Banking Soundness and Monetary Policy
Chapter

5 Global Capital Markets and the Stability of Banking and Financial Systems

Editor(s):
Charles Enoch, and J. Green
Published Date:
September 1997
Share
  • ShareShare
Show Summary Details
Author(s)
ANDREW CROCKETT

The task of those charged with safeguarding the stability of the financial system has never been an easy one. However, the job is becoming even more demanding as a result of the phenomenal growth of financial markets following the tide of deregulation and globalization over the past twenty years or so. The awareness in official circles that banking system fragility poses a serious potential threat to the stability of the real economy, both at the domestic and international levels, has been growing for several years.

The present seminar is yet another expression of these concerns. Even though it is the stability of the banking system that is the explicit subject of these discussions, I take the liberty in this paper of looking at the financial system more broadly. My reasons for doing so are partly because the very changes that concern us challenge traditional distinctions among different types of financial institutions and partly because I wish to put the discussion into a broader perspective of systemic soundness.

Nature of the Problem

During the past twenty years or so, we have witnessed a profound change in the size and structure of the world’s financial markets. The trend, which emerged in a few countries during the 1970s, subsequently gathered momentum, and spread globally, is supported by three factors. First, the growing ascendancy of free market philosophy provided the intellectual basis for the removal of quantitative and qualitative restrictions on balance sheet structures, as well as other restrictions that implicitly supported cartel-type arrangements. It also stood behind the removal of exchange restrictions that compartmentalize capital markets geographically.

Second, a wave of technological innovation led to the development of new financial instruments and a phenomenal reduction in the costs of gathering, processing, and disseminating information. This has led to the creation of new markets and the rapid expansion of others. It has also facilitated the management and co-ordination of activities that span wider geographic and product domains.

Third, the macroeconomic environment has been favorable. The growth of output and trade and the absence of major episodes of financial or economic crisis have encouraged globalization, which has brought in its train the need for more complex and geographically diversified financial services. A few figures will serve to illustrate the growth of financial market activity over the past decade and a half.

The two panels of Figure 1 plot the combined turnover in the secondary bond and equity markets in the major industrialized countries. Total transactions in securities markets (relative to underlying GDP) have increased by seven times in the United States since the beginning of the 1980s, and by comparable amounts in most other major industrial countries, except Japan. The growing importance of the international dimension of the same markets is shown in Table 1, which calculates the volume of gross transactions in these traditional instruments between residents and nonresidents. The same message is conveyed by the results of the Triennial Survey of Foreign Exchange Markets conducted by central banks and coordinated by the BIS. The daily net foreign exchange turnover grew almost fourfold between 1986 and 1995 to US$1.2 trillion.

Figure 1.Turnover on Securities Markets

(As a percentage of GDP)1

Source: National data (1996 data provisional).

1Estimates of the annual secondary-market transactions in equities and bonds, including in some cases those carried out over the counter. A purchase and corresponding sale are counted as a single transaction.

2Total transactions settled through Euroclear and Cedel as a percentage of total GDP (in U.S. dollars) in the Group of Ten countries.

Table 1.Cross-Border Transactions in Bonds and Equities

(As a percentage of GDP)1

19751980198519901992199419951996
Canada3.39.626.764.4113.2211.8194.5234.8
France5.021.453.6122.0201.2179.6229.2
Germany5.17.533.456.785.1157.7169.4196.8
Italy0.91.14.126.692.2207.1252.8435.4
Japan21.87.762.5119.471.959.965.182.8
United States4.19.035.189.0106.6131.0135.3151.5
Sources: National balance of payments data; Bank for International Settlements-Note: 1996 data refer to January through September.

Gross purchases and sales of securities between residents and nonresidents.

Since 1996, data based on settlement.

Sources: National balance of payments data; Bank for International Settlements-Note: 1996 data refer to January through September.

Gross purchases and sales of securities between residents and nonresidents.

Since 1996, data based on settlement.

Figure 2 shows that the growth of more traditional banking activities has followed much the same pattern. The total volume of international assets held by the BIS reporting banks has more than doubled over the last decade.

