Enrique Marshall: Central banks' contribution to financial stability -
the experience of Chile
Speech by Mr Enrique Marshall, Board Member of the Central Bank of Chile, at the Central
Bank of Bolivia's First Financial Workshop "Macroregulation and Financial Stability", La Paz,
29 September 2010.
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I am indebted to Kevin Cowan and Jorge Cayazzo for their valuable comments on an earlier version of this
presentation but the opinions expressed here are the exclusive responsibility of the author.
1. Introduction
Financial stability has been a concern for central banks since their very origins. The functions
for which they were created - to regulate money and credit markets and to serve as lenders
of last resort - have a direct bearing on the objective of financial stability and this relationship
has been further reinforced by the fact that many central banks have also undertaken a role
in regulating and supervising the banking system.
Both the economic literature and historical experience provide sound grounds for this
concern for stability, clearly demonstrating that the functioning of the real economy requires
an efficient and stable financial system. The hardest lesson of history, however, is that
financial crises have occurred time and again, with a very high cost in terms of both their
fiscal impact and the associated losses of output.1
Financial stability has, as a result, emerged as a paramount objective of public policy.
However, the transformation of this general intention into specific objectives and policies has
been, and remains, a complex matter that often involves options or dilemmas that are not
always easy to resolve.
To start with, the concept of financial stability is difficult to define precisely, nor do we have a
sufficiently solid analytical framework equivalent to that used to conduct monetary policy.
Moreover, responsibility for preserving stability is normally shared among different
authorities, each with its own approach to the issue.
As a result of the current global financial crisis, financial stability is very much at the center of
debate, prompting an in-depth review of institutional arrangements, authorities'
responsibilities, policies and the instruments that can be used for this purpose. In developed
countries, where the crisis had its origin, financial reforms are underway in a bid to overcome
the weaknesses that were detected. Emerging economies, although they did not experience
the same problems, must take advantage of the opportunity to review their own situation,
draw lessons and advance in perfecting their financial systems. From this point of view, the
exchange of opinions that is the purpose of this seminar may help in drawing up
recommendations.
2. The Central Bank of Chile and financial stability
The concern of the Central Bank of Chile (BCCH) for financial stability is anchored in its legal
responsibilities and the powers or instruments assigned to it. An organic law in force since
1989 establishes that the BCCH's objective is to "safeguard the stability of the currency and
the normal functioning of domestic and external payments".
The first part of this objective is interpreted as the maintenance of price stability or, in other
words, low and stable inflation. For the past ten years, the BCCH has applied a policy
framework with an inflation target of 3% and a 1% tolerance range.
The second part of its objective is directly related to financial stability. For payments to be
made normally, the banking system, money and credit markets and supporting infrastructure
must all function properly. The reference to external payments seeks to highlight the
importance that trade and financial flows with the rest of the world have for an open economy
such as Chile. Financial stability is, in other words, an essential part of the BCCH's
responsibilities, very much in line with what we see in most of the world's economies.
In the eyes of BCCH, the two parts of its objective are different and separable, but affect and
reinforce each other. The management of monetary policy, which seeks price stability,
requires that money and financial markets work well while financial stability requires, among
other conditions, that inflation remains low and stable. The recent financial crisis has
underlined the interrelations between these two objectives.
The powers with which the BCCH is endowed also have a clear relation to financial stability.
The BCCH can provide the system with liquidity under normal terms and conditions and,
although forming part of the management of monetary policy, this simultaneously fulfills
functions related to financial stability. Liquidity can also be provided in extraordinary
circumstances and the BCCH is empowered to make emergency loans to banks suffering
temporary liquidity problems. Moreover, if a bank is forced into liquidation, the BCCH must
provide the funds to pay deposits guaranteed by the State, which include all sight deposits
and those of small savers.
