Mr. White discusses promoting international financial stability: the role of the BIS
Paper by Mr. William R. White, Economic Adviser and Head of the Monetary and Economic
Department, Bank for International Settlements, to be published in the forthcoming conference volume
"Regulatory and supervisory challenges in a new era of global finance" from the Forum on Debt and
Development (FONDAD) to be held in August 1998.
A. Why financial stability is important
It is not surprising that central bankers worry about financial stability, even those central
bankers who do not have statutory responsibilities for banking supervision. Weak financial systems can
have long-lasting and insidious macroeconomic implications (the problem of "financial fragility") that
are naturally of concern to central bankers. Moreover, sudden failures in financial institutions, financial
markets or payment systems (the problem of "systemic crisis") threaten contagion effects warranting the
close attention of central bankers given their traditional role as lender of last resort. The seemingly
ceaseless string of financial crises through the 1980s and 1990s, in both industrial (e.g. Scandinavia and
Japan) and emerging market economies (e.g. Mexico and South Asia), indicates that these are practical
and not theoretical concerns.
One problem arising from financial fragility is that central banks will be tempted to
forbearance in the conduct of monetary policy, with associated risks to price stability and an increased
likelihood of asset price bubbles. Even if the monetary authorities do not choose to behave in this
fashion, market perceptions that they may be forced to do so may actually encourage speculative attacks
on currencies and eventually a process of self-fulfilling expectations.1 Conversely, attempting to pursue
stabilising macroeconomic policies when the financial system is already fragile can lead to institutional
failures, giving rise to both heavy costs for national Treasuries and important negative feedback effects
on the real economy.2 These processes were seen in Sweden, Finland and Mexico and still more recently
in a number of Asian countries. A stronger financial system would alleviate both macroeconomic
problems. In the same spirit, it should also be noted that unstable macroeconomic policies can also
contribute to financial instability through asset price bubbles and other channels. In short, monetary
stability and financial stability are two sides of the same coin and central bankers should be concerned
about both. This is perhaps the principal lesson to be learned from the financial crises we have witnessed
around the world in the past two decades.
Sudden failures in financial markets or payment systems can also have far-reaching
effects. Major changes in the prices of financial assets, perhaps but not necessarily related to movements
in underlying fundamentals, could threaten the solvency of individual institutions. A recent example of
such phenomena was the impact of the sudden decline in the value of the Mexican peso and some Asian
currencies on the creditworthiness of private borrowers and in turn their bankers. Such unexpected
developments could also lead to exaggerated concerns about counterparty risk, with associated
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reductions in liquidity in other financial markets. The recent drying-up of trade credit in Indonesia and
some other Asian countries is an example of what might happen. Finally, technical failures in payment
systems, which currently process many trillions of dollars daily in the Group of Ten countries alone,
would threaten a massive payments gridlock whose effects could easily extend beyond the financial
sphere into the real economy. The disruptive effects of such a development would obviously increase
(and perhaps non-linearly) the longer the problem persisted.
It is also the case in the modern world that financial instability is unlikely to remain
contained within national borders. All financial disruptions are likely to have an international dimension
because the three pillars of any financial system - financial institutions, financial markets, and payment
and settlement systems - are increasingly international. In the early 1980s, virtually every OECD country
limited or even refused the right of establishment to foreign financial institutions. By 1995 this
discrimination had virtually disappeared in industrial countries and is being reviewed in many emerging
markets.3 Cross-border transactions in bonds and equities in 1980 amounted to 10% of the GDP of the
Group of Seven countries (excluding the United Kingdom); by 1995 this had risen to 140%. Derivative
instruments were essentially unknown in 1980; daily turnover (notional amounts) had risen to almost
US$ 11⁄2 trillion by 1st April 1995 and one-half of these trades involved a non-domestic counterparty.4
Finally, the fact that new information is now available instantaneously and almost costlessly around the
globe further increases the likelihood that shocks in individual countries will be propagated elsewhere,
even when such contagion might not be warranted by underlying economic fundamentals.
