Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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The Seventh Central Banking Seminar held from January 27–31, 1997, brought together central bank governors, deputy governors, and senior bank supervisors from some 40 countries representing industrial, transition, and developing economies. The present seminar was the latest in a series sponsored jointly by the Institute of the IMF and the Monetary and Exchange Affairs Department (MAE). The series provides a gathering point, roughly every two years, for the policymakers and senior practitioners who face the day-to-day challenges in formulating and implementing monetary policy to discuss their experiences and the latest research in their fields of responsibility. On some occasions, the seminar has focused on central bank issues in general; on other occasions, it has concentrated in one particular area of central bank concern. The present seminar was of the latter form. Issues of banking soundness have become so pervasive in recent years, and the lessons learned from experiences in handling them so important, that banking soundness clearly merited selection as the topic for this seminar. But the usefulness of the seminar would be much reduced if it did not focus also on the wider economic environment within which policy makers are addressing the issues of banking soundness—particularly, an environment increasingly integrated across both sectors and countries.

In his opening remarks to the participants, IMF Managing Director Michel Camdessus observed that financial market liberalization and the resulting unprecedented growth of international capital markets—in short globalization—have had a major impact on the conduct of monetary policy and of macroeconomic policies more generally. The efficiency gains that follow from a more market-based allocation of capital have brought benefits to both source and recipient countries. At the same time, however, the growing levels of capital flows have placed increasing demands on the private sector institutions which intermediate them. Equally important are the corresponding demands on the public sector institutions responsible for stability in the financial sector and for monetary policies in general.

The importance of addressing these challenges was put in context by First Deputy Managing Director Stanley Fischer. During the past ten years, well over one-half of IMF members have experienced significant banking problems, affecting countries in every geographic region and at all levels of economic development. Direct costs—often borne by the government budget—exceeded 10 percent of GDP in some cases, and indirect costs surfaced in slower economic growth, higher inflation, and often exchange rate crises. The crisis in Mexico in 1995, which was discussed in detail by Miguel Mancera, Governor of the Bank of Mexico, was seen by many participants in the seminar as the wake-up call of the importance of the banking sector to the macroeconomy. There is general agreement with the proposition that, while most economic emergencies do not originate in the banking sector, the weaker the banks are the more likely an adverse shock elsewhere will result in a banking crisis. Such a crisis will add to overall economic weakness and make it more difficult and costly to resolve. Thus, there is a need to address banking soundness issues in order to preserve the authorities’ macroeconomic objectives. Addressing these issues also must be at an international level, because globalization can lead to contagion of banking sector problems across international boundaries. Thus, addressing banking soundness requires also harmonization of banking standards and coordination and collaboration among those who apply them. Andrew Crockett, President of the Bank for International Settlements, reinforced the importance of the international dimension of handling banking sector issues, highlighting the enormous volumes of international banking business carried out each day in the present liberalized global economy.

The remainder of this overview is organized as follows. The next sections summarize some of the theoretical issues pertaining to banking soundness discussed at the seminar. These include the interaction between price stability and banking soundness; the two dimensions of monetary policy; the critical elements for ensuring a sound banking system; and the need for harmonization of banking standards, especially in the international context. Then the country experiences in the handling of banking sector issues are summarized. This is followed by the principal themes of the seminar and then a few brief concluding remarks.

Banking Soundness and Monetary Policies

In his presentation at the beginning of the seminar, MAE Director Manuel Guitián laid out the theoretical foundations for analyzing banking soundness, arguing that banking soundness was an important dimension of monetary policy. It is widely recognized that a sound banking system is beneficial to economic prosperity and the transmission of monetary policy to the real economy. Indeed, in this sense, a sound banking system has many aspects of a public good, and therefore some degree of official involvement is justified. A “pure” market solution will lead to an underprovision of sound banking. In the past, banking soundness as a monetary policy objective had been overshadowed by the primary focus of monetary policymakers on managing monetary policy to achieve price stability. Widespread banking sector problems in recent years have emphasized also the central bank’s responsibility regarding the banking system; perhaps policymakers are now able to devote more time to it because of the progress made toward price stability in many countries. Bank of Italy Deputy Governor Tomásso Padoa-Schioppa added an historical perspective to these discussions: central banks were originally organized to facilitate a payments system, later to maintain the soundness of the banking system, and only recently was monetary policy added to the central bank’s responsibilities.