In addition, the BCCH has powers to regulate the money market and the system of
payments. It establishes norms for deposits and bank borrowing and regulates the working of
large-value clearing houses and payment systems and also has some powers of prudential
regulation. It regulates market risks and relations between banks' active and passive
operations as well as the operations of saving and loan cooperatives and bank and non-bank
credit card systems. On these same lines, it sets some norms with systemic implications that
refer to pension fund investments such as, for example, the percentage of their portfolio that
they may invest abroad. In addition, it participates in some decisions in the sphere of
prudential regulation for banks, issuing a prior opinion or giving its agreement.
For prudential reasons, the BCCH can impose restrictions on foreign exchange operations.
In the case of foreign trade, it can require the repatriation and liquidation of export revenues
and set a term for import coverage while, in the case of financial flows, it can impose reserve
requirements as it, in fact, did in the 1990s.
The BCCH is also authorized to accumulate and maintain international reserves. This has a
direct impact on the country's international liquidity position and, in the last instance, on the
stability of cross-border financial flows and, therefore, the normal functioning of the domestic
financial system.
Since the BCCH's origins, banking regulation and supervision have been entrusted to the
Superintendency of Banks and Financial Institutions (SBIF) which depends on the
government through the Finance Ministry. There is also a supervisor for securities and
insurance and for pensions. This institutional arrangement has, in general, worked well over
the years. In order to ensure the necessary coordination and communication between the
different authorities, a committee was created a few years ago that brings together all the
financial sector supervisors and in which the BCCH also participates. It has allowed the
BCCH to make its view on issues of systemic importance known to the supervisors.
Numerous initiatives implemented by the BCCH over the past decade underline its firm
commitment to financial stability. These include:
a) creation of a large-value payment system based on real time gross settlement
(2004);
b) publication of a Financial Stability Report as from 2004;
c) stress tests for the banking system and disclosure of their results which are
published in the Financial Stability Report;
d) incorporation of non-bank credit card systems into the regulated system, although
with looser norms than those applying to banks (2006);
e) implementation of a household financial survey, carried out countrywide for the first
time in 2007 and followed by panel studies for Greater Santiago in 2008 and 2009,
gathering information that has served as the basis for numerous research projects;
f) participation, along with other authorities, in an initiative to modernize the system for
clearing and paying financial securities, which will lead to the creation of a clearing
house and central counterparty in line with international standards (2009-10).
During the recent crisis, the BCCH was decisive in exercising its powers as regards financial
stability and these proved effective in maintaining the normal functioning of the system. In
April 2008, it announced a program of accumulation of international reserves for US$8 billion
with the aim of strengthening the country's international liquidity position in a context of great
uncertainty about the outlook for the international economy and a significant appreciation of
the Chilean peso. This measure was successful in achieving its objectives. Subsequently,
due to the intensification of the crisis in September/October 2008, the BCCH took
extraordinary measures to provide liquidity in pesos and dollars and ensure the normal
functioning of the financial system. Through these measures, it was able to dissipate internal
financial tensions and bring about a fairly quick return to full normality.
Compared with other central banks, the BCCH faces some limitations in managing situations
of tension or crises. It is expressly forbidden to provide financing, directly or indirectly, to the
government and state institutions or enterprises. It cannot, therefore, acquire securities
issued by the Public Treasury as part of its monetary operations. This does not, at present,
represent a significant restriction because these operations are carried out using the BCCH's
own securities but, in a critical situation, could limit its ability to inject liquidity into the system.
Similarly, it can only provide liquidity to banks and cannot intervene directly in the financial
markets by buying securities from other types of institutions or investors, nor can it make
direct or indirect capital contributions to institutions in difficulties.
However, the BCCH has not been alone in seeking to ensure financial stability. Fiscal policy,
prudential regulation and banking supervision have also made a very positive contribution.
