Central banks and challenges of financial stability


Friday, 25 June 2010


John Lipsky, first Deputy Managing Director, International Monetary Fund (IMF), delivered this lecture at the International Conference on Central Banks and Development of the World Economy, in Moscow,Today, countries around the world are working to improve the financial systems’ resilience, starting with financial institutions themselves and the agencies that supervise and regulate them.


For central banks, this means playing a larger role in safeguarding financial stability, and there are many areas where efforts are being stepped up to address shortcomings exposed by the crisis.First is the need to improve supervision of the financial sector. The crisis demonstrated clearly that correcting weaknesses in supervision is as important as the efforts currently underway to reform financial regulation. So far, however, it appears as though most of the public’s attention regarding financial sector reform – and, perhaps, most of official attention as well –has focused on the large regulatory agenda. Nonetheless, IMF analysis suggests that there is significant scope for improving supervision.


Second is the need to strengthen frameworks for maintaining systemic financial stability. The crisis demonstrated that a successful monetary policy framework focused on price stability creates room for maneuver in crisis response. At the same time, the crisis also showed that systemic risks – especially those created by pro-cyclical tendencies – had not been fully understood. This recognition gave rise to a new appreciation for the prospective contribution of macro-prudential regulation in reducing systemic vulnerabilities. To achieve this goal, however, new macro-prudential tools need to be developed and agreed.


Third, there are compelling reasons–including strong fundamentals and favourable growth prospects -to expect a sustained and substantial increase over the coming years in capital flows to emerging economies. Of course, the overall impact of such inflows is overwhelmingly positive. Nonetheless, they can pose macroeconomic policy challenges for authorities in recipient economies.


Improving supervision

Turning first to the issue of supervision, post-crisis analysis by IMF staff and other experts found shortcomings related to both the ability and willingness of supervisors to act in the face of institutional weakness.


Prior to the crisis, for instance, supervisors relied excessively on financial firms’ own risk analysis and internal controls. In broad terms, they relied heavily on the self-disciplining qualities of markets. In other words, supervisors were insufficiently intrusive and skeptical.


In a rapidly changing environment, spurred by financial innovation, analysis by my IMF colleagues and others suggest that in many cases, supervisors did not fully understand new complex products and did not do enough to make sure that financial firms’ boards and managements fully grasped the riskiness of these products. In other words, supervisors were insufficiently proactive and adaptive.


Not surprisingly, supervisors tended to confine their assessments to regulated entities and did not adequately consider risks posed from outside of the regulated system. Thus, supervision was insufficiently comprehensive.


Supervisors often did not act quickly enough to develop their supervisory judgments. In other words, in many cases, supervision was insufficiently conclusive.Indeed, our analysis—based on over 100 reports under the joint IMF-World Bank Financial Stability Assessment Program (FSAPs)—suggests that supervisory weaknesses are widespread. While most countries are in compliance with international standards regarding the legal and institutional framework for supervision, over one-third of countries in our sample did not meet key supervision standards.


Specifically, standards relating to the supervision of risks, consolidated supervision, adequacy of resources, operational independence, and enforcement powers were found to be lacking. More recent data suggest that deficiencies in consolidated supervision, operational independence, powers to take corrective action, and comprehensive risk management continue to be pervasive.


Broadly, a supervisory regime that creates both the ability and the will to be intrusive, skeptical, proactive, adaptive, comprehensive, and conclusive should have the following components:


•Clear objectives and mandates, sufficient operational independence, adequate resources, and broad support for its mandate.

•An appropriate mix of supervisory approaches and techniques, including on and off-site work that focuses on identifying emerging risks both at the firm and system-wide levels.

•Access to a broad range of available remedies that can be implemented if regulated firms fail to meet standards, coupled with an approach combining rules-based actions with supervisory judgment.


