the failure of an investment bank, Lehman Brothers. In addition, the US government took the position that AIG, an insurance company, needed to be bailed out because of its centrality in the system. Understanding the complex interactions between the different parts of the financial system and how these can create financial instability is a major part of the postcrisis reform agenda. In particular, it involves knowledge of the nature of the interconnections between various institutions and the way shocks might be transmitted through the financial system. Among the issues that are being explored given these complexities are the authorities’ ability to collect the data needed to perform financial stability analysis, including from unregulated or lightly regulated parts of the financial system; the effect of various policy measures in reducing financial system interconnectedness; and last – but by no means least – where to draw the regulatory boundary. A particularly tricky issue concerns the extent and nature of regulatory oversight of the ‘shadow’ (or, less pejoratively, the ‘market-based’) banking system comprising money market mutual funds, some hedge funds, and certain other nonbank financial intermediaries. The common feature of this sector is that it engages in the same type of maturity transformation and has the same or even greater ability to take on leverage as the regulated banking sector. However, lacking the backstop of the financial safety net, it is exposed to the same risk of runs that the formal banking sector experienced before the advent of lender of last resort (LOLR) assistance and deposit insurance.

Second, there has been growing recognition that the focus of financial stability analysis and monitoring has to be on the complex interaction of the elements of the system as a whole and not just its individual components. One of the major failures of the supervisory system during the period prior to global financial crisis that fully emerged in September 2008 was to view systemic stability in terms of the aggregation of individual financial firms. If all financial institutions operated prudently, then shocks would be unlikely to have systemic implications. This incarnation of the fallacy of composition has been dramatically shown to not be the case, particularly as a large portion of the entire sector could be subjected to the same shock, as was the case with collapsing real estate prices in the United States.

Third, financial stability policy has shifted to a more overt concern with the ‘plumbing’ of the financial system. Starting in the 1980s, central banks had already moved to reduce payment system risk through the adoption of real-time gross settlement (RTGS) systems. RTGS reduced the systemic risk resulting from the buildup of large overdrafts intraday in traditional systems which settled on an end-of-day net basis. In addition, attention had also been given to improving the robustness of settlement systems used in securities trading, for example, by the implementation of delivery-versus-payment (DvP) technologies. Since the financial crisis, this focus has continued, with increasing emphasis on bringing a large portion of the over-the-counter derivatives markets into centralized clearing systems. The aim of these initiatives, like the earlier ones on RTGS and DvP, is to reduce the risk that the failure of one firm to meet its obligations will set off a chain reaction throughout the financial system.

Finally, there has been an increased awareness of the international dimension of financial stability. The interconnectedness of the financial system is not just a fact of life within national jurisdictions, but it also extends beyond national boundaries. As events of 2007–08 demonstrated, the fragility of a specific part of the US financial system – subprime lending for real estate purchase – could be rapidly transmitted through securitization to the global financial system. The transmission mechanisms were many and varied: European banks had been large purchasers of securitized assets based on subprime loans; credit default swaps written or purchased on these same instruments became another instrument of potential contagion. Following the collapse of Lehman Brothers, however, the chief mechanism by which financial instability spread around the global financial system was the traditional one of a loss of confidence leading to the fear that one could not be sure about the soundness of any financial institution. And the worst enemy of well-functioning financial markets is a loss of confidence or uncertainty. These events brought home very clearly that global financial stability is a global public good that may be inadequately supplied unless more formal mechanisms can be established to coordinate policies to assure financial stability better. Among the postcrisis institutional innovations, the formation of the Financial Stability Board, a mechanism of the G20 member countries to coordinate financial stability policy, is designed to meet this need.

Given these brief comments, the first task of the contributions to this section is to sort out the fundamental issues, such as addressing the issue of how to define the term ‘financial stability,’ as there is no neat, quantifiable equivalent to an inflation target. And while the risks in the financial system need to be managed, they cannot be eliminated. Indeed, it would not make any sense to try to do so, as managed risk-taking lies at the heart of successful financial intermediation. In a second paper, there is a debate concerning which agency should do what and how the interactions between those responsible for the stability of the system as a whole and those responsible for the stability of individual institutions should be coordinated. A paper by Dirk Schoenmaker (‘The Role of Central Banks in Financial Stability’) specifically examines the role of central banks. It also discusses how accountability should take place for financial stability. Central banks have become increasingly independent in order to conduct monetary policy focusing on the medium term, which is beyond many governments’ electoral horizon. But at the same time, their performance in this regard is readily measurable and they can be held accountable for their actions. The same accountability is not possible in the case of financial stability. Supervisory failures are easy to identify but not successes. It is quite difficult to decide whether financial stability has been achieved because of or despite supervisory actions. Furthermore, it is difficult to assign any grades for relative successes and failures. This issue is therefore the topic of a specific paper (Michael Taylor, ‘The Independence and Accountability of Regulatory Agencies’). Still another paper considers what regulation and supervision can hope to achieve and where the boundaries of its oversight should be drawn (David Llewellyn, ‘Safeguardi...

Table of contents

• Cover image
• Title page
• Table of Contents
• Copyright
• Volume 2
• Section Editors for this volume
• Preface
• Contributors
• I: Political Economy of Financial Globalization
• II: Theoretical Perspectives on Financial Globalization
• III: Safeguarding Global Financial Stability
• Index