delisle worrell : making the financial system more secure address by dr delisle worrell, governor of the central bank of barbados, at a joint luncheon meeting of the barbados international business association ( biba ) and domestic bankers, hastings, 2 february 2010. * * * the dramatic collapse of lehman brothers in september 2008 may well have completed the process of rethinking the management of financial systems, and of reinventing central banks. it used to be that central banks were mainly concerned with monetary policy, and only peripherally with matters of financial regulation. indeed, there was sentiment in favour of removing responsibility for financial regulation from the ambit of central banking altogether, and some argued that for the monetary policy maker to be financial regulator as well, was a conflict of interest. that view of the world began to come unstuck in the 1990s, with the onset of a series of international financial crises with far reaching implications, and the mandate for monitoring the health of the financial system was placed squarely on the shoulders of the central bank. financial stability is now firmly on the agenda of central banks everywhere, and the bank ’ s mandate of necessity encompasses all financial institutions which have the potential to destabilise the system as a whole, whether or not they are actually under the central bank ’ s legal purview. in this address i will explain what we mean by financial stability, why financial stability is important, and how we seek to attain financial stability. the quest for financial stability interest in financial stability was rekindled by a series of financial ( and exchange rate ) crises which began with the mexican crisis of 1994, followed by crises in russia, brazil, the far east, and turkey, to name the best known examples. in response, the scope of financial sector oversight, which had previously focused on the prudential health of individual institutions, was broadened to encompass the financial system as a whole. the aim was to avert the possibility of new financial crises emerging, to develop early warnings of possible financial difficulties, and to minimise the cost and ramifications of such financial failures as did occur, so as to prevent them snowballing in ways that would lead to widespread failure. that aim was reflected in the intensification of research on financial risk management, the widespread adoption of indicators of financial soundness, the universal obsession with the much misunderstood stress tests, the publication of financial stability reports, the revision of international guidelines for financial oversight and the institution

by the imf of a programme for assessing and reporting on the financial systems of all its member countries on a periodic basis. it is by no means reassuring that, in spite of this intensive effort over more than a decade, a crisis of unimagined proportions should have emerged, affecting the financial systems of all major countries, even those which were thought to be most skillfully managed and regulated, according to the new methodologies and guidelines. one important element in the quest for financial stability was the development of tests of the soundness of the financial stem. over the last decade, the financial community has adopted a commonly used suite of financial soundness indicators for commercial banks, with a lesser known set of indicators for insurance companies. the health of the financial system is judged by comparing each indicator against a rule - of - thumb benchmark, most of which are codified in an international agreement. for example, the international benchmark for the capital adequacy of commercial banks agreed under the original accords signed at the bank for international settlements in basel, switzerland, is that banks should maintain minimum capital equal to 8 percent of assets. ( the assets are weighted according to the risk they are thought to carry. ) other indicators include the ratio of impaired assets to total assets, the ratio of liquid to total assets, the return on assets or equity, and the institution ’ s exposure to foreign exchange, interest rate or capital market variation. the indicators help to assess the current health of the financial system, but they offer limited insight into possible future challenges. early warning systems ( ewss ) have been developed in an effort to provide this insight. the logic of these systems is that, by examining the behaviour of financial indicators just before previous crises and financial failures, we may detect a pattern which could warn of future crises. the ewss therefore attempt to forecast financial system performance based on a combination of indicators, taking into account past experience. a complementary approach is to forecast financial performance indicators, such as profitability and liquidity, as a supplementary outcome from the forecasts of general economic performance. stress tests may be the most widely recognised tool recently developed for the analysis of the fragility of financial systems, and they are just as widely misunderstood. what we ought to test for, is how far the financial institution or system is from its limit. for example, we may conduct a test to determine what level of loan delinquency would serve to render a financial institution bankrupt. would its