2 Financial Stability Review: December 2003 – Financial stability themes and issues
Financial stability
themes and issues
The stresses afflicting financial systems have continued to abate over the past six months, and the strengthening
global economic outlook should help to contain credit risk. Most financial institutions in the United Kingdom and
overseas appear to have weathered the episodes of equity market, interest rate and exchange rate volatility during
2003. But the past and prospective rises in market interest rates pose risk-management challenges for both lenders
and borrowers, particularly in the light of the historically high ratio of household debt to income in many countries,
including the United Kingdom. These issues are explored further in the Bank’s regular assessment of The financial
stability conjuncture and outlook. Some of the continuing efforts of the UK and other authorities to make financial
systems more resilient – for example, by improving banking liquidity regulation – are reviewed in Strengthening
financial infrastructure.
One way in which the authorities can promote systemic stability
is by being clear about their objectives and demonstrating that
they are acting to achieve them. In Transparency and financial
stability, Prasanna Gai and Hyun Shin argue that greater
transparency, in general, acts as a discipline for policy-makers
and financial market participants. For policy-makers, the
discipline derives from the desire to preserve and enhance
reputation; whereas, for the private sector, discipline tends to be
imposed through market prices. However, disclosures can be a
two-edged sword, particularly with respect to financial stability. If
a financial institution or system is fragile, the provision of
information can act as a lightning conductor that co-ordinates
and channels the pessimistic expectations of market participants.
The authors argue that a central bank can guard against this
threat by presenting its analysis of financial stability and its
policy stance as a whole regularly and in a coherent format. Thus
financial stability reports, for example, can be of some assistance
in trying to guard against short-run market movements brought
about by incentive or information problems affecting private
economic agents.
It may also help to mitigate stresses on a financial system if
private agents are confident that the authorities would act
effectively in the event of a financial crisis, systemic or otherwise.
Glenn Hoggarth, Jack Reidhill and Peter Sinclair, in Resolution of
banking crises: a review, consider the merits of the various
techniques that have been used by authorities in different
countries. The article draws on information gathered at a
workshop organised by the Bank of England’s Centre for Central
Banking Studies, involving officials from a number of developed
Financial stability themes and issues – Financial Stability Review: December 2003 3
Financial stability and emerging market economies. In widespread banking crises,
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the authorities often face a trade-off between maintaining
financial stability today through intervention and increasing
financial fragility in the future by increasing moral hazard.
Amongst other challenges, this also complicates the authorities’
and issues communication strategies (illustrating Gai and Shin’s thesis). The
authors draw out four main conclusions about system-wide
banking crises. First, central banks have usually provided
liquidity at an early stage to failing banks and extended
government blanket guarantees to depositors. In nearly all cases,
investor panics have been quelled, but at a fiscal and moral
hazard cost. Second, open-ended central bank liquidity support
seems to have prolonged crises, thus increasing rather than
reducing the output cost to the economy. Third, bank
restructuring has usually occurred through mergers, often
Financial Stability Review government-assisted, and some government capital injection or
December 2003
increase in control. Bank liquidations have been rare and
creditors – including uninsured ones – have rarely made losses.
Fourth, resolution measures have been more successful in
financial restructuring than in restoring banks’ profitability or
credit to the private sector.
Even where banking crises have been resolved quickly, there has
been a lingering impact on credit conditions and the
effectiveness of financial intermediation. This highlights the
importance of effective surveillance by the authorities, and an
understanding of when problems in individual financial
institutions could be symptomatic of systemic difficulties. Two
articles in this Review contribute to that goal by examining
aspects of the interrelatedness of banks.
In Large complex financial institutions: common influences on asset
price behaviour?, Ian Marsh, Ibrahim Stevens and
Christian Hawkesby investigate the behaviour of some key
financial firms’ share prices and credit default swap (CDS)
premia. Their goal is to establish to what extent large complex
financial institutions (LCFIs) appear to be influenced by common
factors. If, statistically, common factors turn out to be important,
that would suggest that LCFIs share exposures to similar shocks,
or that, because of links amongst them, adverse shocks can be
propagated from one to another. In either case, a fall in the share
price of an individual institution, or a rise in its CDS premium,
would be of greater concern to a central bank. The authors find
that there is indeed a relatively high degree of common asset
price behaviour amongst most LCFIs, especially when compared
with non-financial companies (matched with the LCFIs for size
and country of origin). But some LCFIs are more closely related
than others on this metric; for example, US LCFIs appear closely
related to each other, but less so to European LCFIs.
