Financial Risks, Stability, and Globalization
Chapter

10 The Central Bank’s Role in Fostering Financial System Stability: A Canadian Perspective

Author(s):
Omotunde Johnson
Published Date:
April 2002
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It is a pleasure to be back at the International Monetary Fund where I spent nearly 24 years. Throughout my time here, issues of financial stability figured importantly in many of the countries with which I was involved. This was particularly so over 1996–98 when I was Deputy Director of the Monetary and Exchange Affairs Department (MAE), for this was the period when there were systemic financial crises in Venezuela, Bulgaria, Mongolia, and, of course, Thailand, Indonesia, and Korea. At that time, many of us in MAE became heavily involved in the design and implementation of financial system restructuring programs in very challenging circumstances. My current position as a central banker, of course, gives me a new and different perspective on issues of financial system stability. So, I welcome the opportunity to speak to you about a topic that has taken on a vastly increased importance since the mid-1990s: the role of the central bank in fostering financial system stability.

As you know, the past two decades have witnessed literally dozens of systemic financial crises throughout the world. And these have hit all sorts of countries—both industrial and developing. I think it is fair to say that in a number of these cases the actions of the central bank, whether before or during the crises, did little to promote financial stability. And in some cases, central bank action—or inaction—actually precipitated the crisis or aggravated its severity.

We have also come to realize that such crises can be extremely costly, not only for the taxpayer, who all too frequently bears the cost of insolvencies in the financial system, but also because of the way financial crises undermine the fabric of the macroeconomy, weakening output and employment. So a discussion of the role that the central bank can play in helping to achieve and maintain a sound financial system is certainly topical.

We need to think about these issues not only in the context of industrial countries, where many of the principles for central banks to fulfill this role are well established, but also in the context of developing and emerging market countries, where financial deepening is still a work in progress and where central banks face many challenges in endeavoring to foster a stable and robust financial system.

Recent experience has also taught us that financial system stability and broader macroeconomic performance are intimately linked. If the macroeconomic situation of a country is highly unstable, it is most unlikely to be able to achieve a sound and robust financial system. Conversely, if a country has a weak financial system—particularly a weak banking system—it becomes much more difficult for the authorities to pursue sound monetary, financial, and even fiscal policies. So fostering a sound financial system is absolutely central to the work of any central bank!

Although central banks have a fundamental interest in a stable and robust financial system, there often are several agencies in each country that contribute to financial system soundness. In a quick check with the IMF staff last week, I learned that the central bank acts as the main agency that regulates and supervises banks in about two-thirds of the IMF’s member countries, while the supervisory function is vested in an institution other than the central bank in the remaining third.

Canada is in this second category. At the Bank of Canada, we believe that there are strong reasons for having the responsibility for supervision of financial institutions vested in an agency that is separate from the central bank. In particular, at least in the Canadian context, it appears logical that the task of determining the solvency of individual financial institutions should be undertaken by a separate agency from the one that is responsible for monetary stability and last-resort lending—i.e., the central bank. This gives clarity of responsibilities, mandates, and perspectives, and it encourages productive cooperation among the public agencies that are responsible for financial system stability.

A second aspect of our view at the Bank of Canada is that there is no substitute for good governance within private sector financial institutions themselves, through their management teams and boards of directors, and through public disclosure of their financial condition.

The second aspect is related to a third aspect. In its work on financial system stability, the IMF staff has consistently taken the view that the private market is generally the most efficient means through which to resolve the social coordination problems associated with achieving a robust financial system. In Canada, we share this perspective. As a result, the Bank of Canada takes the view that its interventions to promote financial stability should be the minimum needed to achieve its public policy goals, so as to rely on private market forces as much as possible. The Bank also places a great deal of emphasis on limiting moral hazard in public policy intervention. This means that the Bank seeks to avoid public policy initiatives that could create incentives for excessive risk-taking by economic agents.

These are the basic principles that we have tried to put into effect in Canada for many years. It has not always been easy to do so and we have had our problems. But I believe that we have evolved a sensible, pragmatic approach to the development of a sound financial system, and we are gradually elaborating a clearer and more comprehensive view of how the central bank can contribute to it. Let me give you some thoughts on this issue.