B. A strategy for promoting financial stability
Any strategy for promoting global financial stability must begin by recognising two facts.
First, the pace of change in modern financial markets is extraordinary, ongoing and irreversible. Second,
financial transactions are becoming increasingly complicated and opaque and are involving an ever
widening and changing cast of characters. The implication is that the "system" which policy-makers aim
to stabilise is both difficult to define at any moment in time and rapidly changing.
An important underlying force driving both developments is continuing improvements in
computing and telecommunications which have brought a sharp reduction in the costs of carrying out
even extremely complicated financial transactions. Deregulation, which implies a significant expansion
in the importance of market forces, has also contributed materially to the process of change to date. Yet,
in part at least, deregulation is a by-product of technological change which has made it far easier to avoid
existing regulations. For example, when Microsoft can be traded at a transactions cost of 2 cents a share
on the Internet, Japanese domestic regulations that enforce a cost of US$ 5 are simply unsustainable.
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Better and cheaper communications have also contributed materially to the breakdown of
sectoral and national distinctions in international financial markets, as well as to the growing
participation of a whole host of new players. The importance of this last development should not be
underestimated since such new participants as pension funds, mutual funds and hedge funds are not
likely to behave like traditional banks, a possibility which creates new uncertainties about how the
international financial system might react during periods of stress. The fact that emerging markets are
also far more important on the global stage than they were ten years ago, and that emerging financial
markets have many idiosyncratic properties (often including a lack of transparency and of good corporate
governance), further complicates the task of formulating policies to ensure financial stability.5 This
combination of complexity and rapid change, allied with the increased integration of the international
financial system, points, however, to four strategic implications.
First, measures to strengthen the system must be comprehensive. There are no simple
answers. This means that wide-ranging measures must be directed to promoting the good health of each
of the major components of the international financial system: financial institutions, financial markets
and payment and settlement systems. In each instance, the overriding objective must be the stability of
the system as a whole; that is, policy-makers must seek to ensure that disturbances in one component of
the system are not easily transmitted throughout the system because they can interact with some other
weakness elsewhere.
The second strategic implication is that policy-makers and regulators must rely
market-led processes
increasingly on to provide the discipline required to lead to prudent and stabilising
behaviour. It seems to be a fact that regulators everywhere are having trouble keeping up with modern
investment practices. Nor do they wish to respond with still stricter regulation of the traditional sort. This
would be very costly in terms of efficiency, would only invite more evasion, and would probably lead to
moral hazard problems and still greater dangers in the future. Rather, regulators are increasingly
choosing to rely on the judgements of market participants, who are likely to be more up to date with
evolving practices. In turn, the market will allocate rewards and punishments as necessary, both to
owners of firms and to their directors and managements. This will help improve internal governance and
encourage appropriate behaviour.
For market discipline to work effectively, regulators should put growing emphasis on
disclosure and increased transparency. Better information aids "good judgement" as well as minimising
the risk of "bad judgement"; say the likelihood that creditors might mistakenly shun good counterparties.
However, since firms are often hesitant to increase voluntary disclosure, an important role for the public
sector is to convince a small number of important and well-managed firms to start the process going.
Other firms will then have little choice but to follow for fear of being accused of having something to
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hide. This strategy was recommended in a recent BIS document6 (the Fisher Report) on the disclosure of
derivatives transactions, and also underlies the strategy of the IMF in asking for better macroeconomic
data from emerging countries (SDDS) in the wake of the Mexican crisis.
This approach might also be used to support efforts, recently undertaken by the G-10
Deputies7 and the Basle Supervisors,8 to reduce the risk of financial instability in emerging markets. Here
the basic idea would be to build on the recently agreed set of international "Core Principles" governing
the behaviour of (say) banks and their supervisors. Subsequently, a set of quantitative indicators of the
health of the financial system might be drawn up9 and applied in the first instance to countries whose
financial systems were known to be in good condition. With time, the market (including rating agencies)
might come to insist on similar information from other countries, which in turn would encourage
pressures for desirable financial sector reforms. Recognising that the Core Principles were conceived of
as minimum standards, the "hurdle rates" sufficient for banking systems to be judged healthy might be
significantly higher in emerging than in industrial economies. Financial systems of many emerging
markets are subject to relatively large macroeconomic shocks and to potential transitional problems in
the context of financial deregulation, and may be prone to greater swings of sentiment than in more
developed markets.10 All such considerations should be taken into account when setting minimum
requirements.
complement
The third strategic implication is that market discipline must be a to, rather
the traditional activities of regulators and
than a substitute for, policy-makers. Publicly available
information may arrive too late or be of too poor quality to support adequate market discipline.
