Central banks and financial stability
Remarks by T. Padoa-Schioppa, Member of the Executive Board EUROPEAN CENTRAL BANK, Jakarta, 7 July 2003
It is a great pleasure for me to be here today at the invitation of the Central Bank of Indonesia and to have the opportunity to share with you my views on the importance of financial stability and, in particular, the role central banks play in achieving it.
The financial crisis in South-East Asia in the late 1990s provided a very stark demonstration of the destructive effects of financial instability. In Indonesia alone, estimates of the fiscal costs of re-capitalising the banking system are put at over 25% of GDP. And to this we need to add the opportunity costs of lost output, investment and employment, as well as the social costs associated with instability, to even come close to a full welfare analysis of the crisis .
Central banks (and other policy-makers) have been acutely aware of the problems of financial instability for many years. Indeed, one of the historical reasons for setting up a central bank was to have an institution that could act as lender-of- last-resort so as to prevent widespread disruption of the financial system, a topic I will return to later on. But, arguably, despite its long history, the conceptual framework underlying the analysis of financial stability was, until relatively recently, largely underdeveloped. In this sense the Asian crisis acted as a very serious wake-up call, to policy-makers in developed and developing countries alike, of the need to understand better the precise ways in which financial crises, and instability more generally, come about.
Six years on, I think we have made progress in setting out the conceptual road map for financial stability. The contours of the "land" have not been fully explored and there are no doubt obstacles to be faced en route. Nonetheless, I think we are now better placed to understand the genesis and propagation of financial instability.
I would like to concentrate today on two areas where our thinking has developed. First, how the objective of financial stability fits with the other objectives of central banks. Second, the range of tools at the disposal of central banks to combat financial instability and prevent systemic crises.
Central bank objectives
The two main objectives of central banks around the world relate to the maintenance of monetary and financial stability. While monetary stability simply means price stability, no such straightforward definition exists for financial stability. Defining financial stability is notoriously difficult, and that is why people find it more convenient to define financial instability.
While verifying that an economy faces financial instability is generally obvious, it is not so easy to tell when threats of such instability might be approaching. In order to monitor these threats, one needs to have a clear idea of what are the elements contributing to financial stability and when these could be at risk. For this purpose, an explicit definition of financial stability - rather than a definition of its negative counterpart - can be useful. In addition, a concrete definition of financial stability is important for the direct links between financial stability and monetary policy.
At the European Central Bank (ECB), we consider financial stability as "a condition whereby the financial system is able to withstand shocks without giving way to cumulative processes, which impair the allocation of savings to investment opportunities and the processing of payments in the economy". We do not define financial stability as explicitly referring to banking stability only, but it does not contradict the argument that banks play a crucial role in the soundness of the financial sector. This may be especially true in developing countries, where banks typically have a dominant position in the financial sector.
Having touched on the issue of definitions, let me now turn to a possible trade off between the two concepts. We probably all agree that monetary policy and financial stability are intimately linked. There is little doubt that price stability supports sound investment and sustainable growth, which in turn is conducive to financial stability. Since the fragility of banks and their counterparties tends to be heightened when prices are unstable, the pursuit of price stability can be seen as a crucial contribution to financial stability. Similarly, attaining financial stability should also contribute to monetary stability in the long run.
However, while both inflation and deflation are detrimental to financial stability, price stability is certainly not a sufficient condition for financial stability. It is a fact that significant episodes of financial crises - or situations that could have led to crises - took place in the last two or three decades in a context of overall price stability. The Japanese banking problems of the early 1990s are perhaps the most famous illustration of this point. Thus, achieving stable prices does not mean that central banks can ignore financial stability.
An important question is: could there be circumstances in which the monetary policy stance required to maintain price stability could harm the stability of the financial system? Theoretically, such situations do have fairly robust underpinnings, although empirically these occasions appear to be quite rare - mainly a result of the strong link between recessions and financial crises. But such situations can arise. If for example, the central bank assigns a relatively high probability to financial instability and assesses that such instability is associated with deflationary tendencies, it may need to accept higher inflation in the short term.