A stable financial system is one in which all economic agents—households, business firms, financial services firms, and government—can confidently hold and transfer financial assets without experiencing serious risks of disturbances that undermine financial values or repayment prospects. The first essential prerequisite for achieving financial stability is confidence in the monetary framework, based on confidence that reasonable price stability will be maintained. In most countries, the achievement of monetary stability is the prime responsibility of the central bank, as the monetary authority. So the first and most fundamental thing that a central bank can do to underpin financial stability is to implement, in a transparent way, policies that achieve this goal. While—in principle—the central bank has the ability to create “risk-free” domestic money at will, considerations of price level and exchange rate stability imply that it can not do so without limit. If it produces too much liquidity—whether through a misguided monetary policy or as a result of unsterilized liquidity support to troubled financial institutions—price and exchange rate stability will be jeopardized or destroyed. Thus, the central bank’s role in providing liquidity to the financial system must be conditioned and constrained by the need to avoid these sorts of moral hazard in acting as lender of last resort.

In contrast to monetary stability, which is usually more or less the exclusive domain of the central bank, responsibility for financial system stability is often—as I have said—shared among several public sector agencies. So it is essential to specify the criteria for determining the nature of these responsibilities, how they will be allocated to different agencies, and the extent to which public disclosure of the condition of financial institutions, as well as market discipline, are relied upon to reinforce financial soundness.

In general, creating the appropriate framework for financial system stability, regulating the system, and promoting its robustness imply four distinct types of public policy authority. These are

  • a policymaking authority—that is, an agency that develops and implements the framework of laws and regulations governing the operation of the financial system;

  • a supervisory authority—that is, a body that seeks compliance of regulated financial institutions with the established supervisory framework and rules;

  • a system that limits risks to retail depositors without creating generalized guarantees. Usually, this means an authority for a limited (i.e., self-financing) deposit insurance system; and

  • a central bank to act as monetary authority and lender of last resort to the financial system.

In Canada, for example, these four functions are performed by four separate public sector bodies. The Department of Finance is responsible for policymaking, the Office of the Supervisor of Financial Institutions is the supervisory authority at the federal level, the Canada Deposit Insurance Corporation manages the deposit insurance system, and the Bank of Canada, of course, is responsible for monetary policy, the lender-of-last-resort function, and oversight of systemically important clearing and settlement systems.

But if separate agencies are to perform these separate roles, they must also cooperate closely. Their work in assuring financial stability must be well coordinated, and each institution must operate according to its comparative advantage. It follows from the collective nature of providing for financial system stability that it is important for the principal agencies to share information and advice. In Canada, this coordination mechanism is provided chiefly though two high-level committees that include all of the four agencies: the Financial Institutions Supervisory Committee (FISC) focuses on regulatory and supervisory matters and is chaired by the Superintendent of Financial Institutions; and the Senior Advisory Committee (SAC) focuses on financial sector policy development and is chaired by the Deputy Minister of Finance. The heads of the four agencies also sit together as members of the Board of Directors of the Canada Deposit Insurance Corporation.

Any financial system is composed of three basic components: clearing and settlement systems, financial institutions, and financial markets. Since each of these plays a vital role in the financial system, a disruption in one can cause instability in the others and in the financial system as a whole, leading to adverse macroeconomic consequences.

The Central Bank and the First Component: Payment, Clearing, and Settlement Systems

The fact that a central bank can create and lend domestic currency liquidity means that—within the confines of the domestic economy—it can provide for credit-risk-free payment certainty among financial institutions that exchange payment orders for value through transfers among accounts that are on the central bank’s own books. This, in combination with the lender of last resort function, gives the central bank a strong interest in monitoring institutional payment flows through major clearing and settlement systems, and in keeping abreast of the latest technological developments in payment system management and risk proofing. Thus the central bank is the logical institution to oversee the operation of systemically important clearing and payment mechanisms.

The Central Bank and the Second Component: Financial Institutions

Financial institutions—banks, other deposit-taking institutions, insurance companies, and other financial services firms—are the second component of the financial system. In industrialized countries, the central bank typically is not responsible for developing the legal and regulatory framework within which these institutions operate. By contrast, in many emerging market countries, the central bank possesses unique expertise and is active in these areas. But whether or not the central bank is responsible for developing the legal framework for financial stability, it certainly has an interest in contributing to the analysis that underlies well designed policies. In cooperation with the government, the financial system supervisor, and the deposit insurance corporation, the central bank should be able to provide informed advice on the design of financial sector policy and legislation. A central bank is also well placed to play a role in encouraging the implementation of clear internationally accepted rules, because it brings a broad macroeconomic and financial perspective to bear—and indeed, an international perspective—through its close contacts with other central banks.