Moreover, safety-net provisions may also alter the incentives of market agents to respond appropriately
to the receipt of new information.11 Finally, it would be simply naive to assume that the markets will
always exercise discipline appropriately. Throughout history, there have been instances recorded of
excessive price volatility in financial markets, "bubbles" and other misalignment of financial asset
prices.12 Moreover, banks and other financial institutions, buoyed by waves of "excessive optimism" or
even "irrational exuberance",13 have frequently lent large sums of money to borrowers who ultimately
proved unable to pay. Recent events in a number of Asian countries would seem to provide further
evidence of this particular kind of market failure, albeit along with a number of other important
shortcomings.
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It is particularly worth noting at the present moment that imprudent behaviour and
excessive risk-taking by financial institutions often follow periods of declining profits due either to
deregulation, and the associated loss of monopoly rents, or bad investment decisions in the past.
Examples of such phenomena can be found in the domestic behaviour of US banks in the 1980s14 and the
expansion of Asian loans by certain Japanese and European banks more recently.15 Given the strong
current trend towards financial deregulation in emerging markets, and the likely effects of similar
developments in industrial countries (the "Big Bang" in Japan, the effective demise of Glass-Steagall in
the United States and the effects on European banks of the introduction of the euro16), regulatory
oversight will continue to have an important role to play for the foreseeable future. Indeed, it is plausible
to argue that the combination of these changing circumstances, allied with the spread of Internet and
other technologies17(as well as important demographic changes18), could be ushering in an unprecedented
period of transformation in modern financial markets. If so, policy-makers will need all the instruments
available to them if this process of change is not to prove disruptive.
The role of policy overseers will, however, have to change to reflect this required
complementarity between market discipline and regulatory oversight. Just as monetary policy in a
deregulated financial system must be conducted "with the grain of the market", regulatory oversight must
be increasingly directed to improving market processes. In response, regulators have already begun to
strengthen the focus they put on the adequacy of internal control procedures. This applies both to
financial firms and to firms providing infrastructure services in the international financial system.19
There must too be a greater willingness to use market-developed (firm-specific) models for evaluating
risk exposures of various sorts (market risk, credit risk and liquidity risk); this process too is also well
begun. Regulators will also wish increasingly to set or suggest standards for external disclosure. This
will foster the use of market discipline in general and will facilitate the participation and contribution of
14
The losses associated with the debt crisis of the early 1980s were followed (if not necessarily caused) by
vigorous expansion into LBOs, property loans and proprietary trading.
15
At a CEPR conference in London on 4th-5th February 1998, David Folkerts-Landau of Deutsche Morgan
Grenfell stated that many European banks had responded to declining rates of return in European banking in
the early 1990s by "targeting middle-market Asia". French banks have been repeatedly warned by the Bank of
France to cease making international loans at margins that are too low to cover all-in costs. Crédit Lyonnais is
known to be the French bank most significantly exposed to Asia.
16
See McCauley and White (1997).
17
Technology allows both the unbundling and the rebundling (pooling) of risks. This contributes to the
development of securities markets as opposed to the use of intermediated credit. Moreover, new technological
developments have supported the advancement of non-bank financial intermediaries at the expense of banks,
and the advancement of specialist "non-banks" to the detriment of both. Finally, by making information cheaper
to obtain publicly, technology directly attacks the insider information which is at the heart of relationship
banking.
18
The broad implications of projected demographic trends in the OECD area has been the focus of recent
OECD studies. See Roseveare et al. (1996). The G-10 Deputies currently have a Working Group looking into
the macroeconomic and international financial implications.