An important assumption underlying the bank soundness as a public good argument is that banks are in some way special and therefore warrant special attention relative to other financial institutions. Given that many nonbank financial institutions are now providing many of the services that were formerly provided exclusively by banks, this raises the question, whether banks are indeed still special. Bank of England Governor Eddie George addressed this question and concluded that, while there has been some erosion in their “specialness,” banks do remain special in a number of important regards—they are the repository of the economy’s immediate liquidity, they form the backbone of the payments system, and their assets and liabilities are inherently mismatched in a maturity sense. Mr. George pointed out that this last characteristic makes them particularly vulnerable to systemic risk. Thus, for a country to benefit from the unique functions of banks, special attention is required.

In discussing the linkages between the price stability and the banking system soundness objectives of monetary policy, participants agreed that these were mutually dependent. As outlined above, a sound economy depends on the banking system and the banking system in turn relies on a healthy economy in the sense that even sound banks can be pushed into crisis with a sufficiently large macroeconomic shock. From the policy implementation perspective, there can be conflict in the short term between the two objectives because, for example, a tight monetary policy may put banks under pressure, while central bank support lending to a commercial bank will expand the money supply and thus impact price stability. Manuel Guitián downplayed this potential conflict and suggested that it be seen as an intertemporal tradeoff: the choice between price stability today—strict pursuit of this goal without regard to the consequences for the banking sector—versus price stability tomorrow—explicit concern for the macroeconomic consequences of a systemic failure.

While conference participants concurred on the need to address banking soundness at the official level, there were a range of views on how it should be addressed and by whom. Both questions involve moral hazard, that is shifts in incentives that affect the risk-taking decisions of bankers and their depositors. If a bank manager knows that the central bank will step in should the bank become insolvent, he may take additional risks with the bank’s investment portfolio. Similarly, a depositor, knowing that he will be protected if his bank fails, will disregard risk when choosing a bank. This is the essence of the dilemma of handling the banking sector during the seminar. Banking is a public good, and therefore some official involvement is justified; however, this involvement can distort private incentives and raise the risks that the banking sector becomes unsound. Much of the discussion on handling the banking sector during the seminar was aimed at devising principles and modalities for public involvement while minimizing the moral hazard effects that this involvement might provoke.

A Three-Pillar Paradigm for Banking Soundness

Manuel Guitián proposed a three-pillar approach to banking soundness, one involving official oversight, internal governance, and market discipline. This approach reflects the view that supervision alone cannot keep pace with the demands from liberalization, globalization, and technological advances in financial instruments; thus supervision must be complemented through a mix of internal and external financial discipline. By including internal governance, the approach incorporates the view that banks themselves are best placed to manage their portfolios and maintain good management practices. The inclusion of market discipline reflects the fact that in the absence of competitive markets—and the penalties resulting from failure in competitive markets—there will be inadequate incentives for bank owners, managers, and customers to make appropriate financial decisions; moral hazard effects will work to undermine banking soundness.

Prudential Standards

Wolfgang Artopeous, President of the German Federal Office of Banking Supervision, argued that reliance on quantitative prudential standards and high capital ratios as a guarantee of banking safety was no longer sufficient. From his perspective as a national supervisor, competition and the resulting erosion of profits (or monopoly rents), together with the development of sophisticated risk management techniques, have rendered uniform quantitative criteria increasingly obsolete. Such criteria can no longer be refined in line with the demands of the new risk management techniques practiced at leading banks. Their role will increasingly be confined to use as rough indicators of capital adequacy and a means of dampening risk expansion.

From this perspective, recent supervisory moves to allow banks to use their internal risk management models to calculate the capital needed to back up their portfolio risk represent a fundamental change of approach—quite distinct from the traditional approach, which rests on fixed weighting of risks in capital adequacy calculations. This new approach is in line with the three-pillar model discussed above in that it places increased reliance on internal procedures—governance—while maintaining meaningful official oversight. The new approach will require ever-greater sophistication on the part of the supervisor so that state-of-the-art risk management models in use in the banking sector can be assessed and compared, and unacceptable levels of risk determined.

