Per Jacobsson lecture by Charles Goodhart - Zurich, 27 June 2004

28 June 2004

Some New Directions for Financial Stability?

I. Introduction

When the in-coming Labour government in the UK transferred responsibility for the supervision of banks to the newly formed Financial Services Authority (FSA) in May 1997, at the same time it reaffirmed, (e.g. in the Chancellor's statement on the Bank of England of 20 May 1997, reprinted in BEQB, 1997, p. 246), that the Bank of England retained responsibility for overall financial stability. But what exactly are the functional responsibilities of a central bank which is required to maintain systemic financial stability without having supervisory oversight of individual financial institutions? Particularly since a number of other major countries have been following this same route, for example in Scandinavia, Japan, Germany, Austria, and now China, it is worth starting with this question.

Several aspects of this role are clear and relatively uncontroversial. Whereas the FSA has responsibility for supervising the individual financial institutions,11 the central bank retains responsibility for the smooth running of the domestic payments system, and by extension oversight of the structure and soundness of the clearing and settlement systems of the main financial markets, money and bond markets, the foreign exchange market and (perhaps to a somewhat lesser extent) of the equity market. Similarly the central bank will be the body most concerned with the inter-linkages between domestic financial markets' and payments' systems and international markets and systems, in the European case with the Target system.

A second, associated, function, thrown into prominence by 9/11, is to undertake contingency planning against a major physical disruption of markets whether by terrorism or natural causes.

A third role, perhaps the best known component in this portfolio of operational tasks, is to provide injections of liquidity, either to the financial system as a whole via open market operations, or via Lender of Last Resort actions to individual institutions. A problem with such latter LOLR operations is that they might put taxpayers' money at risk. In many cases of bank rescues, for example in Scandinavia and Japan, the scale of the losses were such that only the fiscal authority could take up the burden. Even when this was not so, as in the case of the Johnson Matthey bank rescue in 1984 in the UK, lending by the central bank may involve some subsequent loss, and the taxpayer is the residual owner of the central bank. Such losses from LOLR are the more likely, the greater the incentive on a commercial bank in trouble to defer approaching the authorities until it has used up every other possible avenue of raising funds. Is there an analogy here at the international level with the IMF and national governments?

Moreover, the official body which such a troubled bank must first approach in the UK is the FSA, not the Bank. Consequently a decision of how to deal with an impending financial crisis has to depend on a troika, or combination of three authorities, FSA, Bank and Treasury (or Ministry of Finance) and hence the political authorities.

While this troika has been nicely formalised, in the UK at least, by a Memorandum of Understanding (MOU) and the establishment of a Tripartite Standing Committee, the implications of all this for theinternational handling of crises have not been, in my view, so clearly prepared, at least in the European context, and I shall turn to this specifically later. One immediate conclusion, however, is that the central bank in a country where the banks, (or a significant proportion of the major banks, as in the USA), are subject to supervision by a separate supervisory authority, can hardly any longer be the sole financial representative at national, or international, discussions of regulatory changes.

The period from 1974 until the end of the 1990s when the Basel Committee on Banking Supervision was a private informal enclave of central bankers, establishing soft law for the international financial architecture, was constitutionally extraordinary, though generally beneficent. It deserves a full, detailed historical treatment. Be that as it may, the separation of supervision from central banks, and the enhanced involvement of Ministries of Finance, (together with the greater role of the IMF and World Bank in this field), is now making the procedures for reforming the international financial architecture, both globally and in the European Union, more messy and complicated, but somewhat more 'democratic', than perhaps they used to be.

So there are lots of valuable and useful bits and pieces that come under the wing of the financial stability function, but it is, perhaps, arguable whether they amount to a coherent whole. Moreover, until a crisis comes along, this branch has no regular unilateral decision that it can take, unlike a Monetary Policy Committee setting interest rates. In most cases decisions, for example on regulatory changes, are taken after much discussion between FSA, Treasury and the Bank, or even more tortuously in international committees. There is no clear-cut instrument, nor a clear-cut objective, except the negative one of avoiding financial instability.

Indeed there is currently no good way to define, nor certainly to give a quantitative measurement of, financial stability. When Phil Davis, who has established a professional chat group of experts on this subject on the internet, asked the group to define financial stability, the most persuasive responses were that it was just the absence of financial instability.

Let me put the problem another way. When a central bank issues an Inflation Report, it describes what has been happening to a whole series of economic variables, and (usually) sets out some account of its forecasts for the main macro objective variables (e.g. inflation and output). While this is commonly done descriptively in words, lying behind it all are (a suite of) quantitative economic models, (based on some combination of theory, practical relevance and empirical fit). In comparison, the Financial Stability Reviews put out by much the same central banks, and indeed initiated once again by the Bank of England, have roughly similar descriptions of financial developments, and very useful and interesting these are, but there is no overall, coherent model lying behind it all, as in the case for the Inflation Report. With imitation being the sincerest form of flattery, the Bank of England has been recognized as leading the way so far for those Central Banks without responsibility for supervision of individual banks.

Yet there is a long way yet to travel. In this talk I shall outline some new directions that we need to consider in this field. First, I shall develop the theme already noted, which is that we need to construct models ofsystemic stability, not just of individual bank probability of default; second, that we need to pay more heed to the links between fiscal and monetary policies on the financial stability side; third, that, exhausted as you all may be by the marathon effort of agreeing Basel II, we do need to go on to integrate concern with interest margins and liquidity alongside the reforms to risk-related capital adequacy requirements; and finally that the combination of risk-related CARs and the on-going trend to market, or fair value, accounting behoves us all to give further, serious consideration to ways of mitigating procyclicality.

1 1 Whereas it is clear that the FSA has sole responsibility for supervising individual financial institutions, the division of responsibility for systemic financial developments is more nuanced. Thus the Financial Services and Markets Act in the UK also gives the FSA a parallel responsibility for "maintaining confidence in the UK's financial markets".