Figure 2.International Bank Lending

(In billions of U.S. dollars)

Note: For 1996, end-June data.

Source: Bank for International Settlements.

The forces of market liberalization and the globalization of transactions have transformed the structure of the financial industry virtually everywhere and given rise to a more efficient and competitive financial industry. Liberalization has provided greater scope for markets to achieve a better allocation of financial resources, domestically and worldwide. It has improved the menu of investment outlets available to suppliers of funds and offered end users easier and cheaper access to finance. Financial innovation has also provided market participants with new instruments to better manage their risk exposure. The reduction in transaction costs has raised the liquidity of securities markets, while the removal of foreign exchange controls has permitted capital to flow more freely toward higher returns, promoting a greater diversification of portfolios. As the trend toward more open and competitive market structures continues, the ensuring efficiency gains are likely to grow.

These benefits, however, have not been achieved without costs to the stability of the financial system. Greater market liberalization and internationalization go hand in hand with greater risk of potential disruptions that originate in or are transmitted through financial markets. More open and competitive markets can develop dynamics of their own and are subject to temporary fluctuations that are hard to explain on the basis of underlying fundamentals. The larger these markets, the greater is the economic impact of such fluctuations. Heightened competitive pressures, which squeeze financial institutions’ profit margins, could lead them to pursue riskier strategies, increasing the possibility of failure. Economies that are more open to international capital markets are also more exposed to shocks originating abroad, which are then transmitted through international capital flows.

A growing body of academic research has focused on the interaction between financial and macroeconomic stability. It provides a theoretical confirmation of what financial authorities have always believed: namely, weak financial systems, and episodes of severe strains or outright failures in financial institutions and markets, can have serious repercussions on overall economic stability.

There are several channels through which such effects can be transmitted. Balance sheet weakness at financial intermediaries severely affects their ability to channel funds from savers to borrowers, with adverse implications for investment. Instability at individual institutions can lead to more generalized fragility, or to sudden swings in asset prices, which in turn result in large losses and failures of firms both in the financial and the nonfinancial sectors. Decreased financial wealth can then severely affect the ability of firms to raise finance and continue normal operations.

A further set of channels has to do with contagion effects where the failure of one or a few institutions can lead to strains elsewhere in the financial system because of interconnected activity and mutual exposure through the payment system. Of a similar nature are the problems faced by debtor countries when a liquidity crisis in another country leads to an abrupt reevaluation of international investors’ assessment of risk and triggers a sudden reversal of capital inflows with potentially adverse macroeconomic consequences.

Finally, financial instability can impinge on a country’s ability to pursue a prudent macroeconomic policy. International experience shows that the fiscal costs of resolving widespread financial failures can be high. The desire to limit these costs may induce monetary policy “forbearance”: to avoid the high costs of closing or recapitalizing of financial institutions, the authorities may be tempted to maintain a looser policy stance than that warranted by the prevailing macroeconomic conditions, hoping that the extra liquidity will help financial institutions out of difficulties. In such circumstances, financial markets may also sense the unwillingness of the authorities to defend rigorously any existing exchange rate target and a speculative attack may quickly follow.

The new financial environment facing policymakers and regulators is one in which certain traditional types of risk have increased and in which there are heightened perceptions of other types of risk, which in principle may have existed before but were of lesser concern. At least four kinds of changes in financial markets can be highlighted, each of which leads to greater uncertainty about where problems might arise, how they might manifest themselves, and what policy responses might be appropriate both to prevent problems and to deal with them if they do arise.

The first notable change is the increased volume of transactions in today’s markets. The implication is that the effects of a market disturbance could be considerably greater and affect a wider array of participants than was the case twenty years ago. Since low transaction costs have increased the speed at which prices adjust to changes in market conditions, positions can be modified almost instantaneously and a wide range of other markets can be affected before the official sector has time to react.

