Vahur Kraft: Safeguarding financial stability - key issues for the central bank
Speech by Mr Vahur Kraft, Governor of the Bank of Estonia, at the conference on the Challenges for
the Unified Financial Supervision in the New Millennium, Tallinn, Estonia, 2 July 2001.
* * *
Good afternoon, ladies and gentlemen.
After the most interesting presentation by Minister Kallas, it is my pleasure to address this
distinguished audience on more general issues. Departing slightly from the pre-announced agenda, I
will discuss the key challenges to maintain financial stability from the central bank's point of view.
I. Why is the central bank interested in financial stability?
The question "why is financial stability so important for the central bank" does not need to be
discussed here in detail. Monetary transmission can not be efficient if weak financial system distorts
interest rate signals by increasing margins or if the financial markets have ceased to function as some
participants do not trust other players. The causality can run also in other direction. Over the past
decade, we have once and again witnessed how weak financial systems have directly caused the
currency crisis that resulted in capital flight, devaluation and deep recessions. The latter is particularly
relevant for fixed exchange rate systems. And finally, central banks are interested in financial stability
because often the central banks would have to take the leading role in crisis resolution, by providing
emergency assistance and working out restructuring plans.
These concerns are very familiar to Bank of Estonia. Fixed rate of Estonian kroon and the currency
board to support the peg necessitates in strong financial system for several reasons. In the open
economy, if the exchange rate is fixed, the interest rates should be let to fluctuate, from time to time
within wide margins, to meet the market supply and demand for Estonian assets. That monetary
transmission channel from the rest of the world - in our case from the ECB in Frankfurt - to Estonian
economy is of vital importance to provide early signals to address emerging imbalances. Financial
system is, thus, both the messenger and the first line of defense, as the banks have to withstand
volatile interest rates in case of negative expectations and resulting market uncertainty. Lack of lender
of last resort even more underlines the essential role the financial stability plays to avoid domestic
currency crisis.
As Minister Kallas vividly explained, we have gone through lot of experiences over the past decade. At
the outset of East-Asian crisis, Estonian currency system survived the speculative attack that we at
these times considered a pure "Asian contagion". The 1-month TALIBOR rates were pushed up from 6
to 15 percentage points in less than 2 weeks. Of course, it became clear afterwards that at least part
of the reasons for the attack were entirely home grown. Nevertheless, it showed us very convincingly,
- in real life, so to say -, the importance of capitalized and liquid financial system that was able to
adjust its risk management accordingly. A year after, as the Russian ruble collapsed, we had to deal
with both international and domestic loss of confidence in the financial system during the economic
downturn. Again, the interest rates more than doubled (from 8-18%) in a few weeks due to the
temporary loss of confidence in the currency. These two episodes provided clear examples of the
importance of financial stability for the monetary and, ultimately, economic conditions in case of a fixed
rate. But these experiences also provided policy insights that are useful not only under the present
circumstances but also for the financial policy making in a common currency area.
II. What are the main challenges for the central bank?
Central bank's direct responsibilities to maintain the financial stability, apart from direct supervisory
functions, can be divided into three large areas.
Firstly, central banks are responsible for analysis of financial system developments and to determine
the early signs of possible financial difficulties. Central banks are well positioned for that task because
of the close relations with market participants and because of the analytical skills that provide natural
ground for analyzing the so-called macroprudential indicators and perform regular stress testing.
Secondly, central banks are by definition involved in designing and building up financial system safety
nets. The so-called "traditional" central banks are directly responsible for short-term emergency
liquidity support to prevent the problems of one institution to develop into a systemic crisis. Even if the
ability to provide liquidity assistance is limited, like in case of currency board, central banks take - or
are even supposed to take - a leading role in crisis resolution.
Thirdly, central banks are often responsible for regulating the banking system. That is also the case in
Estonia, even after the reorganisation of the supervisory function has been completed. Bank of
Estonia is responsible for banking regulations while the Ministry of Finance will regulate insurance and
securities market. From the central bank's point of view, the banking regulatory policy goes somewhat
beyond the traditional micro-prudential approach that is basis for Basle capital accords. The equally
important question for central banks is to what extent the banking policy depends on the general
macroeconomic conditions or to put it simply, should regulatory changes take into account business
cycles or should they be guided solely by concerns on micro level.
III. Early warning systems and macroprudential analysis
Let me now touch upon these three broad categories in more detail. Estonian experiences and the
regulatory questions lead me directly back to the first main task - efficient monitoring and analysis. For
us, the harsh lessons from late nineties have underlined the need to better understand the key
vulnerabilities in financial system. This task has become even more pressing now when Estonian
banks have become an integral part of major Scandinavian financial groups. While this development
has somewhat lessened our concern for immediate liquidity and capital, the performance of the
financial system is yet to be tested during an economic downturn. In essence, we do not know how the
strategic partners of Estonian banks would react if the GDP growth will slow, loan losses amount and
bank profitability starts to decline. We must be vigilant to grasp the changes as soon as possible.
