Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 7 Monetary Transmission Mechanism

Financial Stability: International Experience

Almost all central banks accept the possibility of providing emergency liquidity assistance to the market or to individual institutions when failure would lead to systemic effects. Exceptions to this are countries like Bulgaria that operate under currency board arrangements which inhibit last-resort lending (Table 8.3). Some central banks recognise the possibility, at least in principle, of providing emergency liquidity assistance to non-depository institutions (Australia, Denmark, India, New Zealand, Norway, South Korea and Sweden). In practice, however, emergency liquidity support to non-banks is less likely than for banks because they are less likely to be systemic and/or illiquid .

E-Money There is also considerable variation in the provision of, and the involvement of central banks in, deposit insurance schemes. In nearly all the industrial countries, there is usually some form of deposit protection scheme operated either by a supervisory agency or a separate body. Transition economies generally have separate entities that operate a deposit insurance scheme. The widest variation in practice is among emerging economies. Some have recently developed deposit insurance schemes (South Africa), or enacted revisions to the earlier scheme (Argentina and Brazil).

According to a recent survey of over 150 countries, prudential banking supervision was the responsibility of the central bank in almost three-quarters of the countries (Central Banking Publications, 2004). Furthermore, the most common model of supervisory structure is for the central bank to supervise banks only. Although it is still most common to have separate supervisory agencies for banks, insurance and securities firms, there is an increasing interest in integrating the supervision of different financial sectors. Goodhart et al. (1998) have identified several reasons for this:

• The rapid structural change in financial markets spurred by the acceleration in financial innovation.

• The realisation that financial structure in the past has been the result of a series of ad hoc and pragmatic policy initiatives raising the question of whether, particularly in the wake of widespread banking crises, a more coherent structure should be instituted.

• The increasing complexity of financial business as evidenced by the emergence of financial conglomerates.

• The increasing demands being placed on regulation and its complexity, in particular, the development of a need for enhanced regulation of 'conduct of business' (covering financial products like pension schemes and insurance offered to consumers).

• The increasing internationalisation of banking, which has implications for the institutional structure of agencies, at both the national and international levels.

A majority of industrial economies do not have prudential regulation and supervision within the central bank (Table 8.5). An important exception to this is the United States, where the Federal Reserve has the responsibility for banking regulation and supervision, while that of non-banks is with the Office of Thrift Supervision. However, central banks often retain a role, formal or informal, in the design of regulatory framework. Norway was the first country to establish an integrated agency outside the central bank in 1986, followed by Denmark in 1988 and Sweden in 1991. As Taylor and Fleming (1999) point out, there were strong similarities between these countries' economic and financial systems. This consequently produced many similarities in terms of the basic structure and organisation of their integrated regulatory agencies. There was also a common motivation for the move towards an integrated regulator, viz.,

1. a desire for more effective supervision of financial conglomerates and

2. to obtain economies of scale in the use of scarce regulatory resources.

As regards EMEs, the survey indicates that, in most cases, central banks are primarily responsible for the regulation and supervision of deposit-taking institutions and, in some cases, other financial intermediaries as well (India, Malaysia). Amongst the sample EMEs, two central banks, viz. Chile and Mexico do not perform the prudential regulator and supervisor role.

Given the broad range of financial stability functions with respect to regulation and supervision, two issues of interest are: first, should supervision be vested with the central banks and second, whether the supervision of the three major segments1 of the financial system should be integrated? Perhaps the most strongly emphasised argument in favour of assigning supervisory responsibility to the central bank is that as a bank supervisor, the central bank will have first-hand knowledge of the condition and performance of banks. Illustratively, the Federal Reserve is able to exploit the synergies by retaining supervision with itself. This, in turn, can help the central bank in identifying and responding to the emergence of systemic problems in a timely manner. Sceptics, however, point to the inherent conflict of interest between supervisory and monetary policy responsibilities. Table 8.6 compares the supervisory role of the central bank in 98 countries. More than three-fourths of the countries assign banking supervision to the central banks, including 66 per cent in which the central bank is the single supervisory authority. Like the United States, a few countries (13 per cent of the total) assign bank supervisory authority to the central bank and at least one other agency. About a fifth of the countries do not assign any bank supervisory responsibilities to the central bank.

