Banking Soundness and Monetary Policy

23 Bank Soundness in a Global Setting: Main Themes and Policy Conclusions

Charles Enoch, and J. Green
Published Date:
September 1997
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We have now come to the end of the Seventh Central Banking Seminar. In this wrap-up session, I would like to summarize the main themes that have surfaced and to draw a few conclusions that follow from them. But first, I would like to thank all of you for participating in this seminar. As speakers, discussants, and most important, as participants raising probing questions, providing insightful comments, and engaging in informal discussions, all of you have added greatly to the richness and depth of these proceedings. By sharing experiences in your own countries, it will be possible to hone our thinking into practical solutions for the benefit of all.

At the beginning of the seminar, I prefaced my remarks by referring to the closing remarks made at the end of the Sixth Central Banking Seminar, That seminar centered on monetary policy frameworks, but the discussion pointed to a need for further investigation of the role of the monetary authority in promoting sound and efficient financial markets. Experience in the intervening period has proved this conclusion quite appropriate—in some ways unfortunately so, in view of the events that took place soon afterward. There have been a number of well-publicized banking problems that ranged from the crisis in Mexico to the well-contained Barings failure that have demanded our attention. At the same time, much progress has been made toward price stability, thus allowing policymakers to shift some attention toward soundness issues in a natural progression. Since the last seminar, we have gained considerable practical experience and also made progress on the theoretical front; this seminar has offered us the opportunity to discuss what we have learned and to share ideas on how to face new challenges stemming from globalization and technological innovation. Against this background, four basic themes emerged at the seminar discussions:

  • the interaction of banking soundness with monetary policy;
  • the boundary between the public and the private sectors and the risk of moral hazard;
  • harmonization of banking supervision practices and prudential standards and procedures; and
  • the consequences of technological innovation and advances.

Bank Soundness and Monetary Policy

Bank soundness could once have been described as the “neglected dimension” of monetary management, but as this seminar has demonstrated, this description no longer applies. Clearly one factor behind the increased attention devoted to this subject is the high incidence of banking sector problems in recent years. But I would like to think more positively, and I believe that another factor is the growing consensus on the importance of the price stability objective of monetary policy and the considerable progress that has been made toward achieving it. It is only natural that when one problem appears to be under control, more time can be devoted to other issues—in this case, bank soundness.

During the seminar, Tommaso Padoa-Schioppa placed this shift in emphasis into its proper historical perspective (see Chapter 6). Abstracting from other reasons that governments possibly had in mind and that conform to public choice theory motivations, central banks were first organized to provide for an efficient system of payments and then to ensure the safety of the banking sector. In fact, it is only in this century that they were given the mandate of guardians of price stability, which speaks forcefully about the quality of price performance of this most recent period of history. As has often been pointed out, the twentieth century provides a historically poor example of commitment to, and performance in terms of, price stability.1 Yet, as I have just noted, the record of inflation control has markedly improved in recent years. In this context, the increasing recognition of financial system soundness as a policy objective represents a return to the original purposes of central banks.

Another factor contributing to this renewed interest is the two-way relationship between price stability and bank soundness as objectives of monetary management. As covered in depth in Bank Soundness and Macroeconomic Policy,2 an unbalanced monetary environment can fuel banking instability because banking activity in inflationary environments is not very conducive to efficiency, and inefficient banks tend to be unsound. And conversely, a sound banking system is necessary for an efficient transmission of monetary policy signals to the economy.

The Boundaries Between the Public and Private Sectors

Delineating the boundaries between the public and private sectors in policy design and implementation will likely be one of the most critical questions facing economic policymakers in the years ahead.3 The area of bank soundness is no exception. During the seminar, a consensus emerged that market forces have a key role in a modern framework for bank soundness. Viewpoints differed, however, on where the balance should lie between the three pillars of banking sector stability—market discipline, internal governance, and official prudential regulation and supervision. Some participants favored giving the largest weight to market forces; others, though willing to rely heavily on market discipline, still believed that the supervisory authorities—-whether at central bank or elsewhere—should retain an important share of responsibility for the protection of banking system soundness through the exercise of official oversight. In this context, Donald Brash explained that while New Zealand relies primarily on market discipline, the new approach to banking supervision should not be interpreted to mean that the Reserve Bank is not concerned about conditions in the banking system (see Chapter 16). A measure of official oversight is necessary, and possibly the central point made on this front was that, as suggested by Tommaso Padoa-Schioppa, it should complement market forces (see Chapter 6).