Frederik Musch, Secretary General of the Basle Committee, also stressed the dynamic evolutionary nature of the supervisory framework. The Basle Committee guidelines and their application are intended to be flexible, to change over time, and to vary with country circumstances. While minimum capital standards were intended to be harmonized across countries experiencing similar conditions, specific quantitative limits have been agreed on for only a few categories of risk management. Thus there remains room for national discretion in the setting of standards in the remaining areas, for example, exposure limits as well as classification and provisionary standards on nonperforming loans.

While Mr. Musch highlighted the need for flexibility, he also brought out the importance of a common framework. In particular, he observed that the Basle Committee approach on capital requirements and lending limits had been adopted in 90 percent of a sample survey of 140 countries. He pointed out that it did not suffice to say that in some countries there were no derivatives so these developments were irrelevant. It was likely at a minimum that a branch of a local bank was undertaking such business in London, or was paying another bank to do so on its behalf. Pierre Dhonte, Deputy Director in the IMF African Department, concurred on the importance of international standards. If banks in Africa are to participate in globalization, they must follow internationally accepted practices such as those determined by the Basle Committee. However, he argued, these standards must be adapted to reflect local circumstances. For instance, countries in Africa are subject to larger macroeconomic shocks than G-10 countries, and consequently banks in these countries must maintain tighter prudential standards. Also, in the risk assessment area, local conditions may warrant different weighting from that adopted in advanced industrial economies: in some cases, governments have fallen into arrears, or have very high debt burdens, and therefore their debts should not necessarily carry a zero risk weight.

Hassanali Mehran (Senior Advisor, MAE) pointed out that market-friendly supervision was not friendly supervision. He stressed also that enforcing a bank failure could be seen sometimes as a supervision success, not a sign of weakness. Wan Jun (People’s Bank of China) drew a medical analogy: like a good doctor, even a good supervisor could not save all the patients.

Market Discipline

Donald Brash, Governor of the Reserve Bank of New Zealand, presented the case for relying essentially entirely on market discipline. New Zealand undertook an extensive review of the options for banking supervision and in 1996 put in place a system radically different from that conventionally practiced. The Reserve Bank review had identified a number of problems with conventional supervision arrangements. These included (1) an insufficient regard for compliance costs and regulatory distortions caused by regulation and supervision; (2) the risk to taxpayers from a situation where the regulator has exclusive information on bank finances and hence may be thought responsible for losses to depositors and other creditors (moral hazard); and (3) the inherent limits to the effectiveness of conventional supervision; in particular, the backward-looking nature of the supervision, as evidenced by the fact that many countries following the conventional approach have had banking sector problems.

The new New Zealand approach rests on the commercial banks making extensive public disclosure of their financial position. By making greater use of market forces in enforcing oversight on the banks, the Reserve Bank hopes to reduce the responsibility of the authorities, and correspondingly to increase that of bank owners and to some extent depositors. Market participants, supplied with reliable information should be able to make an informed judgment about each bank which will provide stronger financial surveillance than would official oversight alone. The Reserve Bank now carries out its remaining inspection duties using publicly available data, and thus may be considered to have less of an obligation—both implicit and explicit—to support a failing institution than is the case of supervisors in other countries.

Reliance on the market, however, may not work in all cases. Mr. Brash accepted that reliance on market discipline was likely to be effective in New Zealand because of the limited role of the official sector: banks are privately owned and there is no deposit insurance.

MAE Deputy Director Malcolm Knight also pointed out that all major banks in New Zealand are foreign-owned, and that their home supervisors continue to stand behind them. Also, the new regime has not yet been tested: there have been no bank failures since the regime’s inception in 1996. The effectiveness of market forces is predicated on a sound financial infrastructure; for example, the existence of strong accounting practices and legal frameworks that focus directors’ attention on their responsibilities, and a financial press that can analyze bank data for the public to help them in choosing a deposit institution.

Internal Governance

Many of the seminar participants touched on the role for internal governance in bank supervision, Mr. Brash put emphasis on bank directors’ responsibilities. Both he and Mr. Artopeous made the point that conventional supervision by regulation and inspection provides only snapshot information of a bank’s financial condition, and in today’s world this is not sufficient. Balance sheets can change so quickly (for example, using derivative instruments) that severe problems can arise almost immediately after a conventional inspection. In addition, bank balance sheets are becoming increasingly complex, and official inspectors may not be able to keep up with the latest financial technology.