19
In the realm of the governance of banks, see Basle Committee on Banking Supervision (1998b). With respect to
governance issues in the area of financial infrastructure, see Committee on Payment and Settlement Systems
(1997c).
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rating agencies in particular. Finally, it is worth noting that as markets evolve, as they will certainly
continue to do, the complementary nature of the relationship between the regulator and the markets will
have to continue to evolve as well.
The fourth strategic implication is that regulation or guidance from policy-makers must
international agreements among policy-makers
be the by-product of from different countries. Given the
reality of international competition, efforts must be made to establish a "level playing-field" for
regulatory purposes. Participation in such agreements must also be widespread enough to avoid the
danger of regulatory competition (regulatory arbitrage) for non-participating countries. Finally, given the
required complementarity between regulatory and market discipline, the dialogue leading up to
international agreements must somehow involve both public sector and private sector participants. The
BIS plays an important role in facilitating such an international dialogue.
C. The role of the BIS in promoting financial stability
1. The process of achieving agreement
Before turning to what the BIS does, it is perhaps useful to be clear about what it does
not do. In particular, it does not normally use its own financial resources to promote or finance particular
courses of action by its members. In these respects, its mandate is completely different from that of other
international financial institutions such as the IMF, the World Bank and the regional development banks.
Rather, since being founded in 1930, its unchanged mandate has been to promote international
cooperation on monetary and financial issues, principally but not exclusively among central banks.
Leaving aside the banking services provided by the BIS to central banks and international institutions
(which have resulted in a balance sheet of about $130 billion), the BIS could be described as being
essentially a talking shop. However, this talk had led to many important decisions being taken with
significant international implications. While the small BIS staff organises and facilitates meetings, and
its research papers (both published and unpublished) help raise the analytic quality of the debate, the
greater value added is provided by the national representatives who attend meetings at the BIS and
contribute to international cooperation in other ways.
International cooperation at the BIS is based firmly on the principle of national (state)
control.20 This recognises the reality that sovereignty in the modern world still resides at the level of the
nation state and that national legislatures (particularly those of larger countries) are often not willing to
cede their power to international bodies. Moreover, this approach also helps alleviate concerns about the
existence of a "democratic deficit"; that is, the fear that important decisions might be made by
technocrats rather than public servants directly accountable to nationally elected politicians. The depth of
such concerns is evident to anyone following the current debate about the introduction of the euro, the
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desirability of the European Central Bank being politically accountable, and the future political structure
of Europe. Yet such concerns are by no means confined to Europeans alone.
Members of the various committees which meet at the BIS negotiate positions among
themselves. Each clearly pursues national objectives and, in general, each has been in close contact with
private sector agents in his or her own country to ascertain their views. The objective of the exercise is to
find a negotiated agreement which is mutually acceptable, across countries and to both public and private
sector agents, and which can then be ratified by Ministers and Governors and subsequently implemented
using national legislation or regulation. The fact that the size of committees is relatively small facilitates
the decision-making process, as does the tradition of making decisions by consensus. The recognition
that a failure to reach an international agreement would open the door to both unfair competition and
regulatory arbitrage also drives the process forward.
The fact that national legislators have been willing to accede to such a process, and that
private sector participants likely to be affected have also generally signed on, testifies to the moral
authority exercised by these international agreements and the perceived legitimacy of the process itself.