A second change is that the conventional borders between bank and nonbank financial institutions, and in many cases between financial and nonfinancial firms, have become more blurred. Accordingly, the traditional structure of the financial industry is being continuously challenged, and old distinctions are less appropriate as a foundation for our regulatory and supervisory framework. Markets are increasingly competitive and contestable, while at the same time we observe the emergence of conglomerate structures that bring together entities operating in previously separated financial markets.

A third element of change, which is likely to grow in importance, is the increased institutionalization of savings. Growing awareness of the limitations of government-provided pension arrangements, and the increased capacity to manage institutionally diversified portfolios, have fueled the growth of private life insurance and pension funds, mutual funds, and other types of pooled investment vehicles. Many of these institutional investors are relatively new to the financial scene and untested in stressful market conditions. There is concern that the different incentive structure under which they operate may encourage “herd-type” behavior among their ranks, more so than is the case for traditional investors.

Finally, cross-country capital flows are growing rapidly, and domestic systems are consequently increasingly exposed to shocks emanating from abroad. The removal of exchange controls has enormously increased the ability of capital to cross borders in search of higher yield or to flow back in quest of higher security. Such flows can now be large enough to pose significant problems for financial and economic stability in the countries most affected. Of particular concern are the implications of such flows for the countries known as “emerging markets.” Most are economies that are both growing fast and rapidly liberalizing their economic structure. The pace of economic change stands behind both the demand for and the supply of internationally mobile capital. Emerging markets offer an excellent opportunity for diversification, and thus reduction in the risk assumed by global investors, but at the same time their rapid growth, greater vulnerability to swings in sentiment, and other special characteristics distinguish them from industrial markets.

From the discussion so far it is obvious, I believe, why the question of banking soundness cannot be adequately analyzed in isolation from the more general question of the structure and stability of the financial system at large. Given the speed and complexity of the changes under way in the international financial system, it should also be obvious that any strategy that aspires to promote robustness in a liberalized global marketplace has of necessity to be comprehensive and consistent in addressing all three of the pillars that constitute the financial system: financial institutions, market structures, and infrastructure linkages. Moreover, it has to recognize the importance of the interactions between the stability of the financial system and more general economic conditions.

Improving the Resilience of Financial Firms

Growing competition and the lowering of geographical and functional barriers in the wake of financial deregulation have combined with financial innovation to unleash strong forces for restructuring and consolidation in the financial industry. The key issue from a policy perspective is whether this restructuring is likely to proceed smoothly. Experience suggests that strains are likely to appear as competitive pressures confront stubborn cost structures and when the natural tendency of management to favor growth conflicts with prudent risk management. The danger is that managers of financial institutions will be tempted to pursue higher-risk strategies to keep profitability up and to seek increases in market share at the cost of the quality of business. A wide range of techniques can be used (and have been used) to implement such strategies. The risks of these strategies may not be apparent when overall macroeconomic conditions are favorable, since it takes time for questionable lending decisions to turn sour. At the same time, the existence of explicit or implicit safety nets makes it easier for banks to attract funds than it might otherwise be. All of this puts a particularly heavy burden on supervisors.

It is the responsibility of financial supervisors to discourage abuse of the safety net and at the same time foster competition and innovation and maintain a “level playing field.” In today’s competitive, liberal, and dynamic environment, this is a challenging task that requires a willingness to reevaluate the conceptual framework of regulation. As a result of such a reevaluation, capital adequacy standards have come to be the cornerstone of our present regulatory apparatus, replacing direct controls on permissible banking activities. The development of risk-based capital adequacy standards is, in my view, the appropriate regulatory approach to counterbalance incentives that would otherwise be distorted by the presence of the safety net. In order to preserve reasonable competitive equity among various institutions, capital requirements have to correspond as closely as possible to the risks that market participants actually run. A significant recent development illustrating the adaptability of the regulators in this respect has been the extension of capital requirements to market risk and the acceptance, with appropriate safeguards, of banks’ own models of such risks.

