Central Bank and financial system stability

The Central Bank of Sri Lanka has been mandated to attain two core-objectives: economic and price stability and financial system stability.

They were added to the mandate of the Central Bank by an amendment made to the Monetary Law Act in 2002.

There appears to be a great deal of misunderstanding in the minds of many about what is meant by financial system stability and this article is intended to clarify the issue and remove any misunderstanding.

The two core-objectives of the Bank are complementary to each other. Accordingly, the attainment of financial system stability will help the Bank to attain the economic and price stability and vice versa. When the financial system is stable, then, the Bank could effectively implement monetary policy measures to attain economic and price stability. This is because the Bank uses the banking institutions as the vehicle for implementing its monetary policy measures.

The monetary policy measures so implemented mainly take the form of making money more expensive or cheaper by increasing or reducing the interest rates, raising or lowering the level of excess cash in the system by conducting open market operations and changing the ability of banks to create new credit by requiring them to hold compulsory cash balances.

Similarly, the maintenance of a stable price level will encourage banks to take a long term view of their business and make proper risk assessments when granting loans. This would improve the quality of the loans, reduce the level of defaulted loans and aise the overall efficiency and productivity of banks.

However, in certain extraordinary circumstances, the two objectives would conflict with each other. This often happens in hyperinflationary situations where prices would elevate to a very high level within a very short period of time. Then, finding time to concentrate on financial system stability would be a luxury for a central bank. Hence, the central banking laws in many countries have allowed the central banks to address this issue by prioritizing on the price stability to the exclusion of the financial system stability.

But, in the case of the Central Bank of Sri Lanka, such prioritization is not permissible, since both objectives have been termed as core objectives. Hence, both of them command equal attention by the Bank. As a result, how the Central Bank would actually behave if the country is hit by hyperinflation is beyond the imagination of anyone, including the central bankers. One can make a judgment on that only after the country has actually gone through that situation. Probably, when the heat of hyperinflation has engulfed the whole economy and it can no longer be tolerated, the Bank would choose price stability in preference to system stability at least till the hyperinflation is brought under full control.

The Central Bank endeavours to attain the financial system stability by supervising and regulating banking institutions. Supervision is done by conducting both on-site and off-site examination of banks. In the case of the former, the bank supervisors would periodically visit banks, examine their books and accounts and ascertain the underlying unmitigated risks and deficiencies. In the off-site examinations, detailed information and data on banks are regularly assessed to identify impending crisis situations in banks.

In regulating banks, the Central Bank would tell banks what they should do and what they should not do. The good behaviour so cultivated will put the banks out of risky situations, a prime source of financial system instability.

Regulation and supervision
As far as the objective and the operational mechanism are concerned, a bank does not differ from any other firm. Yet, unlike an ordinary firm, banks are always subject to supervision and regulation to a greater degree. An ordinary firm is usually allowed to be regulated by the market. If a firm does well, it is rewarded by allowing it to continue in business. If a firm does not do well, then, it is punished by forcing it to close down.

The market punishment of a firm is very severe. But, the prospect of having to bear that severe punishment one day forces a firm to discipline itself. If a firm does not take this message seriously, the resultant costs would become unaffordable. The shareholders would lose their money and employees their jobs.

However, banks are always treated differently. As a result, they are first disciplined through regulation by regulators. Any regulation through market is given only a secondary consideration. This is because a bank, unlike an ordinary firm, can bring about severe losses to an economy, if it does not do well. Hence, its failure has to be avoided by resorting to whatever the methods that are available.

Banks usually provide four important services and these services are indispensable for the smooth functioning of an economy.
First, they function as intermediaries between borrowers and savers. If there is no one to provide this service, both borrowers and savers will have to go in search of each other. That would raise the costs of their finding the ideal client, assessing his ability to pay back and taking effective measures to prevent him from defaulting.

Second, they are the holders of the financial savings of the society. So, if they fail, the society would lose its entire savings. Needless to say that it would bring about innumerable miseries to everyone giving rise to social calamities.

Third, as mentioned earlier, central banks use them as vehicles for conducting monetary policy. If monetary policy is not conducted, the society runs the risk of having permanent inflation. Hence, banks are co-partners of safeguarding the value of money.

Fourth, banks provide a gamut of related financial services to businesses. Those services help them to operate efficiently and at a lower cost.

In view of the above, it is extremely costly to allow a bank to fail, though it is not the same if an ordinary firm fails.

Of course, when an ordinary firm fails, there is a cost to the society. However, that cost is localized and short-lived. It is localized because it does not affect other firms. It is short-lived because within a very short period of time, the society can get adjusted to it and a new firm would emerge to continue with the supply. For instance, suppose a soap manufacturer fails. What are the costs involved? The society would lose the output of soap it would have produced and the employees would lose their jobs. But, other soap manufacturers can step up their production and meet the shortage or a completely new firm can emerge and take over the output of the failed firm.

