RDP 1999-05: Trends in the Australian Banking System: Implications for Financial System Stability and Monetary Policy 6. Implications for System Stability and Monetary Policy

In this section we draw together the implications of current trends in the financial system for policy. We have presented a wide range of arguments regarding the implications of consolidation, conglomeration and other changes in the financial system on system stability and efficiency.

Certain changes appear to have been associated with efficiency improvements. In particular, following deregulation of the banking sector (and aided by technological innovations and the move towards globalisation) there has been a trend towards greater financial depth, wider availability of increasingly sophisticated financial products, and more recently, greater competition from non-banks which has led to lower margins on many core banking products. However, the impact of further consolidation on efficiency remains a widely debated issue. No clear consensus exists on the implications of these changes for system stability.

One lesson is clear. Monetary policy-makers cannot remain indifferent to developments affecting financial system stability. Furthermore, central banks need to pay some attention to questions of efficiency, since both efficiency and stability have implications for macroeconomic performance. However, some developments may imply a trade-off between stability and efficiency.

One crucial question is what can central banks do to contribute to the stability (and efficiency) of the financial system? Beyond the need to ensure a strong supervisory system (for central banks that maintain this responsibility), there are at least four important contributions that can be made:

1. Low inflation and stable growth: Maintaining low inflation and stable growth is a necessary (though not sufficient) condition for financial system stability. The experience of Australia and some other OECD countries has been that higher inflation rates can encourage the movement of intermediated funds away from projects which are profitable over the longer term, and towards excessive speculation in asset markets. This speculation can lead asset prices far away from levels justified by fundamentals, which in turn can destabilise the financial system.
2. Payments system access: Central banks can influence the terms and conditions under which financial institutions can participate in the payments system. In this way the central bank can have an influence on the level of contestability, and hence, the degree of efficiency of the financial system. At the same time, developments that reduce the risks in the payments system, such as the widespread move towards real-time gross settlement (RTGS), can reduce the possibility that the payments system either initiates or propagates an episode of financial system instability.
3. Emergency liquidity support: Central banks are the ultimate source of domestic liquidity. In some cases, a preparedness by the central bank to extend emergency liquidity, either through the market or to institutions directly, can play an important role in preventing disturbances having macro consequences. However, care is needed to minimise the distortion of incentives for prudent management and private monitoring of risk, both of which can enhance both stability and efficiency.
4. Contributing to the debate on consolidation and conglomeration: As the above discussion highlights, there are many ways in which recent trends and pressures might influence system stability, although the net effect of these changes is not clear. Central banks can emphasise the importance of these developments for system stability which is often overlooked in the ongoing debate which tends to focus on the more microeconomic issue of efficiency.

A second important question is as follows. Given the structure of the financial system, what should central banks do if they see a rise in system instability? There are two broad approaches. First, it may be that monetary policy with a medium-term horizon needs to take account of the stability of the financial system in such a way as to imply a non-standard response to short-term inflationary pressures. The second approach for central banks and financial system supervisors might be to adopt prudential standards which more explicitly depend upon the degree of risk in the financial system. Both of these approaches are worthy topics for future research.