The Central Bank and the Third Component: Financial Markets

Financial markets transmit signals from one sector to another. They provide information and interaction opportunities that allow market participants to manage risks and to form, and act upon, their expectations about future developments. The structure of financial markets—as determined by trading and risk management practices, the mechanisms of asset price discovery, information disclosure requirements, and so on—plays an important role in propagating shocks through the financial system. Such disturbances can affect a central bank’s ability to efficiently maintain price stability. So in countries where financial markets do not work well, they can severely disrupt economic decisions and resource allocation far beyond the financial sector. That is why the central bank also has an intense interest in the functioning of financial markets, in their development, and in the framework of rules and conditions that governs their operation. To give just one example, the prices established in markets for government securities serve as benchmarks for pricing other fixed-income securities and loans by financial institutions to businesses and households. Given the fundamental importance of government debt markets in any economy, and particularly their central role in financial deepening in developing countries, the central bank also has a strong incentive to promote markets that are open to the widest possible group of market participants, and that are well regulated, transparent, and efficient.

The Central Bank as Lender of Last Resort

Aside from the routine, collateralized, overnight lending that a central bank may undertake for banks that are temporarily short of liquidity in the payment system, lender-of-last-resort interventions are intended to address three types of problems: (1) gridlock in a payment system; (2) a run on an illiquid deposit-taking institution, or group of institutions; and (3) the collapse of a formerly well functioning financial market. The means of lender-of-last-resort intervention—whether through direct central bank liquidity support to an individual institution or through a temporary provision of liquidity to the system as a whole (via Bagehot’s Rule)—depends on the nature of the episode being addressed. But in conducting such interventions, it is critical that the central bank avoids creating incentives for further financial instability.

The lender of last resort should limit its direct lending to cases of market failure. The main guiding principal in the exercise of the lender-of-last-resort function is to avoid moral hazard. Normally, this will require the central bank to receive a credible judgment from the supervisory authority that an illiquid institution is, in fact, solvent. As a further means of controlling moral hazard, the central bank should lend only at market rates of interest or above, and only on a fully collateralized basis. These latter strictures (i.e., lending against collateral and generally at a penalty rate) are specifically included in the Bank of Canada Act.

In this key area, central banks need to give additional attention to a number of issues. Let me give just two illustrations.

  • It is essential for the central banks to develop clear, limited access strategies for initiating or continuing extraordinary last-resort lending (i.e., to decide, in advance, the categories of institutions to which the central bank should lend and the conditions of access, including policies for last-resort lending to domestic branches of foreign banks or in response to runs on the foreign currency liabilities of domestic financial institutions). These policies, in my view, need to be transparent, limited in scope with a clear exit strategy, and designed to be consistent with the country’s chosen exchange rate regime.

  • In cooperation with supervisory agencies, the central bank should work to establish appropriately strong criteria for early intervention of troubled institutions, a write-down of their net worth, and their early closure in case of approaching or actual insolvency. While other agencies may have the primary role in this area, the central bank must work to ensure that it will never become the investor of last resort in troubled financial institutions!

Strengthening the Central Bank’s Role in Promoting Financial System Stability

As you can see from these examples, the central bank’s interest in financial system stability brings with it many complex issues. But let me end by suggesting four areas where we, as central bankers, may aim to improve the way we approach the work of helping to provide for financial system stability. The first is for the central bank to develop and regularly monitor various indicators of financial system stability. Such indicators relate to clearing and settlement systems, financial institutions, and financial markets. Second, we should do more fundamental research on financial stability, and should also seek to promote research collaboration with other central banks and institutions, both at home and abroad, that are interested in these issues. Third, it may be a good idea for central banks in countries that have relatively deep financial systems to develop a financial stability report of the type that is currently produced on a regular basis in countries such as Sweden and the United Kingdom. Fourth, central banks should contribute regularly to the work of international fora that are developing core principles, standards, and best practices for the operation of the various components or “pillars” of the financial system, and this work should be closely coordinated with multilateral peer review in the form provided by the IMF’s Financial System Stability assessments.

In all of this work, the central bank should basically be trying to learn as much as it can about how macroeconomic shocks are transmitted through the financial system and, conversely, how financial shocks are transmitted through the economic system. In the end, this sort of system-wide monitoring informs the broader goal of achieving monetary stability that I emphasized at the beginning of my talk, because it helps us in a central bank to better understand the environment within which the effects of our monetary policies are transmitted, and the circumstances in which last-resort lending may be required.

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