Employees also would find jobs in other sectors. Whatever it may be, it is a short-lived localized cost without far reaching implications on the entire society.

However, if a bank fails, the outcome is different. Banks are usually linked to each other as inter-bank lenders and borrowers. Hence, the failure of one bank would create a domino effect leading to the collapse of the entire banking system. Such a cost is globalized, since it affects the entire banking system and also the business firms. The cost of the failure would be felt equally by all segments of the society.

As a result, governments have chosen to supervise and regulate banks in order to prevent bank failures. It would help to establish a stable banking and financial system. This role played by the government is similar to its role as the producer of public goods. Such goods have to be produced and supplied by governments, because the market system does not allocate resources for their production. This is because in these types of goods, people can enjoy the benefits without paying and pass the costs to others who do not get any benefit at all.

On behalf of the government, in Sri Lanka, this role is played by the Central Bank.

Norms of financial system

stability
Many believe that the Central Bank should protect each and every bank in the financial system. This should not be the case. That is because it is neither possible nor desirable to do so.

It is not possible to protect each and every bank, because it involves the use of an enormous volume of resources. To conduct an effective supervision of all the banks in business, a large army of bank supervisors need be engaged. They also have to gather a vast volume of information, data and statistics on a current basis at a huge cost to both the provider and the recipient. Even if such data are gathered, processing them for meaningful interpretation and timely use would be difficult. Hence, supervisors may not be able to protect each and every bank.

The only way available for a government to protect a given bank is to pay the depositors’ money out of government funds. To do this, there are three ways: raising revenue through higher taxation; curtailing existent expenditure programmes and printing new money.

The first two pass costs direct to the people. The last option leads to inflation and hits people indirectly. It reduces the real value of savings, incomes and financial assets. Hence, all these measures would pass the burden on to the tax payers who are unwittingly called upon to make sacrifices on behalf of the depositors of a failed bank.

It is also not desirable to give a general protection to a failed bank due to a number of reasons.

First, it results in an inequity in burden sharing in the form of an undesirable re-allocation of wealth from one section of the society to another. If the process of re-allocation continues and becomes wide-spread, it creates a disincentive for people to hold wealth. That would hinder the whole wealth creating process which is essential for the long term expansion of the economy.

Second, it gives rise to what the economists call the moral hazard problem. This problem arises when one person is protected by another person and the protected person, having known that the cost is being borne by the protector, becomes careless and does not take even the minimum precautions which he would have taken under normal situations. By being careless, he in fact makes the undesired event actually happen. As a result, the protector’s costs are raised and he will have to continue to give protection at ever increasing costs. Thus, governments, by promoting careless behaviour in banks, make the entire system unstable.

Third, such a general protection would lead to another problem known in economics as the adverse selection problem. This problem arises when people make decisions to take advantage of announced benefits or created anomalies. When people know that the governments take care of the liabilities of failed banks and the owners do not have to bear them, they would go into banking business, not because they are competent and skilled in banking, but because of the chance available for escaping liability. Hence, right from the beginning, the selection of banking as a business becomes adverse to banking and such banks are doomed to fail. This situation threatens the continued stability in the financial system.

Fourth, arising from the moral hazard behaviour, the general protection given to each and every bank, generates another economic issue. This is known as the rent-seeking problem. This problem arises when people realize that they can earn money not by working hard, but simply by taking advantage of different anomalies or distortions in the system. As such, banking is chosen not as an investment, but to earn money in the short run and pass the liability to the government once the bank fails. If the financial system becomes rent-seekers’ paradise in this manner, its continued stability is at risk.

Thus, it is not desirable for taxpayers to bail out failed banks, because it creates a situation in which they have to continue with bearing that burden forever.

If the taxpayers’ money should not be used to protect banks, then, why not use the central bank’s funds? That is more dangerous than the use of tax payers’ money. That is because such money, known as high powered money, leads to the creation of more money in the economy by several-fold. Such an increase in money supply generates inflation and, if inflation becomes uncontrollable, it leads to even hyperinflation as in the case of present Zimbabwe.

Thus, financial system stability means, not protecting individual banks, but maintaining stability in the financial system as a whole. The central bank should take action to maintain this stability in the system. Any protection of an individual bank should be done only if that bank is sizably large and its failure can threaten the stability of the entire system. Otherwise, individual banks which do not threaten the stability of the system should not be protected at the cost of the tax payers.

Maintaining solvency in individual banks is the responsibility of the boards of directors and the management of banks.

The cost of the failure should be borne by the owners. The central bank as the regulator should only ensure that they do so through continuous supervision, effective regulation and good governance in management.

The depositors should, therefore, choose banks for business by ascertaining that banks have fulfilled all these requirements. When they decide to leave weak or imprudent banks, it gives the necessary market signals for such banks to re-establish good behaviour.

Hence, there is no better regulator of an individual bank than its own customers who demand better and better services from a bank continuously.