The key to vulnerability analysis is a successful implementation of ideally several analytical tools,
including early warning systems and macroprudential analysis. As we know, the early warning
systems typically try to estimate the impact of external factors on domestic financial systems, i.e., how
vulnerable the banking sector is to decline in exports or to worsening market sentiment.
Macroprudential analysis undertakes to broaden that approach to a variety of economic indicators,
using the stress testing models. Several organizations are focussing on these developments, including
the BIS, ECB and IMF. The topic gains even more prominence for us as the European Commission,
acting on the request from the ECOFIN Council, is starting to prepare the so-called Macro Financial
Stability Assessments later this year that would evaluate the resilience of the financial systems of
prospective new member states.
Several prerequisites are necessary for the development of reliable and robust early warning systems
and even more so for the meaningful macroprudential approach. Reliable data and reasonably long
time series is a necessity as well as is the profound intertemporal analysis. All these assets are in
relatively scarce supply in EU accession countries with ten years of independent banking history.
However, we have got a few initial building blocks in place. We have looked at our banking data in the
light of the very recent IMF research and were encouraged that our statistics covers the key indicators
fairly well. Secondly, we have dedicated significant resources to improve our analytical skills over the
last couple of years. And finally, we have had an encouraging experience on stress testing during the
FSAP mission last year, although the approach was simple. Against that background, we will give
considerable attention already this year to further upgrade of financial system analysis and we are
looking forward to cooperate in that respect with our friends in Europe as well as in Washington.
IV. Safety nets: crisis prevention
From here, I would like to proceed to the other major challenge for the central bank - to build up
financial safety net. We know that a full-fledged financial safety net consists of two major pillars: crisis
prevention and crisis resolution. Efficient analysis is a sine qua non for every effort to prevent financial
difficulties. Of course, we have the problem that all models tend to be perfect in forecasting the past
while their predictive power is unknown at best. Therefore, our concern is how to build a network of
institutions that would minimize the risk of a sudden shock.
I would like to start this part by stressing the importance of the dialogue with market participants. The
constructive discussions with bank managers serve two purposes. The commercial bankers know and
in their own way understand both the market situation and the prevailing trends in the so-called "real
economy". Thus, these regular discussions are most welcome complement to the economic analysis
by central bank experts. But the regular contacts provide also a unique channel for moral suasion, for
explaining central bank's concerns and in some occasions, possibilities to put pressure on managerial
choices. Obviously, these contacts are easy to arrange in a small country like Estonia. We have made
use of that opportunity and established dialogue with our financial sector on financial as well as on
general economic issues, both on regular as well as on ad hoc basis. What we should do more is to
have more in-depth contacts with the main strategic partners of our banks.
The other essential, albeit specific element for crisis prevention is the pre-emptive involvement of the
private sector in crisis resolution. I would like to point out two simple but effective principles that we
have relied upon. Firstly, the completely free movement of capital, both long and short term, has
increased the credibility of our financial policy and, thus, encouraged strategic partners to take much
longer term approach to their investments. That has by now resulted in a full integration of our banks
into Scandinavian markets. Secondly, Estonia has avoided volatile short-term capital flows due to
strong fiscal stance.
While these "soft" policy principles support crisis prevention by providing relatively stable and
transparent environment, the resilience of the system depends ultimately on the actions of market
participants themselves. The task of the authorities is to provide an adequate regulatory framework
and to undertake maximum effort for the supervision of the implementation of these regulations. There
is another interesting, albeit still debated issue - to what extent should the supervisors rely on banks'
internal risk control models and ratings. Estonian banking supervisors have taken relatively
forward-looking approach in that respect by increasingly relying on risk-based approach of
supervision. At the same time, and having in mind rapidly developing economy and currency board
arrangement, we believe that our banking system should have also robust liquidity buffers as well as
sufficient capital to withstand the fluctuation of asset prices. Therefore, we have set relatively high
reserve requirement half of what the banks can meet by the holdings of high-rated foreign assets. We
will further adjust the system of reserve requirements in the future as monetary policy framework will
converge towards the eurosystem principles.
Finally, I would like to stress that as an essential element of the safety net, the Deposit Insurance
Fund is functioning well and has proved its usefulness already two years ago. The immediate task for
Estonian authorities is to introduce the investor protection scheme for the other parts of the financial
system.
V. Safety nets: crisis resolution
In free market economy, no policy and no supervision can prevent the possibility of financial distress in
any particular financial institution. What the public policy can do is to minimize the likelihood of
systemic crisis. Crisis resolution is the key to avoid systemic disturbance. As we know, the ultimate
policy choice for the authorities is to find the balance between the public sector and private sector
solution from the one hand and between the pre-determined schedule and ad hoc approach from the
other hand.