While formal recognition of the validity of proprietary models of market risk represents a positive and innovative step in the right direction, the fact remains that credit risk is still the principal cause of distress in most recent cases of widespread banking strains. Credit risk is probably the most old-fashioned category of risk, but its character has not been unaffected by the changing financial environment. From an accounting viewpoint, a rising proportion of credit risk has been incurred off balance sheet because of the increased involvement of banks in trading activities. The use of credit derivatives and securitization can separate the activity of holding credits from that of bearing credit risk. From an economic point of view, the growing importance of settlement risk has also shifted the balance toward shorter-lived but larger and less controllable exposures.

Keeping up with the growing complexity of evaluating credit risk is only one of the challenges faced by financial supervisors. Also of key importance is heightened vulnerability to operational risk. As the operations of financial firms become larger, more mathematically intricate, more geographically diverse, and more dependent on data processing technology, the scope for mishap and fraud becomes greater. Bank supervisors are therefore having to pay even greater attention to the adequacy of internal controls, the quality of banks’ senior management, the robustness of economic models, and the risk-taking “culture” of the institutions they regulate. The bad news is that the necessary skills to do all these are in short supply and they carry a high price tag. The good news, however, is that the market mechanism can be enlisted as a powerful and effective ally in the supervisor’s effort to instill discipline. The disciplinary effect of market forces can be strengthened by encouraging a greater degree of transparency on the part of individual institutions with respect to their preferred spot on the risk-return frontier, as well as disclosure at regular intervals of the performance of their internal risk management systems. Armed with this information, creditors and counterparties acting in their own self-interest will adjust the price of equity and the cost of external funds and liquidity to reflect their assessment of the risks run by the institution and the organization’s ability to manage them.

A further complication is the blurring of traditional distinctions between different types of financial intermediaries and the emergence of financial conglomerates. In such circumstances, it becomes important to ensure that competitive equity is maintained and that the regulatory burden does not unduly handicap any of the competing firms in a particular market. Regulatory structures that have historically emerged from a geographically and functionally fragmented environment may need to be adapted to address this problem. Cooperation among different supervisory bodies (those for banking, securities, and insurance) on a cross-country and a cross-market basis needs to be developed. The recent announcement by the international insurance supervisors that they will locate in Basle to facilitate cooperation with banking supervisors is a notable development in this connection.

Financial institutions in emerging markets are confronted with two additional sets of problems that demand special attention from the regulatory community. The first I would label “starting-point problems.” They relate to the structural characteristics of these markets and the growing pains of financial reform. While there is no doubt of the long-run benefits of financial system liberalization, reforms create conditions that can lead to severe strains if not managed properly. We have ample evidence from emerging markets and industrial countries that inadequate preparation for financial liberalization is linked to severe banking crises. Second, the greater prevalence of government intrusion in financial market activities in emerging-market countries, coupled with relatively looser controls over connected lending, presents troublesome initial conditions.

The threat to banking system soundness that derives from these structural characteristics can be accentuated by the markedly higher volatility of macroeconomic conditions in emerging markets. The sources of this volatility are both external, in the form of variable terms of trade, foreign interest rates, and real exchange rates, and internal, in the form of higher and more variable inflation and less stable growth rates. Changes in these conditions are very frequently associated with large swings in already sizable capital flows, which if not properly managed can create major disruptions.

In sum, financial institutions in emerging markets are not only subject to more severe shocks but at the same time are often less well equipped to deal with them. These vulnerabilities suggest that supervisory authorities in these countries have an even harder task than their colleagues in industrial countries in ensuring that the appropriate structures are in place to deal with the problems. A case can certainly be made for a stronger capital cushion to permit the financial system to absorb these shocks. Perhaps even more important, however, is ensuring that the proper incentives are in place to pursue prudent and diversified lending strategies. This includes the all-important accounting criteria that allow impaired loans to be recognized and dealt with before they threaten a lending institution’s survival.

Before leaving this section, it needs to be underlined that prescribing what must be done to foster healthier financial systems is only part of the job. Of crucial importance is generating the “political will” to ensure that effective regulation and supervision actually take place. This is why the work being undertaken by the Basle Committee is so vital. The development of guidelines established by an international group of supervisors can generate “peer pressure” among supervisors that should insulate them, at least to some extent, from domestic political pressures.