In my opinion, as long as the central bank employs a medium-term horizon for the definition of price stability and adopts a forward-looking approach, financial imbalances will necessarily be taken into account, and there need not be any conflict of objectives. Undoubtedly, this is a very information-intensive exercise. But through this process, central banks can and should include financial stability considerations in monetary policy-making aimed at maintaining long-term price stability.
Tools for promoting financial stability
As regards the instruments available for maintaining financial stability, the range of policies rather depends on the exact responsibilities of the central bank. In particular, some central banks, such as Bank Indonesia , are also banking supervisors, whereas others, such as the ECB, operate without prudential regulation. But even without supervisory powers, I would maintain that central banks have a number of "tools" in their financial stability toolbox.
First, if public authorities are to play a successful role in safeguarding financial stability, threats to financial stability must be effectively monitored. Identifying vulnerabilities in the financial and non-financial sectors and potential shocks in these markets is a vitally important part of a central bank's work ; commentators sometimes refer to this as macro-prudential analysis/surveillance. A key lesson from the South-East Asian crisis is the need for policy-makers to be alert to the development of significant financial imbalances in the economy, which can quickly unwind, causing widespread disruption. This is true for both developing and developed economies, as attested by the recent worries about how the financial imbalances in the United States may unravel.
Second, the tools primarily intended for maintaining price stability, interest rates and market operations, can at times be used to promote financial stability. As I noted earlier, in the long run financial and monetary stability should mutually reinforce each other. But, in the short run, easing monetary conditions may be an entirely appropriate response by central banks concerned about financial fragility spilling over into system-wide problems, which in turn could disturb monetary stability. The LTCM example, when the Federal Reserve System eased monetary conditions to increase liquidity in the financial markets, is a case in point.
Third, when it is an option, micro-prudential regulation and supervision and deposit insurance are important elements of maintaining system-wide stability. That is, by ensuring that individual institutions are financially sound, supervisors can help to maintain the stability of the system as a whole.
As regards their specific instruments - capital charges, provisioning policies and risk limits, etc. - supervisory authorities still feel much more comfortable with the micro- prudential perspective (i.e. not using these tools to respond to financial system-wide or macroeconomic concerns). Whether or not such tools should pay attention to limiting financial and economic cycles is currently an important policy question. A strong counter-argument, which is made by many supervisory authorities, is that the efforts already made, and continuing to be made, to upgrade prudential safeguards will be sufficient. While progress in this respect has certainly been very significant and impressive, it remains the case that potential credit and asset price cycles and increased exposure of banks to financial market fluctuations might leave scope for more forward-looking supervisory measures. Such measures would strengthen defences during good times by establishing reserves to be drawn upon during bad times. The implementation of such policies is still fraught with problems (e.g. lack of compatibility with accounting standards), but I think they deserve further consideration.
Fourth, emergency liquidity assistance (or, in older terminology, lender-of-last- resort), perhaps the most traditional tool available to a central bank for dealing with financial instability, is possible. It includes both the provision of liquidity to the financial system as a whole through market operations, as well as emergency lending to individual banks. It is important to recognise that not all liquidity injections aimed at preventing the spread of a liquidity problem relate to a crisis, as central banks routinely offer liquidity against specified collateral requirements in order to support the orderly functioning of markets.
Because of the obvious dangers of moral hazard, central banks have maintained an increasingly cautious stance towards emergency lending by adopting a policy of case-by-case discretion. They decline to specify in advance which financial institutions would be granted emergency liquidity and under which conditions. Gerry Corrigan has dubbed this "constructive ambiguity".