Fiscal policy has, in general, been noted for its responsibility during this period. Moreover,
since 2000, the government has applied a policy rule that sets effective spending as a
function of permanent fiscal revenues. This has made fiscal policy predictable and
sustainable over time as well as making it possible to keep public debt low. Indeed, thanks to
a significant increase in copper revenues, this has dropped to a historically low level in recent
years and gross central government debt is currently running at around 6% of GDP. All these
factors have contributed to financial stability.
Prudential regulation has been another key pillar of financial stability. It was completely
redesigned after the severe financial crisis of the 1980s. The lessons of this crisis were
learned and then incorporated into banking law and, although this has since been subject to
updates and modernization, it has maintained the hallmark strictness it acquired in this
period.
Some of the recommendations put forward in the light of the recent crisis have, in fact, been
part of Chilean regulation for some time. For example, it includes:
a) regulatory incentives for banks to maintain capital in excess of the required
minimum so that their effective capital represents more than 10% of their
riskweighted assets;
b) prudential standards to preserve the quality of capital (hybrid instruments cannot
exceed 50% of basic capital);
c) explicit limit on gross leverage as a complement to capital adequacy rules based on
Basel recommendations (basic capital cannot be less than 3% of total non-weighted
assets net of required provisions);
d) special regulatory requirements for larger banks (capital requirement can reach
14%);
e) robust provisions regime with a forward-looking approach;
f) quantitative norms on the match of the terms and currencies of banks' assets and
liabilities;
g) preventive capitalization, regularization and resolution systems for banks in
difficulties.
Supervision has also played a key role. In recent decades, this evolved from a formal and
passive approach to one that is significantly more intrusive and proactive. Supervision now
focuses on the governance and, above all, management of institutions. Supervisors seek to
be familiar with all the aspects or issues that can be important in an institution's behavior,
rather than merely verifying compliance with regulation or simply reviewing financial
indicators from previous years. The ultimate aim is to induce changes or corrections in the
management of an institution when weaknesses are detected. This approach, known in the
literature as risk-based supervision, is the one that has been recommended in the light of the
recent crisis.
On several occasions, supervision has ventured into what is today termed macroprudence.
At the end of the 1990s, the SBIF issued recommendations urging that due attention be paid
to the concentration of risks in the real estate sector, beyond what each institution might
have on its books. Applying this same logic, it also issued instructions for the treatment of
lending to individuals, particularly consumer loans, in the context of the rapid growth of these
operations. Then, in the early 2000s, it instructed supervised institutions to carefully assess
their clients' exchange-rate risk, regardless of whether their own positions were well hedged.
When mergers and acquisitions intensified a few years ago, it also took the initiative of
introducing stricter regulation for banks of a larger relative size so as to guard against
systemic risks.
Although a factor of a different nature, the development of Chile's capital market has also
contributed to financial stability. The creation of a private pension system brought with it the
appearance of institutional investors as well as new sources of medium and long-term
financing. At the end of 2008, when international markets became tense, Chilean companies
were able to replace external financing with placements on the domestic market on
convenient terms and conditions.
3. Remarks in the light of recent experience
The paramount objective of central banks has been and will continue to be price stability.
Recent decades have brought notable achievements in this area. They were possible thanks
to the institutional strengthening of central banks, including statutes of autonomy and
advances in the design, implementation and communication of monetary policy. It is
important to persevere on these lines whilst also bearing in mind possible adjustments or
improvements.
Central banks, however, also have an important responsibility for financial stability. Although
this responsibility had lost prominence over time, the experience of recent years has clearly
underlined its importance. Moreover, because of their monetary policy tasks, they are in
direct contact with the markets and, therefore, have access to first-hand information about
the functioning of the financial system. This puts them in a privileged position to undertake
tasks related to financial stability.
Central banks must, however, be realistic in setting their objectives. It is critical to ensure that
they do not result in a more than reasonable level of protection for the financial system since
this would encourage banks and other financial institutions to take excessive risks. The
responsibility of central banks as regards financial stability must be geared principally to
strengthening the reaction capacity of the system as a whole. If problems occur in specific
institutions - which cannot be ruled out - the aim must be to minimize their systemic impact.
