Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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It is a great pleasure for me to comment upon Stanley Fischer’s paper, which provides a comprehensive and insightful overview of the most important conceptual and practical issues relating to stable functioning of banks under increased capital mobility.

Fischer invites us to consider the new challenge for the IMF concerning bank fragility that has arisen from greater openness and interdependence of national economies. I find the willingness of the Fund to deal with this set of problems timely and relevant, because they may exert pressure on the Fund’s ability to reach its ultimate goals as formulated in the Articles of Agreement, including the stability of the international monetary system. I think it is a solid and provocative paper, and I agree with almost everything in it.

Perhaps the most important point of the paper is that sound banking systems have become a precondition for national as well as international financial stability and sustained economic growth. To support this idea, Fischer refers to the results of the IMF staff study on bank crises in different member countries, which have been associated with economic decline, high fiscal burdens, depreciation of the currency, and inflation. The cost of resolving banking sector crises may well exceed 10 percent of GDP, as in the case of Venezuela and Latvia. Indeed, the burden may prove unbearable, because developing or transitional economies have limited resources that are already badly needed for economic development and solving social problems.

I completely agree with Fischer that increased attention to the soundness of national banking systems may and will help to provide for long-term macroeconomic stability in the open world economy. This is true despite the declining role of commercial banks in the process of financial intermediation. Nevertheless, commercial banks will continue to be a fulcrum for monetary policy implementation, and in this sense their crucial importance for national economies is not in question. Fischer is right when he says that in the case of an unsound banking system, the monetary transmission will be weak and therefore the effectiveness of monetary policy will be undermined. Moreover, we can also talk about the unique role of banks in many countries as institutions where households prefer to place their savings, hoping for absolute safety and accepting moderate, low, or sometimes even negative real interest rates. This factor makes banks important for formulating monetary policy and defining its quantitative targets. Unexpected withdrawal of savings from time deposits in banks may make the money demand function unpredictable.

I would not dispute Fischer’s conclusion that given the degree of monetary instability in a banking crisis, and the possibly marked shifts in money demand, increasing attention may also need to be paid to assessing policy on the basis of variables other than the monetary aggregates, including for instance interest rates, inflation, and changes in asset prices. But it is useful to note that in transition or restructuring economies monetary transmission through interest rates or other real variables may be quite weak. So the authorities may not find a proper way to achieve final policy goals. The experience of Russia is illustrative in this regard. Evidence from the past five-year period indicates that the interest rate component of monetary transmission has been very vague.

Let me now turn to the problem of linkages between macroeconomic stabilization and banking system soundness. I certainly agree with Fischer when he says that “macroeconomic stabilization improves conditions for the banking sector, as it does for almost every sector of the economy.” But here I would like to focus on the short-and medium-term consequences of disinflation for commercial banks, which sometimes are underestimated. The positions of many banks may be weakened due to gaps between assets and liabilities leading to persistent negative cash flow. This may be aggravated by poor management and risky credit policy, but usually there is an objective basis for this development: it is not easy for banks to foresee precisely the reaction of markets to stabilization efforts.

It is important to consider, therefore, the possibility of helping banks to cope with temporary difficulties at an early stage, supported by rehabilitation programs subject to approval and strict control by the authorities. This approach will slow the speed of achieving low single-digit annual inflation, but it may eventually prove cheaper in terms of the cost of overall macroeconomic adjustment. In view of the above, I would suggest expanding research efforts into optimal solutions of this dilemma—how to achieve macroeconomic stabilization without great deterioration of bank balance sheets.

It is quite clear that the Fund’s involvement in dealing with these issues is essential since the Fund prepares macroeconomic programs that have such profound and varied ramifications for countries and financial markets. I also fully agree with Fischer that “any possible banking system problems have to be fully investigated, and a plan to address them developed, before an overall macroeconomic program can credibly be put together.” On the other hand, it may also be worth-while to review the possibility of establishing a special Banking Sector Restructuring Fund facility for those countries that face banking sector difficulties. This facility would be accessible only to those countries where macroeconomic performance meets the Fund’s requirements.

Concerning the question of responsibility for addressing problems of banking system soundness nothing can be said against Fischer’s point that primary responsibility for undertaking the rehabilitation must lie with the national authorities of a country. Those authorities should give an impetus to all parties concerned to take timely measures to stop the continuing flow of losses from the banking system and to promote financing of the rehabilitation efforts.