Transformed Financial Markets

The forces that have redrawn the contours of financial intermediation have also fundamentally transformed financial markets. Markets in new instruments have risen from the fringes to take, in a short period of time, an important place alongside more established, traditional securities. The consequences of these developments for overall financial stability have been at the center of attention of the official sector and in this section I would like to discuss some of the salient features of the official response.

The impressive growth of the market in financial derivatives, documented in Table 2, is arguably the most telling statistic of the transformation of the financial landscape brought about by financial and technological innovation. The growth of “plain vanilla” contracts traded has also been accompanied by an equally impressive growth, albeit from a smaller base, in more “exotic” contracts.

Table 2.Expansion of Selected Financial Derivative Markets(In billions of U.S. dollars)
Notional Principal Amounts Outstanding
19861988199019911992199319941995
Exchange-traded instruments1583.01,300.02,290.43,519.34,634.47,771.18,862.59,185.3
Interest rate futures and options2516.01,174.02,054.03,229.34,298.47,321.18,401.28,605.1
Currency futures and options249.060.073.581.297.6110.395.781.1
Equity Index futures and options218.066.0162.8208.8238.4339.7365.6499.1
Over-the-counter instruments500.01,330.03,450.34,449.45,345.78,474.611,303.217,712.6
Interest rate swaps400.01,010.02,311.53,065.13,850.86,177.38,815.612,810.7
Currency swaps3100.0320.0577.5807.2860.4899.6914.81,197.4
Other4561.3577.2634.51,397.61,572.83,704.5
Grand total1,083.02,630.05,740.77,968.79,980.116,245.720,165.726,897.9
Sources: Futures Industry Association, International Swap Dealers Association; various Futures and options exchanges; and BIS calculations.

Gross purchases and sales of securities between residents and nonresidents.

Calls and puts.

Adjusted for reporting of both currencies, including cross-currency interest rate swaps.

Caps, collars, floors, and swaptions.

Sources: Futures Industry Association, International Swap Dealers Association; various Futures and options exchanges; and BIS calculations.

Gross purchases and sales of securities between residents and nonresidents.

Calls and puts.

Adjusted for reporting of both currencies, including cross-currency interest rate swaps.

Caps, collars, floors, and swaptions.

This phenomenal spread in the use of derivatives has not been without consequences. Some of the most spectacular financial losses of the past two or three years have been linked to the misuse of derivative securities or to a misunderstanding of the risks involved. Although one could characterize those episodes as a natural part of learning how to use the new tools, the fact remains that derivative securities present a formidable challenge to risk managers and supervisors alike. The complexity of the cash flow structures associated with these instruments underlines more than ever the need for establishing in each institution a solid risk management culture, which integrates accurate risk measurement tools with well-planned organizational structures for risk control at all levels of the hierarchy.

Financial market instability is often a contributory cause to difficulties at financial institutions and can also have adverse effects on the real economy. Markets relieved from the regulatory straitjacket are formidable mechanisms to promote the efficient allocation of resources. Yet, at the same time, they can generate internal dynamics feeding into participants’ self-fulfilling expectations, which may lead to temporary but persistent mispricing of assets. As many of the artificial distinctions and barriers between markets have been lifted, these phenomena and the shocks from their sometimes abrupt reversal can easily spread across the entire system. Improving the functioning of financial markets is therefore a key element of any strategy to strengthen the resilience of the financial system as a whole.

The work undertaken over the last several years by various committees that meet at the BIS is a direct reflection of the growing awareness in official circles, and especially among central banks, that action is required. I would like to highlight in particular the recent work of the Euro-currency Standing Committee, which, as its name implies, was originally created to examine the implications of the emerging Eurodeposit market but has subsequently broadened its focus to include all issues relevant to financial market stability and the impact of derivatives markets in particular.

