Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Why Is Financial Stability a Goal of Public Policy?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Why Is Financial Stability a Goal of Public Policy?

Article excerpt

A number of developments in recent years have combined to put the issue of financial stability at the top of the agenda, not just of supervisory authorities, but of public policymakers more generally. These developments include: the explosive growth in the volume of financial transactions, the increased complexity of new instruments, costly crises in national financial systems, and several high profile mishaps at individual institutions.

The growth in the volume of financial transactions and the increasing integration of capital markets have made institutions in the financial sector more interdependent and have brought to the fore the issue of systemic risk. International capital flows, though generally beneficial for the efficient allocation of savings and investment, now have the power in unstable conditions to undermine national economic policies and destabilize financial systems.

The increased complexity of new instruments makes it harder for senior management in financial firms, let alone supervisory authorities, to understand intuitively the risks to which the institutions concerned are exposed. There are fears that the models underlying the pricing of the new instruments may not be sufficiently robust, that the mathematics of the models may have become disconnected from the realities of the marketplace, or that the operational controls within financial institutions may be inadequate to control the resultant risks.

The crises in financial systems that have occurred have demonstrated the close linkages between financial stability and the health of the real economy. In Mexico, for example, what began as a currency crisis led to a serious recession and created huge strains in the banking system, further deepening the recession. The consequences of the Mexican crisis destabilized several other Latin American countries, notably Argentina, and threatened for a while to have even wider repercussions. In industrial countries, financial strains in Scandinavia and Japan, among others, had adverse consequences for the real economy.

Lastly, there have been a number of wellpublicized losses at individual institutions, due to the breakdown of operational or other controls. Episodes such as Drexel Burnham, Procter & Gamble, Orange County, Metallgesellschaft, Barings, Daiwa, and Sumitomo, though reasonably well contained, demonstrate how quickly losses can mount, and illustrate the systemic risks that would be inherent in a larger scale mishap.

The central case for making the health of the financial system a public policy concern rests on two propositions: firstly, that, left to itself, the financial system is prone to bouts of instability; and secondly, that instability can generate sizable negative spillover effects (externalities). It will be the purpose of this paper to examine these propositions more closely, and in the light of this examination, to consider what forms public policy intervention in the financial sector might take. More specifically, I will address the following questions: what do we mean by financial stability? Why should official intervention (as opposed to reliance on market forces) be required to promote stability? And what concrete approaches can be employed?

WHAT IS FINANCIAL STABILITY?

A distinction is commonly made nowadays between monetary stability and financial stability (interestingly, this distinction would not have been so easily recognized a generation ago, either by economists or public officials). Monetary stability refers to the stability of the general price level; financial stability to the stability of the key institutions and markets that go to make up the financial system. While these are conceptually separate objectives of policy, the linkages between the two are now increasingly recognized.'

The debate on monetary stability has progressed further and its definition has reached a greater degree of consensus than is the case with financial stability. …

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