There is always a tendency toward overinvolvement by official bodies and thus a risk of moral hazard. On this topic, I firmly agree with Eddie George when he pointed out that there had been no evidence of systemic problems or repercussions in the Barings episode, and thus the best course for the Bank of England was to see that the Barings ownership and management were responsible for the consequences of their decisions (see Chapter 11). 1 would add that any other course of action would have risked moral hazard, not only in the United Kingdom, but elsewhere.

Essential to all three pillars of the above framework (market forces, internal bank governance, and official oversight) is the timely availability of good data and information. They are essential for bank executives to make loans and manage their portfolios, that is, for proper internal bank control as well as for both market participants and official supervisors to make appropriate assessments of these portfolios and the resulting financial position of the bank. There was, of course, agreement on this general point, and the main area of discussion among the participants in this area was on the relative merits of quantitative versus qualitative standards, both of which were seen as important. It was felt that balance sheet analysis, typically quantitative in nature, would need to be supplemented by assessments of a bank management’s ability to evaluate risk, clearly a qualitative exercise involving a large measure of judgment.

Quantitative factors have a certain appeal because of their apparent objectivity and concreteness as well as because of the seeming ease with which standard quantitative measures can be applied across countries. This is certainly true, but benchmarks such as the capital adequacy ratio (whether measured to include one or several types of risk) must be underpinned by a well-developed infrastructure, for example, accounting, loan valuation, classification, provisioning, and legal standards. These elements are not always in place in many countries. In addition, quantitative factors are not forward-looking and are not easily adapted to new situations. They focus on what happened yesterday, and as Donald Brash observed, they are becoming increasingly obsolete in the current fast-changing world where what matters most is what will happen tomorrow (see Chapter 16).

Wolfgang Artopoeus stressed that qualitative assessment is vital in bank supervision (see Chapter 17). I would add that supervisors and regulators will need to judge not only whether an individual bank is vulnerable, but also whether an ongoing problem exhibits potential systemic risk Judgment will be necessary in such situations to determine how much of the problem is the responsibility of the public sector and how much lies with private agents. This will entail, inter alia, assessing how the resulting costs are to be shared between the government and the private sector, an assessment the quality of which will be critical to contain moral hazard. These conclusions on the importance of qualitative assessment call for the exercise of judgment, not only by those charged with official oversight, but also by economic policymakers. Such judgment will inevitably entail a measure of discretion, which of course would be quite compatible with the adoption and implementation of a rule-based prudential and supervisory regime for bank soundness.


Two basic dimensions of harmonization were identified at the seminar: that of national standards across borders and within national settings; and that of the rules applied to banks and those that are applicable to other financial institutions increasingly engaged in banking activities, such as finance and insurance companies, as well as security firms.

The liberalization and globalization of financial activities have made inevitable the need to coordinate the supervisory efforts of individual countries at the international level. Indeed, it was the prospect of serious banking crises that could place cross-border financial stability at risk that led to the establishment of the Basle Committee on Banking Supervision in 1974 by the Governors of the Group of Ten (G-10) industrial countries. The Basle Committee is a clear example of an attempt to address issues posed by the international dimension of bank supervision. Much has been achieved by this Committee since then, as illustrated by the widespread observance of norms such as the Basle Capital Accord or the Basle Concordat to which we have often referred in our discussions. Their effectiveness will be enhanced by the efforts underway to develop a broad supervisory framework that can be adopted or adapted by countries beyond the original group of industrial economies. A common set of standards will be of clear benefit to international investors, although care must be exercised in their implementation in settings where the supporting legal and accounting infrastructure is lacking.4

Harmonization of national rules and standards across financial institutions is also important now that these institutions are branching out into each other’s business. Commercial banks are becoming increasingly involved in investment banking, securities trading, and life insurance activities that were once the province of those other financial institutions, while the latter are increasingly taking on activities previously undertaken only by banks—particularly deposit taking. As the traditional distinctions between banks and other financial intermediaries become increasingly blurred, the question arises of whether banks are still special and, from an operational point of view, whether they are still essential to the economy and therefore merit the continuing concern of central banks. We have heard Eddie George on the subject and his conclusion that banks remain special and therefore warrant special treatment, a view for which there was broad support (see Chapter 11). This said, though, there are open questions in this regard: for how long will banks remain special? And, if the trend toward further erosion of their distinct nature continues, how can the authorities best adapt the safety nets that currently protect the banking sector?

