Financial Stability:
The Role of
Prudent Banking Policies
and Information Flows
Dr. Silvio John Camilleri
Banking and Finance Dept. – FEMA
University of Malta
April 2011
Overview of the Presentation
• Financial Stability: A Multi-Faceted Concept
• The Financial Stability Board
• The Role of Prudent Banking Policies
• The Role of Information Flows
• Select Initiatives
• Conclusion
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Financial Stability: A Multi-Faceted Concept
Financial system’s ability:
(a) to facilitate an efficient allocation of economic resources…
and other economic processes (such as wealth accumulation,
economic growth, and ultimately social prosperity);
(b) to assess, price, allocate, and manage financial risks; and
(c) to maintain its ability to perform these key functions - even
when affected by external shocks or by a build up of
imbalances...
(Garry J. Schinasi, 2004, Defining Financial Stability, IMF
Working Paper WP/04/187)
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Features associated with financial stability:
• Monetary Stability (modest inflation rate; exchange rate
stability)
• Banking Stability (required for the financial intermediation
process to occur smoothly)
• Financial market stability (no excessive volatility which could
impact on real economic activity)
• Stability in the job market (unemployment may compromise
loan repayments)
• Stability in real asset prices (immovable property, raw
material)
• Confidence in the financial system is a key!
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The Financial Stability Board
(formerly Financial Stability Forum)
Established to “develop and promote the implementation of
effective regulatory, supervisory and other financial sector
policies”.
“In collaboration with the international financial institutions, the
FSB will address vulnerabilities affecting financial systems in the
interest of global financial stability”.
(Financial Stability Board Charter; September 2009)
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Activities include:
• Developing early warning systems to assess vulnerabilities
and recommending how the latter should be addressed;
• Promoting exchange of information in between members;
• Recommending improvements in regulatory standards;
• Developing contingency plans for crisis management.
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Members comprise:
National and regional authorities responsible for maintaining
financial stability, namely ministries of finance, central
banks, supervisory and regulatory authorities;
(e.g. European Central Bank, Board of Governors of the Federal
Reserve System, Securities and Exchange Commission (SEC),
Financial Services Authority (UK), Deutsche Bundesbank, Swiss
National Bank, Central Bank of the Russian Federation)
International financial institutions; (e.g. Bank for International
Settlements, IMF, OECD, World Bank)
International standard setting, regulatory, supervisory and
central bank bodies; (e.g. Basle Committee on Banking
Supervision, International Organization of Securities
Commissions)
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The Role of Prudent Banking Policies:
Minsky’s Financial Instability Hypothesis
There are endogenous disequilibrating forces within free-market
economies; instability arises as a consequence of actions taken
during times of financial stability.
Hyman P. Minsky: The Financial-Instability Hypothesis: capitalist
processes and the behavior of the economy.
Hyman P. Minsky, 1993, The Financial-Instability Hypothesis, in:
Handbook of Radical Political Economy, edited by Philip Arestis
and Malcolm Sawyer, Edward Elgar: Aldershot.
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Hedge Units: anticipated total revenues exceed payments in
every period.
Speculative Units:
Anticipated Profits < Payment commitments (in the first years)
Anticipated Profits > Payment commitments (in the subsequent
years)
The survival of such firm depends on the ability to raise debt.
This depends on the normal functioning of financial markets.
Ponzi-finance units:
Anticipated Profits < Payment commitments (i=1, …, n-1)
Anticipated Profits > Payment commitments (i=n)
For all except some end points of the horizon, current earnings
do not meet payment commitments. Investments resembling this
type of unit are those with a significant gestation period or where
revenues mainly occur upon completion of a project.
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Robust financial system:
changes in cash flows, interest rates and payment commitments
do not materially compromise the ability of private units to fulfil
their obligations.
This requires a pre-dominance of Hedge Units.
Weak financial system:
changes in cash flows, interest rates and payment commitments
compromise the ability of private units to fulfil their obligations.