In theory, we all agree that emergency liquidity support should be provided only to illiquid but solvent institutions. But the distinction between these two concepts is particularly difficult to make in periods of financial distress, which is exactly when central banks may have to use this tool. Consequently, careful judgement is necessary in providing emergency liquidity assistance. The Asian crisis provides a clear example of this. Central banks in the region had to make difficult choices between providing support to individual institutions and encouraging moral hazard, and limiting the fall-out of failing institutions for the wider economy. All central banks could potentially face this dilemma.
Fifth, central banks are often involved in payment systems either directly or in an oversight capacity, and can exercise influence here. The potential risks related to a disruption of the payment circuit - due to either a failing participant or an operational breakdown - are extremely serious. In addition, credit positions across banks in netting systems can constitute a source of contagion risk. Central banks have often been involved in developing mechanisms to limit the potential increase of these various risks. Specifically, in the field of large-value payments they have promoted enhanced safety arrangements in net settlement systems, supported the introduction of real-time gross settlement systems, and developed the payment and settlement system oversight function. As operators of payment systems, central banks often have the unique expertise to identify potential risks and to handle stability problems. In this respect, more efforts seem to be warranted to better use the data from payment systems to identify liquidity risks.
Finally, communication through the public comments of public authorities can be a powerful additional tool to influence market behaviour in a manner which can be conducive to financial stability. In particular, it may act as a way to overcome coordination failures in financial markets. Central banks' private communication has proven to be an important tool in co-ordinating private sector solutions without the injection of public funds. Such interventions could be beneficial, even if authorities' information is no better than that of private market participants. Authorities' information might be credible simply because they do not have a profit motive and comment on financial developments more infrequently than private market participants. Naturally, communication could be counterproductive if information is issued at an inopportune moment or if the information later turns out to have been wrong. Hence, the use of such "open-mouth operations" should be reviewed carefully.
In a nutshell, I would summarise the main tools at the disposal of public authorities to pursue financial stability in the following way:
Tools for maintaining price and financial stability
|1.||Monetary policy strategy||XX||X|
|2.||Short-term interest rates||XX||X|
|5.||Public and private comments||XX||�||�|
|6.||Emergency liquidity support||XX||XX|
|9.||Prudential supervision||O||O O|
Legend: two symbols (e.g. ××) = primary use of the tool; one symbol (e.g. ×) = additional use of the tool; × = tool of a central bank without supervisory powers; O = tool in the hands of an authority other than the central bank; ® tool available to both.
The financial crisis in South-East Asia in the late 1990s was a devastating experience for the region. Policy-makers the world over have hopefully learned lessons from the episode to try and ensure, as far as possible, that such crises are not repeated. Though the initial causes of the instability and the exact propagation mechanisms may have been peculiar to the region, it raised a number of issues generic to central banking. In particular, it demonstrated that financial stability is an important goal in its own right and that central banks, even those without supervisory powers, need to give it due weight in their policy decisions.
The conceptual framework for financial stability analysis, unlike that of monetary stability, is still being developed. Further work in this area is necessary. But being clear about central bank objectives, any possible (short-run) conflicts and the range of instruments at their disposal moves us in the right direction. Hopefully, I have shown that progress is being made on this front.
I would now be very happy to discuss further any of the issues I have raised, or other financial stability topics relevant for the Bank Indonesia that I did not focus on in my remarks.
 BIS Review 40/1999: Presentation by the Governor of Bank Indonesia, Dr. Syrahil Sabirin, at the Indonesian Executive Circle Forum in Jakarta on 7 April 1999.
 Quantifying the cost of financial crises is very difficult. Welfare losses to the economy associated with a banking crisis are often proxied by losses in GDP. By this measure, for the five economies most seriously affected by the South-East Asian crisis, the fall in GDP below trend is estimated at around 15%.
 Technically, monitoring in itself is not a policy tool. It is rather a prerequisite for the effective use of policies available for maintaining financial stability. As in the monetary policy field, we need strong monitoring to support good policy-making.