The Cross Report of 1986 marked the beginning of this work and focused on the nature of these new instruments and associated markets. It was not until the Promisel Report of 1992, however, that the systemic implications of derivatives were clearly set out. While emphasizing the overall usefulness of these instruments, the latter report nevertheless highlighted some associated dangers. In particular, it provided a definition of systemic crisis and noted the potential destabilizing effects implied by the highly leveraged nature of the new instruments. Derivative securities could accentuate disturbances because they increase the opaqueness of participants’ exposures, intensify market linkages, and are usually employed in conjunction with hedging strategies that could destabilize market dynamics in the case of a large unanticipated market shock. These official concerns led to the recommendations of the Brockmeijer Report of 1994 that the Triennial Survey of Foreign Exchange Markets should be extended to cover derivatives markets. The additional costs of the data gathering were justified by the belief that the information would provide concrete measures of notional size, turnover, and geographical distribution; all three quantities are expected to be directly related to the potential costs of a systemic disturbance.

While aggregate data could help authorities to better comprehend the nature of the risks from a marketwide point of view, greater transparency at the firm level would also help promote financial system robustness from a micro/prudential viewpoint. The Fisher Report of 1994 called for greater public disclosure by financial intermediaries’ of their exposure to both market and credit risk and their capacity to manage it. The rationale behind this recommendation is that greater transparency would not only reinforce the inherent disciplinary capacities of the market mechanism but would also have an important stabilizing influence during periods of market turmoil. More specifically, by providing a clearer picture of counterparties’ overall exposure, disclosure permits firms to gain a better understanding of how competitors may react to market shocks. In particular, disclosure would help mitigate the risk that counterparties would be shunned on the grounds that their exposure is not known and presumed to be too high. Finally, such information (at both the market level and the level of the firm) is of great value to central banks, which must make a rapid assessment of a developing situation and judge the appropriate response to episodes of market distress.

While appropriate standards of disclosure are equally important for emerging economies, their main preoccupation at this stage of financial development is the establishment of fully functioning financial markets. Markets that have the required depth, breadth, and liquidity to finance the government budget in noninflationary ways, to facilitate the conduct of monetary policy, and to allow a greater diversification of risks for the banking system. Liberalized and well-integrated markets can also be used as a disciplinary device as they are in a better position to penalize vulnerable structures and unstable policies. However, contagious reactions of investors can have very severe repercussions on the already volatile economic environment of these countries. Financial market development has to be accompanied by precautionary measures that shield the financial system against these shocks in the form of healthy and robust capital cushions.

Financial Market Infrastructure

Somebody once said that “payment and settlement systems are to economic activity what roads are to traffic: necessary but typically taken for granted unless they cause an accident or bottlenecks occur.” This is a telling analogy, which for many years characterized the attitude of the official and private sector toward the financial market infrastructure. Yet, the growth of the value of transactions, documented in Figure 3, coupled with an increasingly competitive financial environment has dramatically altered the scale of the liquidity and credit risks involved.

Figure 3.Trends in the Value of Payments1

(Ratio of annual value of funds transfers to GDP)

source:Bank of international settlements

1Payments through the main interbank funds transfer system.

2The breakdown into domestic and international transfers is based solely on the specialization of the system; for the United Kingdom, such a breakdown is not feasible.

We are well aware now that the payments network is one of the most likely transmission channels of a generalized shock to the financial system, and some observers even claim that settlement system risk is perhaps the largest single threat to financial stability. Large and unpredictable exposures combined with limited information about their true size and distribution constitute a mechanism that could propagate and intensify financial distress. Participants unable to distinguish short-term liquidity problems from cases of fundamental insolvency are likely to withdraw from transactions. Such reactions can trigger more generalized distress and force the premature closing of positions with detrimental effects on asset price stability.