Statistics regarding international comparison of the scope of supervision across 96 countries was compiled for study. In the majority of these countries (61 per cent), the authority responsible for bank supervision is confined solely to the banking industry. However, bank super visor y authorities also super vise securities firms in 11 per cent of the countries and insurance firms in 14 per cent of the countries. In 13 countries, the authority responsible for bank supervision also supervises both insurance and securities firms.

In the UK, a single agency, the Financial Services Authority (FSA) was created in 1997 by amalgamating ten different supervisory agencies. The move was motivated by a host of factors, salient among them being the growth of conglomerates and the blurring of distinctions between financial services carried out by different types of institutions and a desire for a less costly and more coordinated supervisory structure. Korea and Japan also adopted similar models to the UK by integrating the supervision of banks, insurance and securities into a single agency outside the central bank. Even if financial supervision is undertaken by an agency outside the central bank, the central bank cannot ignore financial stability issues. For instance, in the UK, although financial sector supervision has been entrusted to the FSA, the Bank of England remains responsible for the stability of the financial system as a whole. In this context, central banks can contribute to financial stability through:

1. payments system oversight,

2. contingency planning against market disruption,

3. lender of last resort (LOLR),

4. share in procedures for financial regulation and

5. analysis and communication through reports such as Financial Stability Reviews .

In industrial economies, the role of the central bank in the process of establishing accounting standards is limited. Exceptions to the rule include the Netherlands, New Zealand and Singapore. On the other hand, for most transition economies and several developing countries, central banks play an active role in establishing uniform accounting standards.

The increased concern of central banks with financial stability in recent years is clearly reflected in the publication of reports dedicated to financial stability. In addition, several central banks prepare such information which is published as a part of regular reports (Table 8.9). Central banks publish such financial stability reviews (FSRs) to create public understanding and awareness of what financial stability is and the role that they can play in the process. Such reports also serve as a means of sharing knowledge and information across various departments of central banks that have a bearing on the financial stability function. Notwithstanding these positive aspects, FSRs have their own limitations. A key drawback is that these FSRs are only qualitative in nature and, in contrast to the Inflation Reports, lack robust models. As such, the FSRs lack the quantitative discipline and rigour associated with the Inflation Reports. In part, the absence of suitable models to analyse financial stability issues is the consequence of the usual assumptions made in economic models - complete financial markets, inter-temporal budget constraints and representative agent models. These assumptions rule out default and contagion which are key characteristics of financial instability. Recent theoretical work has, therefore, made efforts to build models that encompass incomplete financial markets, default probability, and heterogeneous agents.

There are several aspects of the involvement of central banks in the regulation and surveillance of markets. For instance, the central bank might be involved only in collection and monitoring of information relevant to these markets. Alternatively, the central bank might be consulted in the design of the regulatory framework or even actively involved in the design of the regulatory framework. As another possibility, the central bank might be formally responsible for the implementation of regulation and supervision or it might have no role at all. A cross-country survey of the central involvement in regulation and supervision of financial markets is presented in Table 8.10. Notwithstanding the varied roles the central bank might have, unless there is no role at all, it is presumed that central bank would have some role and accordingly marked as Y (Yes) in Table 8.10. The three markets that are generally the focus of surveillance by central banks are the money, bond and foreign exchange markets. The money market is the focal point of the implementation of monetary policy and therefore, central banks often exert influence on its development and functioning through the choice of operating procedures, which determines the mechanisms for the provision of liquidity to the system. Central banks are active participants, and overseers of, the foreign exchange market. In case of bond markets, central bank involvement in their surveillance is sometimes underpinned by a fiscal agent role. The role of central banks in the regulation and surveillance of equity market is generally less significant.

In sum, monetary stability is a necessary but not a sufficient condition for financial stability. While in the long-run, monetary and financial stability reinforce each other, the same need not be the case in the short-run. Several central banks are, therefore, pursuing financial stability as an explicit objective in addition to their price stability objective. Although financial innovations have enabled an improved risk management, their success so far is mainly in dispersing risks at a point in time; their ability to manage risks inter-temporally is still not clear. While pursuing their objective of price stability, central banks can contribute to financial stability through appropriate regulation and supervision, enhancing risk management practices in the financial sector, encouraging improved governance practices and by raising the level of transparency in the financial sector.