The role of the Bank for International Settlements in promoting financial stability

Presentation by Malcolm D Knight General Manager of the BIS, at the Basel British Swiss Chamber of Commerce, Basel, 2 February 2004.

Good afternoon, and thank you for giving me this opportunity to renew the long-standing ties between the British Swiss Chamber of Commerce and the Bank for International Settlements.

I feel a special affinity with your association. First, there is my connection with Britain. Every Canadian citizen is also a British subject. But my warmest links with Britain go back to the time I spent there in the 1960s and 1970s, doing my MSc and PhD degrees, and then teaching as a member of the economics department of the London School of Economics. And it was also during the early 1970s that I had my first extensive contacts with Switzerland.

During those years I was part of the International Monetary Research Programme that was operated jointly by the LSE and the Graduate Institute of International Studies at the University of Geneva. That experience taught me both about international finance and about the special challenges confronting the Swiss economy in Europe, and on the broader global stage.

So it has been a special pleasure for me to renew my work in both these areas since my arrival here in Basel 10 months ago.

Promoting the twin goals of sustained non-inflationary economic growth and financial stability has been the overarching mission of the BIS throughout its history. And this is what I want to talk to you about today.

But first let me say just a few words about what the BIS is and does. The Bank was founded in 1930, making it world's oldest international financial institution. Its immediate task was to act as trustee and agent for the international loans intended to finalise settlement of the reparations stemming from World War I - hence the name: the Bank for International Settlements. However, this name did not fully reflect the nature of the Bank's primary mission even in 1930, and it certainly does not do so today.

The primary intention of the Bank's founders' was to create a focus for cooperation among central banks. First, the BIS was to act as the bank for central banks. It would accept deposits of a portion of the foreign exchange reserves of central banks and invest them prudently to yield a market return. We still do this today, managing a balance sheet of some USD 230 billion, equivalent to about CHF 290 billion.

The second important role of the BIS is to provide a forum for policy discussions and international cooperation among central banks. Over the years, the BIS has established a rich structure of meetings in which governors and other senior central bankers can exchange information and opinions on the state of the world economy and its implications for monetary and financial stability policies.

And the solid foundations for these discussions are the economic analysis and statistical work that are performed by the BIS staff.

I think it is no exaggeration to say that - through these activities - the BIS has left an indelible mark on the history of international financial cooperation over the past seven decades. Let me just take three examples from the years following World War II.

First, I think of the reconstruction of Europe after the Second World War. Back in 1950, the BIS was asked to become the agent of the European Payments Union, which was established to restore order to the system of payments for imports and exports among the countries of Europe in the early postwar years. The EPU was highly successful: multilateral convertibility of the European currencies in international payments for current goods and services was restored earlier than foreseen. And in 1958, its task completed, the EPU was wound up - a true success story!

My second example relates to the monetary unification of Europe. From the mid-1970s to the early 1990s, the BIS was the key meeting place for European central bankers as they laid the groundwork for monetary union. Some of you will remember the Delors Report, which outlined the essential blueprint for the creation of a unique new European Monetary Union and the establishment of a European Central Bank. The Report was drafted in the late 1980s, here in Basel, in a meeting room on the first floor of the BIS.

My third example is the creation, by central bank governors, of a number of key permanent committees of experts on various aspects of the international monetary and financial system. Let me give just one illustration. In the early 1970s, discussions about how to enhance prudential supervision of the commercial banking industry resulted in the creation of the Basel Committee on Banking Supervision. This influential Committee has flourished, and is now in the process of finalising the so-called Basel II Accord. I will say more about this shortly.

I could give you many other illustrations of the contributions that the BIS has made to international financial cooperation.

But I would prefer to talk about two broad trends that have motivated most of our initiatives in this arena over the past decade. One trend is the increasing globalisation of economic and financial activity. The other trend is the greatly increased focus on the promotion of financial stability, in all countries, both developed and developing.

The globalisation of markets for final goods, financial and non-financial services, and even factors of production has been one of the most striking developments of at least the past two decades.

And it is perhaps in the area of financial services that one can find some of the most compelling evidence of the impact of globalisation. In the early 1980s, cross-border transactions in securities in the major industrial countries represented less than 10% of GDP. Today, these transactions swamp GDP in most of them.

As of the end of 2002, the stock of cross-border claims on the books of banks in the major financial centres was close to USD 14 trillion. To put this in perspective: it is equivalent to just under half of the annual output of the total world economy in 2002.

The other key trend, the increased focus on the promotion of financial stability, is closely tied to the first issue of globalisation, and has very much shaped the activities of the BIS in recent years. Our concern to promote financial stability involves not only the promotion of price stability, but also support for deep and robust financial markets, for sound financial institutions, and for a stable overall infrastructure for the financial industry.