Central banks in their role as the institutions generally responsible for safeguarding the integrity of the payment system have taken a number of initiatives to ensure the efficiency and soundness of those systems. The work has been done primarily through the Committee on Payment and Settlement Systems (CPSS), which has issued a number of reports with recommendations of best practices for the settlement of many types of transactions and has set explicit standards for multilateral netting systems and the measurement of foreign exchange settlement exposures. In multilateral netting systems, settlement occurs at fixed intervals on a net basis across all participants. As a result, exposures are accumulated during the interval between settlements to very high levels. The Lamfalussy Report of 1990 put forth a set of standards regarding the legal and technical characteristics of settlement systems, which would ensure that they would be robust enough to withstand extreme disturbances. These standards, importantly, include guidelines regarding the control of these risks and underscore the importance for the participants to be fully aware of these risks. The CPSS has also promoted the adoption, when possible, of real-time gross settlement systems as an alternative to net settlement schemes. If correctly implemented, they have the potential of further reducing the exposure of participants to settlement risks.

While the work has been carried out primarily with the G-10 countries in mind, the participation of the representatives from a number of emerging markets was necessary in certain projects, as their cooperation was essential. Also in the areas related to the settlement of domestic securities and exchange traded options, the CPSS has closely collaborated with International Organization of Securities Commissions.

Macroeconomic Stability

The previous sections have discussed some ways in which the resilience of individual components of the financial system can be strengthened. Let us turn now to the all-important interactions between the stability of the financial system and that of the more general economic environment in which financial institutions operate.

In a world where markets are becoming deeper and stronger, it is neither practical nor desirable for governments to try to counteract underlying market forces. The major effect of official action is essentially indirect through the impact that it has on market participants’ expectations. Policymakers, however, still must avoid creating excessive volatility in macroeconomic policies and conditions. Prudence dictates that policy actions should be mutually consistent and sustainable. Sudden shifts of policy, or stubborn insistence on maintaining an unsustainable policy course, can only increase the risks to the financial system.

Although markets have become more efficient in incorporating new information into prices, as can be seen in the decreasing trend in short-term (say, intraday) volatility, the fact remains that market participants cannot act on information they do not have or are uncertain about. Policymakers have to ensure that their intentions and strategy are communicated to the market in a clear and unambiguous fashion and that mechanisms are in place that are conducive to the timely disclosure of all information relevant to the pricing of traded securities.

The volatile character of the economic environment in emerging markets provides an additional reason why economic policymakers should be particularly careful in avoiding actions that further aggravate the fragility of their financial system. Financial liberalization seems to have brought with it both higher short-term volatility and a heightened tendency to misalignment. Relatively large and easily reversible international capital flows have also exacerbated certain inherent problems in these countries’ financial structure. The policy response to this challenge has to be one that reduces the components of volatility that are under the control of the domestic authorities, while leaving a margin of insurance against unavoidable shocks and taking measures that reduce their impact to the financial system.

Disciplined monetary and fiscal policy strategies are the best response to the first task. Fiscal policy in particular has to make judicious use of capital inflows, recognizing their volatile nature. Wringing the most out of capital inflows for short-term growth is a very risky strategy, since these can easily reverse with disastrous financial consequences. A more prudent approach should aim for high sustainable rates of development while, as a first priority, ensuring financial stability. In addition, the management of foreign exchange reserves should reflect these realities and adopt more sophisticated strategies that provide for a larger cushion of financial resources against volatility-induced losses.

Conclusion

The wave of innovation, liberalization, and globalization that has characterized the past two decades has profoundly transformed the contours of the financial industry. This transformation holds the promise of great benefits, but at the same time demands a reevaluation of our conceptual and strategic approach for safeguarding financial stability.

Measures to strengthen the financial system must be comprehensive and cover all of its components in a consistent and compatible way. Since it is impossible to predict precisely where financial weaknesses will manifest themselves, particularly if they do so as a result of the interactions between otherwise innocuous events, participants and markets must be strengthened broadly and comprehensively. We have to focus on maintaining the system’s integrity and not necessarily on avoiding the failure of any one institution.

I hope that I have identified in this paper a gradual shift of perspective in the way we perceive the task of prudential oversight. We have moved away from direct controls toward a more market-oriented approach. This framework emphasizes market discipline and is based on more disclosure and transparency. The future of supervision is the search for mechanisms that balance this greater freedom with greater responsibility and that use market forces in the work of official oversight.

    Other Resources Citing This Publication