Maintaining Financial Stability in a Global Economy: A Summary of the Bank's 1997 Symposium

By Morris, Charles; Parrish, Klara | Economic Review - Federal Reserve Bank of Kansas City, Fourth Quarter 1997 | Go to article overview

Maintaining Financial Stability in a Global Economy: A Summary of the Bank's 1997 Symposium


Morris, Charles, Parrish, Klara, Economic Review - Federal Reserve Bank of Kansas City


World financial markets have experienced tremendous growth in recent years. New financial instruments have been developed, the volume of transactions within individual markets has skyrocketed, and capital flows across countries have risen dramatically. While these developments have made financial markets more efficient, they have also increased the risk that events at one institution or in one market will have immediate and wideranging effects on the entire global financial system. In developing policies to respond to these changes, policymakers must balance the need for financial stability with the desire for an innovative and efficient financial system.

To better understand how to design policies to keep a financial system safe, efficient, and stable, and how to respond to financial crises when they occur, the Federal Reserve Bank of Kansas City sponsored a symposium entitled "Maintaining Financial Stability in a Global Economy." The symposium, held at Jackson Hole, Wyoming on August 28-30, 1997, brought together a distinguished group of central bankers, academics, and financial market representatives from around the world.

The participants generally agreed that, to maintain financial stability, regulation of financial institutions is important and that financial regulators should focus on making regulation more consistent with market forces. In addition, financial stability requires a sound macroeconomic environment-particularly price stability and, for most countries, an exchange rate regime that does not attempt to permanently fix exchange rates. Finally, participants agreed that both domestic and international safety nets should be used cautiously in financial crises to avoid the destabilizing effects of moral hazard.

I. WHY DOES FINANCIAL INSTABILITY MATTER?

Symposium participants agreed that policymakers care about financial instability because a financial sector crisis often causes a severe reduction in real economic activity. Recent examples include banking crises in Scandinavia and Japan, the 1995 peso crisis in Mexico, and the current exchange rate and banking problems in the emerging market economies of Southeast Asia. While there is little doubt that financial instability can harm an economy, there is less agreement about how a financial crisis is defined and under what circumstances governments or other official bodies should intervene.

How is instability defined?

In defining financial instability, Andrew Crockett distinguished between instability in institutions and in markets. According to Crockett, institutional instability exists when the failure of one or a few institutions spreads and causes more widespread economic damage. In fact, as Alan Greenspan noted in his opening comments, occasional failures are an important and normal part of the market process because they promote market discipline, provided of course that the failures do not lead to more systemic consequences. Historically, policymakers have focused on commercial banks because their failure can have systemic consequences. Crockett argued that while banks are still "special" in this regard, policymakers also need to be more watchful for problems at nonbank financial institutions because the distinctions among financial institutions have become blurred.

Crockett defined market instability in terms of the wider impact that volatility in asset prices and flows can have on the economy. By this definition, large changes in asset prices themselves do not necessarily indicate financial instability because they may reflect fundamental changes in the economy, such as changes in expected income flows or in discount factors. Indeed, markets work only if prices are allowed to respond to changes in demand and supply conditions. The difficulty for policymakers, Crockett pointed out, lies in identifying whether a given change in prices is justified by changes in fundamentals.

When is intervention appropriate?

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