A more forward-looking approach could address these concerns. Specifically, there should be emphasis on a bank’s ability to manage risk using its own internal models. Governance procedures would ensure that banks’ policies would be in line with the prescriptions of these risk models by emphasizing bank managers’ responsibilities for their banks’ performance. Richard Roulier of the World Bank provided a comprehensive assessment of governance issues.

Strengthened internal governance would also address the risk of losses from fraud. The Barings failure was discussed in this context; Mr. George made the point that the Bank of England decided against a rescue for Barings because it was clear that Barings’ problem stemmed from an internal management failure specific to the bank, and that there was therefore no systemic risk to the financial system. To offer support to Barings in these circumstances would have caused serious moral hazard implications. Conversely, the decision not to support Barings has strengthened management controls in banking in Britain and beyond.

Responsibility for Ensuring Bank Soundness

An important, on going discussion, surfacing a number of times during the seminar, was whether the central bank itself should be responsible for banking supervision. The decision on this issue is not necessarily “all or nothing.” Even where the central bank does not have formal responsibility for supervision, it clearly retains an interest in banking soundness and hence is still likely to be involved in some way in the supervisory and surveillance process. The broad choice between the central bank and an independent supervisory agency to perform banking supervision mainly centers on the tradeoff between, on the one side, the efficiency gained by having macro-economic monetary policy decisions and banking soundness issues under one roof and, on the other side, the risk of conflict of interest when the institution responsible for monetary policy is also concerned about the effects of raising interest rates on the health of the banking sector and hence on perceptions of its success in its role as banking supervisor.

Pierre Duquesne, Secretary General of the French Banking Commission, concluded in his paper that economic theory demonstrates no clear-cut advantage for either approach. The arguments for linking the two responsibilities through a common institutional framework recognize that there is a two way relationship between the price stability and banking system soundness objectives of monetary policy. There may also be operational advantages, since financial system expertise can be concentrated in one institution, the central bank. In this context, Mr. Duquesne observed that in practice some mixture of the two approaches is common. For example, in France, supervisory responsibility lies with the Banking Commission, but it is closely linked to the Bank of France. In Germany, where supervisory responsibility is formally allocated to distinct supervisory agencies, Bundesbank staff and resources are nevertheless used for much of the supervisory effort.


During the seminar discussion of regulatory harmonization cut across two lines: harmonization across national borders and across sectors. In her luncheon address, Susan Phillips, Governor of the U.S. Federal Reserve Board, framed the topic in terms of coordinating goals—a healthy banking and financial system that can compete safely on a nondiscriminatory basis—and overall philosophies, in particular market-based incentive structures. In short, regulators should strive to promote sound risk management practices through market forces rather than through coordination of specific laws and regulations. In this way, rules are likely to be similar and compatible, but with enough flexibility to account for differences across sectoral and geographical boundaries. Within this framework, supervisors can craft regulations that are consistent with international standards, but that also accommodate local needs.

In this approach, and relying on a bank’s own risk management process, it is clear that no prespecified formula can be applied globally, and that flexibility is important for successful harmonization. Market discipline and the banks’ internal incentives—internal governance—are critical, but the success of such an approach will depend on disclosure. The public must have reliable and timely information about the risk exposure of their banks. Mr. Musch also emphasized that harmonization only covered a very limited set of standards. In other areas, best practices had been established. Deposit insurance had so far been left to the national authorities.

Mr. Padoa-Schioppa pointed out the limited extent of the harmonization so far achieved between banking and nonbanking supervision. For instance, the Concordat was not yet accepted for supervision of subsidiaries of securities houses. This could provide an easy way for financial conglomerates to avoid supervision.