New Technologies

The issue of technological advance and its implications for the financial sector came up in a number of sessions. Its emergence as a major theme points to the importance of innovation and of its implications for prudential supervision and official oversight. In brief, the proliferation of new and sophisticated financial products, such as derivatives, and the growing complexity—geographically, technically, and institutionally—of business relationships in the financial industry make it critical for supervisors to update their knowledge and expertise on an ongoing basis. Unless they keep abreast of new technologies, the official oversight pillar of bank soundness will not be able to check excessive risk taking. In this connection, Federal Reserve Chairman Alan Greenspan recently said, “If it is technology that has imparted occasional stress to markets, technology can be employed to contain it,”5 This is clearly true, but to ensure that this in effect occurs, we need to work hard to provide the resources and incentives for supervisors to keep up with developments in markets where changes are constant and rapid.

Role of the IMF

In the area of banking system soundness, the IMF’s focus falls more on the prevention than on the correction of problems. Thus, from the IMF’s perspective, a critical element of its work is how to ensure that the macroeconomic environment is conducive to sound banking—that is, to ensure that the macroeconomy does not contribute to bank difficulties. A second area of interest for the IMF is to foster the existence of an appropriate incentive structure, not only in the banking sector but in the economy at large. As far as the latter is concerned, these are issues that have been discussed with member countries ever since the beginning of the institution.

On the banking front, we have to add another element, the supervisory framework prevailing in the economy. Although the role of the IMF is not that of a bank supervisor or an auditor, there is a clear interaction between the banking sector, its soundness, and the effectiveness of monetary and macroeconomic policy. Therefore, it makes sense for the IMF to include these sectoral and microeconomic issues and their interaction with macroeconomic performance as part of its regular surveillance activities and consultations with member countries. In this context, it also makes sense for the IMF to contribute to the efforts that the international community is making to improve prudential supervision and banking practices by regularly disseminating to IMF members those that have proven their effectiveness by experiences in advanced systems. Important work in this area has been and is being done by the Basle Committee and in the European Union. As I noted previously, of particular relevance are the Basle Committee’s efforts in conjunction with supervisors from emerging and other economies to broaden the guidelines for sound banking practices originally devised for the G-10 industrial countries and making them applicable to developing and transition countries. The IMF seeks to support the efforts of the Basle Committee, as well as the efforts made by national supervisors in their regional forums.

Final Observations

What lessons can be drawn from this seminar? The first is the interaction between the objective of price stability and the aim of banking soundness, which I believe does not pose the conflict of policy goals that is often brought up. Durable price stability cannot be pursued at the cost of a vulnerable banking sector, nor can the banking sector be strengthened by relaxing the commitment to price stability. The two objectives are mutually supporting and warrant being pursued together. Policymakers have to think not only of what actions are needed to attain price stability now, but also of what it will take to maintain price stability in the future. Clearly, for monetary policy to be effective and efficient, a sound and competitive banking sector is required: sound money goes together with sound banking.

The second conclusion is that we must recognize and strengthen the trend toward market-friendly supervision. By market-friendly supervision I mean supervision that takes both account and advantage of market forces. This is not friendly supervision in the sense of forbearance with shortcomings in internal bank governance or in official oversight. On the contrary, it is supervision that buttresses market forces and allows them to exercise discipline on banks and their owners and managers. A market-based approach to bank soundness encompasses the three essential pillars, as noted previously—internal bank governance, official oversight, and market discipline. All three are necessary, and they must be allowed to exert their respective influences: bank governance to ensure efficiency, official oversight to safeguard systemic stability, and market discipline to contain moral hazard.


See, for example, International Monetary Fund, World Economic Outlook; A Survey by the Staff of the International Monetary Fund (Washington: International Monetary Fund, October 1996), where experience with the process of inflation is amply documented in a long-term context.


Carl-Johan Lindgren, Gillian Garcia, and Matthew Saal, Bank Soundness and Macroeconomic Policy (Washington: international Monetary Fund, 1996).


Manuel Guitián, “Scope of Government and Limits of Economic Policy,” in Macroeconomic Dimensions of Public Finance: Essays in Honor of Vito Tanzi, ed, by Mario Blejer and Teresa Ter-Minassian (London and New York: Routledge, 1997).


Soon after the seminar, the Basle Committee issued its Core Principles for Effective Supervision (Basle, 1997), as well as a three-volume Compendium of Documents by the Baste Committee on Banking Supervision (Basle, April 1997), which gathered all the Basle Committee’s previously published papers regarding various aspects of banking supervision.


Alan Greenspan, “Central Banking and Global Finance,” speech presented at Catholic University Leuven, Leuven, Belgium, January 14, 1997.

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