maintaining marketplace movements

A number of developments in recent years have combined to put
the issue of financial stability at the top of the agenda, not just of
supervisory authorities, but of public policymakers more generally.
These developments include the explosive growth in the volume of
financial transactions, the increased complexity of new instruments,
costly crises in national financial systems, and several high-profile
mishaps at individual institutions.
The growth in the volume of financial transactions and the increas-
ing integration of capital markets have made institutions in the
financial sector more interdependent and have brought to the fore
the issue of systemic risk. International capital flows, though gen-
erally beneficial for the efficient allocation of savings and invest-
ment, now have the power in unstable conditions to undermine
national economic policies and destabilize financial systems.
The increased complexity of new instruments makes it harder for
senior management in financial firms, let alone supervisory authori-
ties, to understand intuitively the risks to which the institutions
concerned are exposed. There are fears that the models underlying
the pricing of the new instruments may not be sufficiently robust,
that the mathematics of the models may have become disconnected
from the realities of the marketplace, or that the operational controls
within financial institutions may be inadequate to control the resul-
tant risks.
The crises in financial systems that have occurred have demon-
strated the close linkages between financial stability and the health
of the real economy. In Mexico, for example, what began as a
currency crisis led to a serious recession and created huge strains in
the banking system, further deepening the recession. The conse-
quences of the Mexican crisis destabilized several other Latin
American countries, notably Argentina, and threatened for a while
to have even wider repercussions. In industrial countries, financial
strains in Scandinavia and Japan, among others, had adverse conse-
quences for the real economy.
Lastly, there have been a number of well-publicized losses at
individual institutions, due to the breakdown of operational or other
controls. Episodes such as Drexel Burnham, Procter and Gamble,
Orange County, Metallgesellschaft, Barings, Daiwa, and Sumitomo,
though reasonably well-contained, demonstrate how quickly losses
can mount, and illustrate the systemic risks that would be inherent
in a larger-scale mishap.
The central case for making the health of the financial system a
public policy concern rests on two propositions: first, that, left to
itself, the financial system is prone to bouts of instability; and
second, that instability can generate sizable negative spillover effects
(externalities). It will be the purpose of this paper to examine these
propositions more closely, and in the light of this examination, to
consider what forms public policy intervention in the financial
sector might take. More specifically, I will address the following
questions: What do we mean by financial stability? Why should official
intervention (as opposed to reliance on market forces) be required
to promote stability? And what concrete approaches can be employed?
What is financial stability?
A distinction is commonly made nowadays between monetary
stability and financial stability. (Interestingly, this distinction would