The more detailed comments below focus on some questions of IMF participation in promoting banking sector soundness as a new function. Fischer has presented in his paper an advanced approach to this matter, which I assess as an almost completed project.

First, regarding surveillance, the Fund has an explicit mandate from member governments to conduct bilateral surveillance, through which individual countries can be monitored and performance verified using reliable national data and a consistent methodology. It should also be noted as an important advantage that the Fund’s experts are in direct dialogue with policymakers of member countries.

In this connection I very much support Fischer’s thesis that the Fund should continue to develop banking sector indicators that complement its macroeconomic indicators in order to identify developments that are most critical to the prospects of the banking sector and the economy as a whole. It is only right that those banking sector indicators be used as important criteria for the general evaluation of country economic performance and the adequacy of economic policy, because banking sector problems can become a burden to the economy and macro policymaking.

No less importance should be attached to the multilateral aspect of surveillance. Because of its universal membership, the IMF is well placed to develop banking standards, using as its base what the Basle Committee has done for the G-10 countries. I agree with the idea that there is a need for consistency and for full analysis of how those standards should be applied under very different conditions in different countries. In this way, the IMF’s efforts may complement the important work of the Basle Committee.

The Fund’s long experience preparing the World Economic Outlook and International Capital Markets, in which banking sector developments have a certain place, would permit the Fund to establish a special banking sector report as a new product. This report could serve to inform the member states about developments in different countries and present the results of comparative analyses as well as general trends in the evolution of national banking systems. The report may prove notable and useful given the high professional standing of the Fund’s analysts.

To ensure the effective fulfillment of these new functions concerning banking system soundness, I would suggest creating the proper mechanisms within the IMF structure. It seems quite relevant to have a unit responsible for multilateral and bilateral surveillance over banking sectors. Despite the lack of available resources that Fischer mentions at the end of his presentation, I still think it is important to find certain funds for launching this extremely important work.

Let me now, at the end of my comments, emphasize the usefulness of technical assistance in the area of banking system development, taking Russia as an example. Without any exaggeration, technical assistance has played an extremely important role in preventing a systemic crisis in the Russian banking system. Several international financial organizations and cooperating central banks (Bank of England, Banque de France, Deutsche Bundesbank, and the Federal Reserve) have provided this assistance. I would also like to express my special appreciation of efforts by the Monetary and Exchange Affairs Department of the IMF to assist the Bank of Russia in the area of banking supervision and bank restructuring in order to strengthen the country’s financial sector during market-oriented reforms. Substantial resources have been devoted to such technical assistance and these efforts are beginning to bear fruit.

MAE has provided a resident expert in banking supervision starting in 1992, organizing regular missions, expert visits, and workshops. Advice and recommendations by experts based on relevant international experience have helped Russia to work out reasonable solutions and practical responses in the face of banking turmoil and possible catastrophe.

Let me mention an important initiative of the World Bank and the European Bank for Reconstruction and Development (EBRD), chiefly through its Financial Institutions Development Program (FIDP). That project, launched in May 1994, covers about thirty leading Russian banks, which if they meet certain standards and pass special on-site examinations can then benefit from twinning arrangements with Western banks and other assistance. With FIDP, participating Russian banks have begun to realize the advantages of balance sheet transparency and better loan portfolio management.

I would also like to underscore the role of EC TACIS, which has provided financing of an advanced training program, with courses, workshops, and study tours on banking supervision, money laundering, and banking restructuring. The U.S. Agency for International Development (USAID) has been assisting very much in the training of bank inspectors and participating in some joint instructional inspections both in Russia and in the United States. Unfortunately, because of time constraints I cannot enumerate all the other sources, forms, and results of technical assistance in the banking area. I will only say that without sufficient and effective technical assistance, Bank of Russia would have been like a blind driver in heavy traffic.

Let me draw some final recommendations from Fischer’s inspiring paper. First, it would be desirable to strengthen the Fund’s coordination role in promoting banking soundness. It looks worthwhile to discuss the idea of setting up a coordination committee, consisting of representatives of the IMF, World Bank, Basle Committee, G-10, and several emerging-market countries on a rotating basis. Second, I would urge creation within the Fund of a separate unit responsible for issues of banking soundness. Third, the establishment of a Banking Sector Restructuring Fund deserves to be thought out in detail. Based on my experience, and further encouraged by Fischer’s paper, such a facility could prove highly useful.

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