Estonia's currency board regime sets for Bank of Estonia clear and strict limits that exclude several
options available for the authorities in many other countries. By limiting the money supply to net
foreign assets of the central bank, the room for emergency liquidity support is very limited. Therefore,
in our case, the private sector solution is preferable and particular modalities of crisis resolution will
depend very much on the circumstances. At this point, I would like to refer back to previous parts of
my speech and underline that this particular approach rests upon a few strong fundamentals.
Continuous analysis of financial system developments and early warning indicators, importance of
strong owners and sound risk management in banks, high liquidity and capital requirements - these
basic principles are a necessity for us.
By combining the principles just mentioned, we can now describe a few hypothetical crisis resolution
situations in Estonian financial system. In some cases, the extreme private sector
solution - winding-down of the troubled institution - would probably be the preferred approach. The
Law on Credit Institutions together with the Bankruptcy Act provides central bank and other authorities
with all necessary powers for closing down the business and letting trustees to take care of the
practical aspects. The Deposit Insurance Fund will immediately reimburse all depositors within legal
limits.
Of course, in other situation, different approach must be taken and a strict adherence to the former
rule is not feasible. Nevertheless, the initial response would still be the private solution. One option
would be the central bank to take the lead as an honest broker and bring together all private and
official parties concerned. Ideally, that would result in design of ad hoc private solution in a form of
merger, acquisition or emergency support. The role of central bank would effectively be the application
of moral suasion, without committing public funds.
However, one can and should not wholly dismiss the need for direct public intervention should it
become necessary. What will be different in our case is that in case of serious trouble, the dividing line
between liquidity support and capital injection would be rather blurred or these operations may even
take place simultaneously, after writing down capital of the troubled institution. The need for very close
coordination between the central bank, the government and supervisors is characteristic feature of this
approach.
Finally, there is perhaps no need to say that over the past decade, we have indeed applied all these
scenarios on our financial institutions in very real circumstances.
VI. Regulations: pro or counter cyclical?
Finally, let me briefly touch upon the regulatory issues. Bank of Estonia is responsible for regulating
the banking system in Estonia. The detailed description of Estonian banking regulations goes far
beyond the scope of my speech, but I would just like to say that one advantage of being a transition
economy was the possibility to draw the legislation from the scratch. That has facilitated very much the
compliance with good practices and de facto full adoption of the EU acquis.
What is a real regulatory challenge for central bank in our case is the question of to what extent
regulatory measures should be taken into account in broader financial policy context. Arguments can
be made for changing the regulations in accordance with the business cycle, especially as it seems
that in modern world financial systems have become more pro-cyclical than before. In that case, early
tightening may pre-empt the possibly devastating effects of asset price volatility and loan losses once
the economy starts to cool down. That might be even more relevant if credit growth is high in the early
stage of the cycle.
This approach has particular appeal for policy makers under the currency board as the active use of
monetary measures is excluded and reserve requirements are essentially the only available monetary
tool. In these circumstances, tightening prudential measures early on might seem a very reasonable
thing to do. It is important to underline that in heavily bank dominated financial system, banking
regulations might serve also as an instrument to affect domestic demand more directly than under
other circumstances. Indeed, Bank of Estonia increased capital adequacy ratio on more or less
cyclical grounds in 1996 and tightened capital requirements further at the onset of Asian contagion,
before the peak of the cycle.
Having said that, one should not look over the possible caveats of this "macro-prudential" policy
approach. One obvious shortcoming is that as financial markets do mature and financial instruments
become more complex, tightening banking regulations will simply intensify financial disintermediation.
In that case, major capital flows will be channeled to less regulated areas that will bring about new
risks of potentially systemic nature. The second problem is that the determination of the exact stage of
business cycle is simply impossible. The longer it takes, the more weight is given to the consideration
whether the tightening would not emerge too late and contrary to the best intentions, would contribute
to pro-cyclical behavior of banks. To be honest, we have recently thought what approach would be
suitable for us to take at present and we have understood that the topic is debated also in several
present EU member states.
VII. Conclusions
After I prepared this presentation, I started even more to support the old truth in slightly modified
wording - maintaining financial stability is more the art than the science. Maintaining the financial
stability is the mission impossible for one institution to carry out in isolation, be it the central bank or
any other authority. What is needed is shared data, shared analysis that brings together macro and
micro prudential aspects of financial stability, common set of principles to fall back in case of systemic
crisis, and perhaps most essentially, there is a need for common mindset.
I would like to highlight one essential aspect of financial stability. The pan-European consolidation of
banking industry has resulted in rapid increase of cross-border ownership. The question of
co-operation between central banks and supervisors is the key to maintain sound financial systems.
That applies both to crisis prevention as well as to crisis resolution. How to pass on early warning
signals, how to provide emergency liquidity support, how to restructure or wind up big financial
conglomerates - these questions are highly relevant for us as well as for the whole common market.
I believe this a good time to stop and pass the word over to our moderator who will elaborate more
thoroughly on the other mission impossible: how to find a right institutional structure for financial sector
supervision.
Thank you for your attention.