Central banks must have a set of instruments that allow them to contribute effectively to
financial stability. Many of these instruments, such as providing liquidity, are inherent or
traditional while others, such as regulating and watching over payment systems, have
developed in recent decades. The experience of the last few years has suggested a need to
review or update the available instruments and to generate the operational conditions in
which they can be used without delay when needed. During this latest crisis, for example,
many central banks were not operationally prepared to receive collateral that was not in
habitual use. It has also been suggested that there is a need to incorporate new instruments,
principally with a macroprudential approach. However, in the case of some of these
instruments - specifically, the use of regulation for countercyclical purposes - evidence is
scarce and debate as yet inconclusive.
However, beyond the contribution that a central bank can make, financial stability requires a
comprehensive framework of financial institutions, policies and practices. The solidity of this
framework and its consistency are crucial. Regulation and supervision, whether or not in the
hands of the central bank, are critical, but so too are monetary and fiscal policy. The recent
sovereign debt crisis in Europe, for example, has demonstrated the importance of fiscal
conditions for financial stability.
Market discipline and institutions' management, although discredited by the crisis, are factors
that can, with an appropriate regulatory framework and incentives, contribute to stability. The
efficiency of regulation and supervision should, in the end, be reflected in good behavior by
institutions and the proper functioning of markets.
Discussion as to the institutional arrangements that are most appropriate from the point of
view of financial stability remains open. One key question is who should be responsible for
the tasks of prudential regulation. Another, although perhaps slightly less important, is who
should do the supervision. There are arguments in favor of different policy options, but any
specific recommendation must take into account the experience and circumstances of each
country. Until the crisis, the prevailing trend was for a body different from the central bank to
be responsible for regulation and supervision whereas now the wind seems to be blowing in
the opposite direction. In this context, one piece of practical advice is not to significantly
change something that has worked well.
In any case, the decisions that are taken may have significant implications for central banks'
institutional insertion, the scrutiny to which they are subject, and internal organization of their
activities. These implications become particularly important if it is decided to give the central
bank broad responsibility for financial stability. In this case, it may be advisable to adjust
internal governance so as to ensure the necessary separation of the objectives of financial
stability and price stability.
Under any institutional model, coordination and communication between the different
authorities with functions related to financial stability will always be very necessary. Even
under a model that assigns all the relevant functions to the central bank, coordination and
communication between it and the government will still be essential because it is the fiscal
authority that is responsible for the use of public resources. In a globalized world, it is,
moreover, necessary to develop mechanisms for coordination and communication with the
authorities of other relevant jurisdictions. In many emerging economies, this is a key issue
because of the significant presence of international banks in these markets. In addition,
stronger coordination and communication between authorities is vital for progress towards
comprehensive or consolidated supervision of financial groups and for avoiding some of the
problems detected in the recent crisis.
One recommendation on which there is fairly broad agreement is to periodically review the
perimeter of regulation and supervision. The traditional view that this should include only
institutions taking deposits from the public has been superseded by events. The consensus
view that has emerged from the recent crisis is that all institutions of systemic importance
must be regulated and supervised. This also includes the obligation to provide information
and disclose positions in order to ensure that markets function properly. The practical
implications of this recommendation may vary from country to country, depending on the
characteristics of their financial systems.
There is also broad consensus that minimum capital requirements, applied on permanent
bases, must be raised and strengthened as stated in the recent agreement reached by the
Basel Committee. However, the recommendation that a capital component of a
countercyclical nature be introduced raises a number of questions. What does seem
interesting, although it is not explicitly included in the recent Basel proposal, is the idea of
having some component of contingent capital. This could be established by issuing bonds
that would, under certain circumstances or conditions, become capital as, for example, if an
institution's capital falls below 8% of its risk-weighted assets.