This implies a pre-dominance of Speculative and Ponzi-Finance
Units.
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Now, changes in cash-flow relations occur over stable periods
and transform a robust financial system into a fragile one.
A financial structure dominated by hedge finance induces firms to
invest and speculate, since idle cash is available.
Cash balances in bank portfolios are seen as inputs for new
lending.
Therefore “stability is destabilising”, leading to an expansion of
investment and then to a recession. There are forces in freemarket economies that lead to financial structures that are
conducive to instability.
Thus regulators should keep an eye on the changes of the
financial structure of banks; constraining speculative and Ponzifinance units.
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The Role of Information Flows
Mishkin’s Information Economics Explanation for a Financial
Crisis
Frederic S. Mishkin, 1997, "The Causes and Propagation of
Financial Instability: Lessons for Policymakers", Maintaining
Financial Stability in a Global Economy (Federal Reserve Bank of
Kansas City, Kansas City, MO., 1997): 55-96.
The concepts of asymmetric information, adverse selection,
moral hazard, and free-rider incentives.
Banks are particularly suited to tackle such problems: long-term
relationships, privately traded contracts, scrutiny of borrowers’
accounts.
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Factors that may lead to instability:
i) Increases in interest rates
ii) Increases in uncertainty
iii) Asset market effects on balance sheets
iv) Problems in the banking sector
All of these lead to a worsening of asymmetric information
problems.
Financial instability may result in a crisis through the slowing
down of information flows which reduce financial intermediation
activity.
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A financial crisis results in the sorting out of insolvent firms from
healthy firms, and this will reduce uncertainty in financial markets,
and reduce the potential for adverse selection and moral hazard
problems.
This will be essential for a subsequent recovery.
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Select Initiatives
Encouraging the Implementation of International Standards
Country Members of the FSB are subject to peer reviews relating
to the implementation and effectiveness of FSB financial
standards and of policies.
(FSB Framework for Strengthening Adherence to International
Standards; January 2010)
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Cross-Border Cooperation in Crisis Management
Different country governments drafted their own packages to
stabilise local institutions during the sub-prime crisis. Such
policies could have been better coordinated given that crises may
propagate across countries. For instance, European banks were
exposed to toxic assets originating in the US.
Collaboration entails the exchange of information and agreeing
on a common course of action.
“If a fully coordinated solution is not possible, discuss as promptly
as possible national measures with other relevant authorities”.
(FSF Principles for Cross-Border Cooperation on Crisis
Management; April 2009)
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OTC derivative contracts
Standardised OTC derivative contracts should be traded on
public venues, where appropriate.
This requires standardisation efforts.
Non-centrally cleared contracts should be subject to higher
capital requirements.
(FSB Report on Implementing OTC Derivatives Market Reforms;
October 2010)
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Reducing Pro-Cyclicality in Bank Capital Requirements
During periods of financial well-being, overall risk is low and this
implies lower capital requirements.
Capital requirements then increase when volatility or vulnerability
increases.
Banks should really be encouraged to do the opposite – building
up a stock of capital during buoyant periods so that this serves as
a buffer during periods of financial distress!
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Financial institutions should be supplementing their capital base
in excess of regulatory requirements so that these resources
become available to absorb losses arising in unstable markets.
The concept of capital adequacy should not be confined to an
estimate derived from VAR models.
“Losses in many banks' trading books during the financial crisis
have been significantly higher than minimum capital requirements
under the Pillar 1 market risk rules”.
(Joint FSF-BCBS Working Group on Bank Capital Issues Reducing procyclicality arising from the bank capital framework;
April 2009)
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Conclusion; Some Issues of Debate
Do big banks pose a threat to financial stability?
Should there be some types of restrictions on banking activity to
avoid the formation of large banks which may be too difficult to
supervise?
Should the restructuring of banks occur at the expense of
taxpayers?
Do depositor protection schemes result in moral hazard
behaviour?
Should regulatory capital be equated with economic capital?
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