Financial stability as a policy objective
| DOI | https://doi.org/10.1108/13590790410809310 |
| Published date | 01 October 2004 |
| Pages | 356-362 |
| Date | 01 October 2004 |
| Author | Patricia Jackson |
| Subject Matter | Accounting & finance |
Journal of Financial Crime Ð Vol. 11 No. 4
Financial Stability as a Policy Objective
Patricia Jackson
INTRODUCTION
Financial stability is an important part of the Bank of
England's role in parallel with maintenance of mone-
tary stability. Indeed central banks and ®nancial
stability have been intrinsically linked since their crea-
tion. The establishment of regulatory bodies (such as
the Financial Services Authority (FSA)) outside the
central banks has not weakened this link. The memor-
andum of understanding between Her Majesty's
Treasury, the Bank of England and the FSA, which
establishes a framework for cooperation in the ®eld
of ®nancial stability, expressly states that the Bank
will be responsible for the overall stability of the
®nancial system. International organisations such as
the International Monetary Fund (IMF) and World
Bank also have an important world-®nancial stability
remit. Financial stability is therefore seen as an impor-
tant policy objective for the ocial sector and in the
paper the reasons for this will be addressed.
THE ROLE OF THE FINANCIAL
SYSTEM
The ®nancial system is central to the economy. Banks
provide essential money transmission services and
they also mediate between savers and borrowers. They
channel funds to small and medium-sized enterprises
(SMEs)andthe personalsector which,withoutthe inter-
mediation of organisations able to process credit appli-
cations and assess the risk, could not obtain credit from
the ®nancial system. Even in markets such as the USA,
where the securitisation of credit card and mortgage
debt has become the norm, the banks carry out the ori-
ginal processing and packaging.
The securities markets help to eect the ecient
allocation of resources through pricing of debt/
equity. They intermediate between larger borrowers
such as prime corporates and sovereigns and institu-
tional or smaller investors. Insurance companies
facilitate risk pooling and risk transfer.
Disruption of the ®nancial system leads to huge
economic costs. Bank research
1
covering 47 banking
crises worldwide over the past 25 years shows that
the costs in terms of output foregone amount to
15± 20 per cent of gross national product (GNP).
This is despite the fact that action is often taken to
stem the eects of widespread banking sector weak-
ness, for example attempting to limit runs aecting
other banks by using various types of state guarantee.
The failure of a large securities ®rm would also impose
considerable costs in terms of disruption to markets
and knock-on eects to other players.
WHY IS PUBLIC SECTOR
INVOLVEMENT NEEDED?
A further question is why the authorities need to have
a role in reducing the likelihood of crises. In other
words why is it the case that market self-interest will
not be sucient? One factor is the externalities of
failure. Individual ®rms when assessing the costs and
bene®ts of particular actions take into account only
their own costs. They do not take into account the
wider costs they could impose on the economy. The
gap between the private and public costs of failure is
greater in the ®nancial services industry than other
industries because the knock-on eect of failure to
other players and the economy can be so large.
Telephones and power play as central a role in the
economy as the ®nancial services industry but failure
of one company would not disrupt provision of the
service in the same way. Given the intrinsic worth of
the assets and business it would be sold as a going
concern. Banks being highly leveraged can start to
unravel quickly if in diculties and con®dence
eects can have substantial eects on other players,
all of which can destroy capacity in the short term.
A number of papers have focused on the potential
for bank runs,
2
and the transmission mechanism
from one bank to another.
3
Other papers have
focused on the wider costs to the economy if banks
fail.
4
It can also be argued that bank behaviour may be
in¯uenced in a perverse way by the wider costs of
failure. Banks may believe they are more likely to be
saved when engaging in unsafe lending if many
other banks are doing likewise. This is because the
costs to the system of a number of failures would be
greater than the cost of a single failure making a wide-
spread bail-out more likely.
5
Behaviour that looks
very much like herding has been seen in a number of
markets and this could be one explanation. One
Page 356
Journalof Financial Crime
Vol.11,No. 4, 2004,pp. 356± 362
#HenryStewart Publications
ISSN1359-0790
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