4 Financial Stability Review: December 2003 – Financial stability themes and issues
Asset price correlations cannot by themselves reveal why
particular financial institutions seem vulnerable to the same
shocks. One possible explanation is linkage through
counterparty relationships. That is one reason to investigate the
extent to which banks fund their lending by borrowing from
other banks. With this in mind, George Speight and
Sarah Parkinson examine changing funding strategies in Large
UK-owned banks’ funding patterns: recent changes and implications.
They point out that, in recent years, borrowing by the UK
corporate and household sectors from banks and building
societies has outstripped deposits from those sectors. The large
UK-owned banks have increasingly funded the growth in their
assets by drawing on a variety of wholesale sources (including
other banks and foreign currency money markets) and borrowing
at a range of maturities. The Financial Services Authority’s ideas
for changes to the quantitative elements of UK bank liquidity
regulation, outlined in a recent discussion paper, address the
need for an all-currency approach to liquidity monitoring and
control, as summarised in Strengthening financial infrastructure.
Wholesale counterparty relationships are a possible route for
contagion in the event of adverse shocks hitting an individual
bank. But systemic problems are also more likely to arise in the
event of common shocks to several banks at the same time. One
possible source of such shocks is an unexpected deterioration in
business conditions. In Company-accounts-based modelling of
business failures, Philip Bunn considers how to identify companies
with a relatively high probability of failing. He estimates a model
using a dataset of up to 12,000 UK public and private
non-financial firms, covering the period 1991–2001, to generate
firm-level probabilities of failure. These are found to depend on
profitability, capital gearing, interest cover, liquidity, company
size and structure, industry and overall macroeconomic
conditions. An aggregate measure of ‘debt at risk’ is then
constructed by multiplying each firm’s debt by the
corresponding failure probability. It turns out that debt at risk is
concentrated amongst a small number of mainly large firms. The
overall debt-at-risk measure derived in this way performs better
in predicting the aggregate corporate default rate than does a
model that does not utilise company-level information. Aggregate
debt at risk as a proportion of total corporate debt was at its
highest in the early 1990s, fell back in 1993 and then remained
fairly stable. But, using post-sample data, it appears that this
ratio may have increased modestly since 2001.
In emerging market economies (EMEs), sovereign debt is often
the main focus of concern. In Assessing sovereign debt under
uncertainty, Gianluigi Ferrucci and Adrian Penalver make the
point that it is desirable when assessing the sustainability of debt
to take account of the uncertainty about the future path of the
economy. The inherent uncertainty about future debt dynamics
is illustrated by developing explicit probability distributions for
Financial stability themes and issues – Financial Stability Review: December 2003 5
Financial stability the evolution of debt over time, calibrated using historical means
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and variances of key determinants of debt sustainability, such as
GDP growth, interest rates and exchange rates. These
distributions are analogous to the so-called ‘fan charts’ for
probabilistic inflation forecasts published in the Bank of
and issues England’s quarterly Inflation Report. The method offers some
improvement over the standard techniques commonly used to
assess debt sustainability. It considers, for example, the
persistence of and interrelationship between shocks to
explanatory variables. The method could prove useful in helping
to evaluate the likely success of IMF programmes, especially in
the context of exceptional access to IMF funds.
Another aspect of assessing EME debt sustainability is judging
whether IMF programmes are likely to lead to renewed private
Financial Stability Review sector capital flows. In The catalytic effect of IMF lending: a critical
December 2003
review, Catherine Hovaguimian considers the theoretical and
empirical evidence about the effectiveness of IMF finance as a
catalyst for such capital flows. Theory suggests that the window
of opportunity for such effects is a narrow one. And the
empirical evidence tends to conclude that catalytic effects have
rarely been evident in practice. Against this backdrop, other
means of dealing with capital account crises may need to be
considered carefully in cases where the probability of the
catalytic effect working is low.
Finally, the Review reprints a speech on Financial stability:
maintaining confidence in a complex world by Sir Andrew Large,
Deputy Governor for Financial Stability. Sir Andrew sets out some
of the broad challenges faced by the Bank in pursuing financial
stability, one of its three core purposes, and discusses some
examples of its recent work. The speech reflects the Bank’s
continuing efforts to promote the kind of transparency about
financial stability policy advocated by Gai and Shin.
6 Financial Stability Review: December 2003 – Financial stability themes and issues