Role of the IMF and International Organizations

Progress in harmonization can come about both through bilateral discussions, or through multilateral organizations, as demonstrated by the work of the BIS and the Basle Committee on Banking Supervision over the past twenty years. More recently, other international organizations have become involved in helping to promote stability in banking systems. Mr. Camdessus, in his opening and closing remarks, observed in this context that the specific roles of the respective organizations might be regarded as “work in progress.” There are ongoing initiatives by the G-10, the Basle Committee, and the International Organization of Securities Commissions (IOSCO) regarding banking supervision in emerging market economies. Mr. Musch observed that the Basle Committee was heavily involved in helping countries beyond the G-10 implement the committee’s recommendations on capital standards either through working directly with the national institutions or through the regional organizations that have been established in recent years and now cover the great majority of countries. For its own part, the IMF will build on its particular areas of expertise and its universal membership. It will of course coordinate its own efforts with these and other institutions. Thus it will focus particularly on the relationship between a sound banking—or financial—system and an effective monetary and fiscal policy capability. It is intensifying its surveillance, first of banking systems and later of other financial intermediaries as part of the regular Article IV consultation process. Where appropriate, it is including measures designed to foster bank soundness in program conditionality. Mr. Khandruyev, Deputy Governor, Central Bank of Russia, welcomed the prospective involvement of the IMF in these areas.

Maintaining a Sound Banking System: Practical Applications

Carl-Johan Lindgren, Assistant Director, Monetary and Exchange Affairs Department, makes the transition in his paper from the theoretical considerations underlying the three-pillar strategy for banking soundness to practical recommendations for making or keeping a banking system sound. The paper’s main conclusions, summarized below, serve as a backdrop to the specific case studies presented.

Most bank failures can be traced to poor management that leads to credit losses, a portfolio that does not produce sufficient income, or in some cases losses through fraud. Internal governance can protect against these problems and can be strengthened through strict licensing rules, care in implementing deregulation, and measures to promote good quality data. The emphasis on internal governance recognizes that bank owners and management have the primary responsibility for their bank’s solvency. Banks are companies that operate in a competitive environment and cannot be practically supervised in all their activities. It is not illegal to manage a bank poorly, but it is illegal to violate bank laws and prudential rules, or keep information from supervisors. Market forces reinforce managements’ incentives to operate a bank safely, provided that owners have funds at risk. For market forces to be effective, official safety nets must be limited, accurate information must be disclosed to depositors and other creditors, and a strict exit policy needs to be in place. Finally, effective regulations and supervision procedures should be designed to reinforce banks’ internal governance and market discipline. The Basle Committee’s capital adequacy framework has been adopted in a number of countries, but attention must be given to complementing it by assigning meaningful risk weights and proper evaluation of asset quality. Further regulations can help to promote prudent policies through specifying limits on credit, liquidity, interest rate, and foreign exchange risks.

Six case studies were presented to the seminar as main papers. Each is an excellent review of the background to that country’s banking sector problems, to the official objectives and guidelines underlying the strategies to resolve them, and the outcomes. While each case is different and demonstrates the importance of flexibility in applying the guidelines discussed at the seminar, there are a number of broad similarities in the approach to banking system restructuring and the evolution to a modern, market-based system.

The case of Indonesia, presented by J. Soedradjad Djiwandono, Governor of the Bank of Indonesia, provides the longest historical review of developing a banking system, from a controlled approach in the late 1960s to a relatively open and competitive market in the 1990s. In the late 1980s, the authorities undertook reforms to promote competition through new entrants, expansion of activities, and greater autonomy in decision making at the individual bank level. The ensuing rapid growth in banking intermediation, however, led to circumstances in which prudential regulations and practice lagged behind actual market activity. In response to instability in the system, new prudential standards were adopted in 1991, the most important of which was the Basle Agreement risk-weighted capital adequacy standard. Later, the Bank of Indonesia encouraged banks to bolster their system of self regulation and required them to disclose audited financial data. Thus, the Bank of Indonesia found that market-based competition alone may not lead to an efficient banking sector. Easy entry to banking needed to be balanced by appropriate regulations that made use of internal oversight and control and international capital standards. Reforms were motivated in part by depositor protection for the benefit of the general public and in part by the objective of developing financial services.

The banking systems in Poland and the Czech Republic both evolved from centrally planned monobank systems. This transition was summarized by Gerard Bélanger, Senior Advisor, European I Department, who observed that Poland, as other countries in transition, had to create an independent role for commercial banking as well as for monetary policy. In a planned economy, the role of money is passive and banks exist to pass credits to directed sectors. In a market economy, the role of money becomes active, giving the holder of money command over real resources. Banks allocate credits according to the expected return on the loans. The transition process has involved a number of challenges to the managements of the banks, including nonperforming loans in bank portfolios, lack of experience in assessing and managing risk, supervisors who were unable to ensure effective oversight, and overall macroeconomic instability. These problems were compounded by inadequate laws and accounting practices, and—as put by Mr. Tošovský—an excess demand for banking services. As a result, in many transition economies, there was a rapid and not commercially driven expansion of the banking sector, often without the necessary controls, both internal and external.