Why worry about these elements of a stable financial system in a modern market economy? Well, I am convinced that, over the long term, economic and financial systems based on open competition and global market forces can achieve outcomes that are far superior to those possible in a highly regulated and controlled environment.

But that said, such market-based systems can, and do, display elements of vulnerability. Markets can be dysfunctional and they can be subject to failures and breakdowns. Investor and borrower behaviour does not always produce sufficiently deep and liquid markets, or prices that consistently reflect economic fundamentals. And, as we have seen in the cases of Enron and, more recently, Parmalat, the essential tools of transparency and oversight that financial markets require - the standards of accounting, reporting and auditing practices applied to financial transactions - can be unacceptably deficient.

When financial stability is lost, the costs can be grave not only for the country in which the financial turmoil emerges, but also for the international financial system as a whole. We saw this in the 1990s when confidence in international capital flows was shaken. First the Mexican crisis in 1994/95 and then the Asian crisis in 1997/98 undermined the confidence of international investors and imposed significant economic and social costs on all affected countries.

In order to foster a global dialogue, the BIS has enlarged its membership since the mid-1990s, to move from an exclusive focus on the industrial countries to include, by the beginning of the new millennium, the central banks of a number of large and systemically important emerging market countries. Now, alongside the Chairmen or Governors of the US Federal Reserve Board, the ECB or the Bank of Japan, the Governors of the People's Bank of China, the Central Bank of Brazil, the Reserve Bank of India and other systemically important emerging economies participate actively in the meetings we organise, whether in Basel, through our offices in Hong Kong SAR and Mexico, or in collaboration with central banks around the world.

Financial stability issues occupy a prominent place on the agenda of central bank governors when they meet every other month at the BIS. Central banks are not directly responsible for each and every aspect of financial stability, but they are the guardians of the overall soundness of their national financial systems. And so they attach great importance to the careful monitoring of the various building blocks of the financial system.

Finally, let me focus on one of these building blocks which is now very much in the news: promoting the soundness of commercial banks.

Banks are among the most important players in the global financial system. They process enormous volumes of payments resulting from countless transactions in the economy each day. They safeguard our savings and circulate credit, the lifeblood of any economy, to businesses and consumers alike.

Commercial banks clearly play a special role in the workings of the financial system. And so central bankers take a special interest in encouraging all banks to operate safely and soundly. And today, central bank governors - and bank regulators - are working hard to reform one of the most important tools that they have to encourage banks to operate safely. This challenge is known in financial circles as the Basel II process. What exactly is this about?

The challenge is to promote sound risk management practices in banks in a way that ensures that they are adequately capitalised and prudently managed - while not hindering a bank's ability to pursue opportunities and profits responsibly. Well capitalised and well managed banks can serve as efficient intermediaries of credit, not only in good times, but also in periods of strain.

Currently, banks are subject to rules regarding their capitalisation that were first adopted by the Basel Committee in 1988. The rules are quite simple. The 1988 Basel Accord stipulated that internationally active banks should hold an amount of capital that is roughly in line with simple measures of the riskiness of their assets, and that all banks should be subject to the same capital charges - the aim being to create a level playing field. The Accord was originally designed for the internationally active banks of the most advanced financial systems, but its appeal has been such that more than 100 countries have adopted it to date.

Unfortunately, the simplicity of the 1988 Accord has also proved to be a weakness. Advances in methodology, technology and telecommunications have changed the way in which banks measure and manage their risks. Financial innovations have introduced new banking products, many of which the 1988 Accord had not anticipated or did not address.

Over the past five years, the Basel Committee has been working to develop a New Capital Accord, or "Basel II". The New Accord is intended to reflect the improvements in banks' abilities to measure risk. It is also intended to align regulatory capital requirements more closely with the actual degree of risk that banks face. But equally important, the New Accord will provide incentives to banks to improve their management of risk.

The Basel II process has not been easy. The Basel Committee has tackled some extremely complex issues. It has consulted widely and openly with banks, with industry associations and with other stakeholders, to improve the proposals and build the necessary support for them.

But the efforts have already proved worthwhile. Both commercial bankers and central bankers have acknowledged the need for a New Accord and have offered strong support to the Committee's efforts. Currently, the Committee expects to resolve the outstanding issues by mid-2004, which will allow banks and countries to continue to prepare for its implementation.

In closing, let me leave you with this thought: in a world of change and innovation, promoting financial stability must be seen not only as a continuous process, but also as a multifaceted challenge that calls for strong commitment to open and honest international cooperation. The BIS remains committed to this mission, which has evolved and gained importance since we first opened our doors in 1930. And this is likely to keep us in Basel for a long time to come. Thank you.