Moreover, although the committees which meet at the BIS have generally drawn their members from the
G-10 group of countries, many of the agreements reached (most notably, capital adequacy standards for
internationally active banks) have simply been accepted by non-G-10 countries as effective global
standards. In this regard, the influence of private rating agencies has often played a useful supporting
role, as have the efforts made by the various committees to disseminate publicly their findings and
agreements.21 Other international financial institutions, such as the IMF and World Bank, have also
played a major role in communicating to a wide range of non-G-10 countries what might be thought of as
"best practice" in the industrial world. It is also notable that this model, which leaves decision-making
firmly in the hands of experts from nation states and relies on international organisations to spread the
word, is the model recently recommended by the G-10 Deputies (in association with many
representatives of emerging markets) in their recent report on financial stability in emerging market
economies.22
These positive comments about the "Basle process" should not blind us either to
shortcomings evident in the past or to some important challenges for the future. The most important
problem in the past has been that, although difficulties were often identified at an early stage, it
sometimes took a crisis of some sort to galvanise into action the process of finding a solution. By way of
example, the Basle Committee on Banking Supervision was set up only after the failure of Bankhaus
Herstatt in 1974, even though it had been recognised well in advance that banks with large international
operations posed special problems. It is also instructive that the question of "Herstatt risk" (i.e. the credit
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was highlighted at the same time (1974) but the first significant attempt to address the problem was not
made until over twenty years later.23 Having registered this shortcoming, it is also true that, the various
committees meeting at the BIS also have become significantly more proactive in recent years. This will
become evident below.
As for future challenges to the current process, the first complication is the need to
involve participants from emerging markets. Hong Kong and Singapore are already the fourth and fifth
largest foreign exchange markets in the world and other financial markets are expanding rapidly
elsewhere. The growing industrial might of countries like Korea, China, Brazil and others must also be
recognised, even if recent events in Asia suggest that there can be setbacks along the way. If the
credibility of the decision-making process rests on the involvement of national experts from jurisdictions
most affected by the decisions taken, then input from emerging markets will be increasingly important.
The issue is how to reconcile such an expansion with the maintenance of the intimate club-like
atmosphere (also involving shared values and shared conceptual frameworks) that facilitate agreement
and decision-making on the basis of consensus.
A second important complication is the breaking-down of the barriers between different
markets and different kinds of financial institution. Not only are national regulatory frameworks
generally based on such distinctions but so also are international committees. At the very least, there
needs to be a channel for communication among such bodies as the Basle Committee on Banking
Supervision, IOSCO and the International Association of Insurance Supervisors. The recent decision in
the United Kingdom to consolidate all forms of financial supervision in the hands of a super-regulator
may presage a more radical solution to this problem, but one which raises still other complications. In
particular, the decision to site this regulator outside the Bank of England, but to give the Bank
responsibility for overall systemic stability, raises the question of overlapping mandates for those two
bodies. Again, there may be international implications if non-central banks come to play an increasingly
important role in the BIS process. Similarly, the introduction of the euro and the establishment of the
European Central Bank raises the question of future representation on the various BIS committees. The
answer to this will presumably depend on the nature of the relationship which evolves between national
supervisors and the supranational European System of Central Banks.24
A final challenge has to do with managing the balance of influence between public sector
and private sector representatives in the process. While in the past public sector participants generally
made proposals and the private sector responded, increasingly the opposite is true.25 This trend is,
however, to be welcomed in that it is consistent with the concept that it is the private sector that should
be held primarily responsible for avoiding possible failures in private financial markets. The role of the
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costs (including externalities) of such failures. As noted above, however, it may well take many years for
this new balance to be struck.
2. Specific measures to promote financial stability
The objective of this part of the paper is to record more specifically how various
committees meeting at the BIS contribute to implementing the strategy for financial stability described
above. Before doing so, it seems worth reiterating that the likelihood of financial stability, both at the
national and the international level, will be significantly enhanced if governments follow stabilising
macroeconomic policies. This objective is also firmly endorsed by the BIS, which indeed regularly
organises a wide range of meetings directed to improving the conduct of monetary policy in participating
countries. While these meetings have traditionally focused on events in the G-10 countries (regular
meetings in Basle of the G-10 Governors, the Gold and Foreign Exchange Committee, Economists,
Model Builders and many others), an increasing number of meetings now focus on macroeconomic
developments in emerging markets as well.26 However, since macroeconomic stability is a necessary but
certainly not a sufficient condition for ensuring financial stability, the implication is that more specific
measures to foster financial stability are still warranted and are indeed urgently required.