Hannah Gronkiewicz-Waltz, Governor of the National Bank of Poland, told the seminar that the initial strategy for developing banks in Poland had relied on enhancing competition through liberal licensing laws, and on privatizing the large state banks. Many banks, however, were unable to manage their growing portfolios, owing to a lack of trained staff and insufficient internal procedures and regulations. Macroeconomic shocks also harmed the weak system; official action was needed to avoid a systemic crisis and to protect depositors. Ms. Gronkiewicz-Waltz summarized the lessons learned, including the importance of internal governance. In this context, bank supervision must exercise influence on the composition of a bank’s ownership and management and require banks to develop appropriate internal practices, for example, limits on loans to insiders. Ms. Gronkiewicz-Waltz recognized the importance of moral hazard effects that derived from the desire to protect depositors. Hence, in principle, losses should be absorbed by capital. However, in a systemic crisis, these concerns must be set aside, and assistance from public funds might well be necessary. In Poland in these circumstances the authorities found it necessary to accord a high degree of protection to bank depositors.

Mr. Tošovský described three phases in the transformation of Czech banking, along the lines of the Polish experience: first, rapid growth in banking services; second, a period of consolidation when prudential rules were put in place and banking supervision was improved; and third, a period in which the banks improved their efficiency and competitiveness toward international standards, and the authorities enforced the new regulations to ensure that the banking system was sound. A key objective was to avoid a systemic crisis and the resulting adverse impact on the macroeconomy. This was achieved in part through a consolidation program that transferred bad loans to a special institution. Later, consolidation of smaller banks became necessary, and this was accomplished through investor participation and recapitalization.

As in Poland, development of the legal and institutional framework—the “rules of the game”—lagged behind the innovations in the financial sector. Parallels can be drawn with other countries, not just those in transition. Financial liberalization, market growth, and the increasing complexity of financial products point to a need for innovation also in legislation and regulatory institutions. Key among the necessary measures is a strengthening of prudential principles in bank operations, ensuring heightened internal governance, the regulation of all financial market participants, and the prosecution of criminal behavior.

Miguel Mancera, Governor of the Bank of Mexico, identified similar features in discussing the causes of the recent banking crisis in Mexico. In Mexico, the financial system was overwhelmed by the growth in domestic and foreign resource flows following the country’s structural reforms and stabilization policies. As in Poland and the Czech Republic, banks were unable to handle the resulting credit expansion in part because managers were not equipped to manage such rapid growth in loan portfolios. Similarly, supervisors were not equipped to keep abreast of the expansion. The resolution of the resulting crisis was guided by the need to contain systemic risk, minimize fiscal costs, maintain monetary control, and limit moral hazard problems by paying careful attention to the incentive effects of the authorities’ actions. The restructuring was implemented more quickly than in the countries discussed above, and involved support to the banks and depositors to avoid a systemic failure, as well as measures to strengthen supervision.

Several of the discussants also presented interesting insights in analyzing the restructuring experiences in their countries. Pedro Pou, President of the Central Bank of Argentina; Marko Škreb, Governor of the Croatian National Bank, and Armando Tetangco, Deputy Governor of the Philippines National Bank, all described situations of banking system unsoundness and the remedial measures pursued in their countries. There were differences of emphasis, but few on the overall causes of the problems and the reasons to address them, compared with those discussed in the papers summarized above.

The banking crises in Japan and Sweden differ from the other cases presented in a number of respects. First, both are advanced economies and have the fiscal resources to handle a banking crisis without putting disproportionate costs on depositors and other creditors. Second, the origins of the crisis can be traced to the easy monetary policies and financial deregulation in the late 1980s that led to a speculative bubble in many financial assets. In this regard, the situation was, in some ways, similar to the banking sector problems experienced in the United States and other Scandinavian countries at the end of the 1980s and beginning of the 1990s. However, the status of the banking sectors in Japan and Sweden differs. Stefan Ingves, Deputy Governor of the Riksbank (Sweden’s central bank), reported that his country’s approach of separating insolvent banks into “good banks” and “bad banks” was largely successful and indeed the selling off of bad assets was ahead of schedule. Mr, Nagashima, Deputy Governor, Bank of Japan, said that while much progress has been made, reconstruction of an efficient and stable financial system is, as yet, incomplete. Apian to revive Japan’s financial markets is in place and encompasses new entrants into banking and other financial institutions. Among the proposals are the abolition of authorized foreign exchange banks (so that nonbanks can participate in this activity), institutional changes at the Ministry of Finance, and the Bank of Japan.

