Central banks have traditionally had two main functions: (i) managing monetary conditions in the domestic economy to stabilise aggregate prices and/or economic activity; and (ii) promoting financial stability as overseer of the financial system, as banker to the banks and as lender of last resort to the financial system. Under normal conditions, when the financial system remains stable, the focus of public attention tends to be on the day-to-day conduct of monetary policy. When a period of financial stress occurs, the emphasis naturally shifts to the Bank's financial stability function. This refocus has occurred over the past two years in New Zealand and in other countries in the wake of the GFC.
In line with the traditional model, the Reserve Bank of New Zealand Act 1989 currently assigns two stabilisation roles to the Reserve Bank: (1) the monetary policy function aimed at price stability; and (2) the financial stability function aimed at promoting the maintenance of a sound and efficient financial system. The main instrument for (1) is the official cash rate (OCR). The instruments for (2) mainly relate to the Bank's regulatory powers to promote prudent behaviour on the part of the banks and to ensure the orderly resolution of any bank failures.
In many countries, responsibility for the prudential supervision and regulation of financial institutions resideswith agencies separate from the central bank. During the 1980s and 1990s, a number of countries chose to reassign the prudential function from the central bank to a separate agency (for example, the Financial Services Authority in the UK and the Australian Prudential Regulation Authority in Australia). In part, this shift reflected a view that the primary role of the central bank should be the pursuit of low inflation, a task best carried out by a central bank with a high degree of policy independence and without the distraction of a broader prudential supervision role. In these cases, central banks were left with a system-wide financial stability, consistent with responsibility for their role as provider of liquidity to the banking system. More recently, in the case of the UK, the prudential supervision function has been reassigned to the central bank.
From the mid-1990s onwards, central banks began to broaden this 'macro-financial stability' role, in particular by monitoring the macro-financial system more intensively and producing regular Financial Stability Reports (FSRs). While the RBNZ retained and indeed broadened its prudential supervision role, it too expanded its MFS function, including a formal mandate to regularly monitor macro-financial stability. (2)
The systemic nature of the GFC and the key roles played by the build-up of systemic risk and liquidity strains have altered and broadened perceptions of what might be needed to ensure macro-financial stability. Relevant questions include: How should the MFS function relate to the traditional (institution-based) prudential function? What are the interactions between the MFS function and monetary policy? Can the objectives and instruments of the MFS function be specified more clearly? Are the Reserve Bank's powers adequate to carry out this function going forward? This article considers some of these questions as it reviews the evolving shape of the MFS function in New Zealand and internationally.
2 International setting
Commonly-used definitions of financial stability refer to the resilience of financial institutions and markets in the face of shocks such as the failure of a bank. The financial system is said to be stable if it can continue to function properly in the face of such shocks. For example:
* Bank of England: "A stable financial system is able to sustain critical services to the wider economy--payments, credit provision and insurance against risk--even when it is hit by …