In many other countries, lax lending standards and banks’ over-reliance on low-cost wholesale funding encouraged rapid credit expansion and an overheating economy. Of course, the crisis brought this to an abrupt end, as the economy tumbled into a sharp recession and credit expansion halted. Banks have spent the past year or so adjusting their balance sheets, paying down debt, increasing provisions, and building up liquidity. Nonetheless, overdue loans have risen to six per cent of the total and credit has been largely stagnant since last January.


Looking forward, a key task here will be to improve supervision. To accomplish this, the central banks’ auuthority to conduct consolidated supervision (including over connected lending) should be strengthened, enforcement powers should be bolstered. For example, by allowing Russian supervisors to sanction bank managements, and supervisory risk management assessments should be enhanced, particularly with respect to loan provisioning and classification requirements.


Monetary policy and financial stability

Beyond issues of improving regulation and supervision, central banks inevitably are going to play a larger role in maintaining systemic financial stability. For one thing, monetary policy considerations are relevant, and the crisis offers some key lessons in this regard. Moreover, innovative macro-prudential tools should be able to help smooth the over-the-cycle feedback between the financial sector and the real economy.


It goes without saying that the crisis posed significant challenges for the conduct of monetary policy in both advanced and emerging economies.Notably, our research indicates that emerging economies with low or falling inflation were able to provide more monetary stimulus in response to the crisis, thereby cushioning recessionary trends. Such countries also benefited from their ability to follow more flexible exchange rate policies.


Thus, the favourable inflation developments of the past year present Russia with a valuable opportunity to reorient its monetary policy toward a clearer focus on inflation goals. In fact, the greater exchange rate flexibility allowed since early 2009 —alongside the CBR’s recent public communications— have pointed in just such a direction.


As is well known, success in establishing and sustaining low and stable inflation is enhanced by increased central bank independence, and by more complete and effective domestic financial markets that create a more robust monetary transmission mechanism.Thus, monetary policy effectiveness is bolstered when banking sector weaknesses are addressed decisively though appropriate bank recapitalisation, restructuring, or resolution.


For many emerging economies, including Russia, the implementation of macro-prudential policies also represent a likely path to achieving greater financial stability. Such tools as counter cyclical capital requirements, forward-looking loss provisioning, liquidity ratios, and prudent collateral valuation have the potential for reducing the build-up of imbalances in good times and in providing buffers for periods of systemic stress. Of course, the potential for such tools–and other measures-to enhance systemic stability will depend, in part, on insuring that the regulatory perimeter is redrawn to include all systemically relevant institutions.


It is worth noting that central banks have an interest in the implementation of macro-prudential tools even if they do not serve as the main regulator, for two key reasons. First, the absence of such tools will tend to increase the burden on monetary policy to deal with rising financial imbalances, thereby raising the risk that central banks ultimately would be called upon to provide emergency liquidity.


Second, the application of these tools is likely to influence the transmission of monetary policy.I want to be very clear on one key point: Much work remains in developing systemic financial stability governance frameworks and in making macro-prudential tools operational. Nonetheless, I have no doubt that such tools will prove to make important contributions in the coming years.


Managing large capital flows

The increase in capital flows to emerging market economies, over the past few quarters, has reflected a partial recovery in such flows, following the crisis-driven “sudden stop” experienced in 2008 and 2009.


There is little doubt, however, that the relative strength of emerging economy policy fundamentals and favorable long-term growth prospects has the potential to attract rising flows from international sources for some time to come. Of course, this is good news, as effectively channeled inflows have the potential to accelerate growth and boost economic efficiency.


In the absence of an adequate policy and institutional framework, however, it is clear that capital inflows can complicate macroeconomic management, reduce the effectiveness of monetary policy, and create systemic stress.


Recent IMF research in this area has confirmed widely-understood insights regarding how countries can best meet the anticipated, desirable challenge of rising capital flows. Capital flows are more beneficial in the context of better-developed financial systems and sound policy frameworks, including credible monetary and fiscal policies, an appropriately valued and flexible exchange rate, and adequate international reserves, among other things.


Thus, capital flows that appear to be outsized (or undersized, for that matter), most likely, are useful indications of the need for policy adjustment or adjustments.





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