Another point on which there is a considerable agreement is the need to review norms and
practices on liquidity management and bank funding. These had become quite lax in many
jurisdictions. Liquidity and refinancing risks were underestimated, particularly in the
environment that preceded the crisis. The recommendations that have subsequently been
put forward include a redefinition of liquid assets, the establishment of a minimum global
liquidity standard, norms using time bands for the match of assets and liabilities, and higher
requirements for liabilities that show greater volatility. In all these cases, there is much that
central banks can contribute. The Basel Committee has recently undertaken to advance in
defining a global liquidity standard and has fixed a calendar for this process.
A robust system of provisions, based on a forward-looking rather than a backward-looking
approach, can make a significant difference to the stability of the banking system. This is
illustrated by the experience of emerging economies where this policy instrument is used
most often and with the greatest intensity. During discussion of the Basel II agreement, it was
suggested that provisions should be its fourth pillar but this idea was, in the end, rejected by
the developed countries because of potential conflicts with accounting norms. After the crisis,
there is, however, renewed interest in provisions as a prudential instrument. The idea of
applying some countercyclical rule has gained ground. Several Latin American countries
have advanced in this direction and their experience should be followed with attention.
Mortgage operations, which are very closely related to the origins of the crisis, will need to be
reviewed. The volumes and amounts committed to this activity are growing and have, without
doubt, acquired systemic importance. This has implications both for the banking system,
where these operations tend to originate, and for the securities market which provides the
financing. The recommendations that warrant attention include the application of a prudent
loan-to-value ratio taking into account cyclical fluctuations in the price of the dwelling, stricter
requirements for institutions in the business of originating to sell, and the use of covered
bonds to finance these loans so as to leave credit risk in the hands of the issuer while
transferring market risk to the investors. This latter recommendation is backed by several
successful experiences including that of Chile with covered bonds.
Because the origins of the recent crisis appear to have been closely related to lax credit
policies in the personal banking segment, commercial practices that lacked transparency and
excessive household borrowing, it has brought the issue of consumer protection to the fore.
Although also a broader issue, consumer protection is related to the proper functioning and
stability of the financial system, particularly if it is understood to include such important
matters as financial education, transparency with clients and market behavior, It can,
therefore, not be ignored when deciding within which institutional framework and with what
policies to address this issue.
4. Final remarks
Concern for financial stability is at the origin of central banks. It can, in fact, be said to be in
their DNA. Although this concern had faded over time, the experience of recent years has
again brought it very much to the fore. As a result, there is now broad agreement that central
banks have an unshirkable role in this field and debate centers rather on the instruments
they need to have.
The crisis has left important lessons, especially for the developed economies where it had its
origins. They have already begun to implement financial reforms in a bid to remedy the
weaknesses that were observed. The emerging economies, although they did not experience
the same problems, must take advantage of this opportunity to review their own situation, to
draw lessons about what worked well or not, and to advance in the task of perfecting their
financial systems.
Chile's institutional arrangements as regards financial stability have generally worked well in
recent decades. This is borne out by the present strength of its financial system and the way
in which it came through the recent crisis without major problems. But there are pending
tasks and challenges. Large financial reforms may not perhaps be required but there is room
for improvements in various areas. They include the need to create a mechanism for
coordination and communication at the highest level with a focus on financial stability in
which the government, the BCCH and the different financial sector supervisors participate.
This would allow the BCCH to make its points of view known formally to the relevant
authorities.
Similarly, in a context in which financial activities have become increasingly complex, the
bodies responsible for supervision need to be strengthened institutionally. From this point of
view, particular attention should be paid to the resources assigned to them and their capacity
to issue norms and regulation in a world that calls for constant adjustments and changes.
Finally, it would be advisable for the BCCH to have a more active role in defining prudential
regulation. In some cases, this role already exists but could be extended to other norms with
systemic implications. For coordination with the SBIF, a mechanism similar to that which
already exists requiring a prior report or authorization from the BCCH when the supervisor
exercises its regulatory power, could be used.
BIS Review 142/2010