Seminar Summary

In his final address to the seminar Mr. Guitián recapitulated some of the principal themes and policy lessons that had arisen.

First, there is the theme of the mutual interaction between banking soundness and monetary policy. Banks are critical for the efficient transmission of signals from the operating instruments to the final objectives of policy, and for the efficient intermediation of financial flows to enable an economy to grow at its potential. Unsoundness in a banking system can lead to significant monetary and fiscal costs, and pervasive economic disruption. This interaction does not pose a conflict between the policy goals of price stability and a sound banking system. Rather, the two objectives are mutually supporting since durable price stability relies on a sound banking sector and banks cannot be strengthened by relaxing the commitment to price stability.

Second, there is the theme of seeking to delineate the boundaries between the public and private sectors in managing banking soundness. Market forces are agreed to have a key role within the three pillars of achieving banking soundness: market discipline, internal governance, and official supervision and regulation. However, there was significant diversity among participants in the relative roles to be accorded between them. There was general recognition of the risks of excessive official involvement. For instance, the decision of the Bank of England to let Barings fail since no systemic threat was apparent, will have demonstrated that the authorities are not standing behind every bank, and will have served to enhance internal bank governance. In this context, Mr. Guitián observed that supervision should utilize market forces. The trend toward market-friendly supervision—taking advantage of market forces—needs to be recognized and strengthened.

Within this theme there is also agreement on the need for good data, and for strong public disclosure, so that both the official side and the markets have a good understanding of a bank’s condition. The importance of a good quantified picture of a bank had, however, to be seen against a recognition that quantification could be only the first step for evaluating a bank, and that qualitative indicators were increasingly important.

The third theme is that of harmonization, both geographically and across sectors, between banks and nonbanks. Banks still are seen as performing distinct special functions. But if the trend toward the erosion of their specialness continues, there will be important issues to address as to how the authorities should adapt the safety nets that they have designed to protect the banks.

The fourth theme is that of technology. Technology is permitting the banking sector to develop products of ever-increasing complexity. Supervisors will need to ensure that they do not fall behind. This calls for ever greater sophistication among supervisors. It also calls for a switch in supervisory approach—as recently announced by the Basle Committee—from concentration on predetermined prudential ratios to focus on a bank’s internal control mechanism.

Having drawn out these themes there is a clear role for the IMF in issues of banking soundness, because of the IMF’s traditional focus on monetary and macroeconomic policies and the direct link between those and the efficient working of the banking sector.

Macroeconomic stability, of course, is important to minimize risks of systemic problems of bank unsoundness. The full enforcement of appropriate prudential standards to ensure that risks are properly managed is a necessary concomitant. Also, the authorities must be prepared to take robust and early action—including closure—against offending banks, in order to ensure that appropriate incentives are in place for the banking sector as a whole. The specification of prudential standards is likely to be a dynamic process, with supervisors constantly having to keep abreast of market developments, and having to match the increasing sophistication of the markets. Strategic policy issues—such as with regard to conglomerates or the diffusion of banking activities beyond the banking sector—will require careful consideration, and full coordination between supervisors, and other specialists of financial market developments, as well as those involved in macroeconomic policy.

While each case of banking sector unsoundness is different, there is also a considerable commonality in the experience. Policymakers and supervisors can learn a great deal from watching developments in the banking sectors in other countries, and how the respective authorities have sought to deal with problems. Analysis of banking problems in one country is likely to bring recognition of familiarity among those confronting such problems elsewhere. Opportunities for bringing together supervisors and policy makers from various countries should therefore serve to increase common understanding of the importance of banking sector soundness, and how to undertake remedial action if the system becomes unsound. It is to be hoped that this seminar organized by the IMF Institute and the Monetary and Exchange Affairs Department of the IMF has played a part in assisting this effort.

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