In this regard, it was suggested above that the international financial system is based on
three pillars: financial institutions, financial markets, and payment and settlement systems. The analytical
model underlying this suggestion is that of a flow-of-funds matrix underpinned by the infrastructure
(payment systems and other "plumbing") required for it to function.27 Perhaps more by luck than design,
there is a BIS committee dealing with each of these individual pillars: the Basle Committee on Banking
Supervision (institutions), the Euro-currency Standing Committee (markets) and the Committee on
Payment and Settlement Systems (infrastructure).28 Pursuing the analytical framework one step further, it
is evident that disturbances at the level of institutions, markets or infrastructure will have implications
for market clearing conditions (interest rates, exchange rates, etc.) in the flow-of-funds matrix which
could well have macroeconomic implications. While all three of the BIS committees recognise these
interactions, and increasingly share information in consequence, it is the Euro-currency Standing
26
The proceedings of some of these meetings and the papers prepared for them are now available in a new
series of BIS Policy Papers. See, for example, Bank for International Settlements (1998b).
27
See White (1994).
28
For the sake of completeness, it should also be noted that various other committees of national experts also
meet regularly at the BIS and contribute in rather more technical ways to issues having implications for
international financial stability. The Committee of Legal Experts has at various times considered the possible
undesirable implications of having different legal codes (in particular, bankruptcy procedures) governing financial
transactions in different countries, and the Committee has recently considered as well legal questions
surrounding the introduction of electronic money. Committees of security and computer experts meet
regularly at the BIS and commonly exchange views on technical issues having systemic implications. One such
issue currently receiving attention is how the official community should itself respond to the "millennium bug"
problem. This work complements the recent document (September 1997) issued by the Basle Supervisors
directed to encouraging the private sector to address this problem in a serious way (see Basle Committee on
Banking Supervision (1997b)). A global conference, jointly organised by the Basle Supervisors, IOSCO and the
Committee on Payment and Settlement Systems, took place at the BIS on 8th April 1998.
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Committee that has traditionally been most interested in the overall dynamics of these systemic
processes.
a. The Basle Committee on Banking Supervision
The Basle Committee on Banking Supervision, whose traditional preoccupation has been
the stability of banking institutions, is the best known of the committees which meet at the BIS. Set up in
1974, the Committee first directed its attentions to ensuring that all internationally active banks were
adequately supervised on a consolidated basis. The first agreement of this sort was the Basle
Concordat,29 which established the principle that no foreign banking establishment should escape
supervision, and that such supervision should be adequate. The Concordat has been revised a number of
times in the light of changing circumstances and perceived shortcomings, but a key principle has been
maintained throughout: the home or parent supervisor is responsible for the global operations of banks
headquartered in its territory and should supervise them on a consolidated basis.
The Minimum Standards paper of 199230 was a further effort to put such principles into
practice. Four standards were laid out to ensure that home supervisors do practise effective supervision
(if not, the host country can refuse a banking licence) and to ensure that the home supervisor has
adequate access to information about cross-border activities of its banks (if not, the home supervisor can
refuse to allow the business to continue). Nevertheless, members of the Basle Committee and other
supervisors continue to feel that the flow of information among themselves remains subject to legal
impediments. Accordingly, at the International Conference of Banking Supervisors in Stockholm in
1996,31 delegates from over 150 countries endorsed a further report prepared by a joint working group of
the Basle Committee and the Offshore Group of Banking Supervisors. In this report 29 recommendations
were presented. These included suggested procedures for the conduct of cross-border inspections by
home authorities monitoring their own banks, and approaches for dealing with corporate structures which
create potential supervisory gaps. Ongoing problems include those posed by countries which still do not
allow on-site inspection by home-country supervisors (Singapore and France, for example) and fears that
information sent to other supervisory agencies will find its way into the public domain under the laws of
the recipient country (a particular concern in the United States). In both cases, changes to domestic
legislation are required which may prove difficult to achieve.
A second preoccupation of the Committee has been to ensure that internationally active
banks maintain a level of capital commensurate with the risks they run. The Committee's first
achievement in this area was the promulgation of the Basle Capital Accord,32 which was published