TheReserve Stability Bank of the of FinancialAustralia System Bulletin August 1999 The Stability of the Financial System The following is the text of the R.C. Mills The subject of financial stability does, Memorial Lecture delivered by the Governor, however, call for some public explanation. For Mr I.J. Macfarlane, at the University of Sydney a start, a lot of people are unsure of exactly on 29 July 1999. what it means. Additionally, there are those who are unsure of what its relation is to central banking, which, as I have just said, they usually Introduction associate with monetary policy. In the remainder of my lecture I would like to cover both these topics, plus two other issues: what It is an honour to be here today at the does the Reserve Bank need to do to fulfil its University of Sydney delivering the eighteenth financial stability responsibilities; and whether R.C. Mills Memorial Lecture. It is customary the changes we have seen in the structure of to start a Memorial Lecture by paying homage financial systems over recent decades have to the person in whose memory the lecture is made the system more or less stable. held, but I would like to break with tradition and do that a little later where it fits in more naturally. What is Financial Stability? On nearly every occasion when I speak before an audience such as this, I talk about some aspect of monetary policy. That is what is expected of me because people – very Financial stability is the avoidance of a naturally – associate central banks with financial crisis. A financial crisis is a more monetary policy. Monetary policy’s major task modern term for describing what used to be is to contribute to sustainable economic called ‘banking panics’, ‘bank runs’ and growth through maintaining low inflation, as ‘banking collapses’. We use the broader term we have been doing with some success during financial because, with today’s more the 1990s. I have talked about this at length sophisticated financial systems, the source of elsewhere, and I am sure that informed people the crisis could be the capital markets or a are well acquainted with the current monetary non-bank financial institution rather than a policy regime in Australia, which is based on bank, although almost certainly banks would an inflation target, an independent central become involved. bank and a floating exchange rate. As a result, A well-functioning financial sector is critical I do not wish to take up any more time going to an economy’s well-being because it is so over old ground. intimately connected to every other sector of 34 Reserve Bank of Australia Bulletin August 1999 the economy through its role of providing are not very frequent and not very deep, public credit. When large-scale failures occur among confidence in the legitimacy of the economic financial institutions, the supply of credit dries system remains intact. The problem with a up and this quickly leads to cutbacks in other serious bout of financial instability or a industries. Additionally, the finance sector is systemic crisis – inevitably involving a boom the part of the economy that is most in asset prices, followed by a bust – is that it susceptible to crises of public confidence. A makes the recession much deeper and longer, problem that hits one part of the finance sector and can even turn it into a depression. can quickly spread to the rest of the sector, The best-known example of this is the and then to the economy more widely. Once Depression in the United States in the 1930s, it becomes widespread, it is termed a systemic the severity of which is now widely attributed financial crisis to distinguish it from one that by modern scholars to the collapse of the US is confined to a single institution or a very banking system.1 Australia had a similar narrow part of the financial system. experience in the Depression of the 1890s, Another way of approaching financial and some more recent examples, which I will stability is to look at it from the perspective of cover later, contained some of the same developments in the overall economy. There elements, although fortunately on a smaller is widespread recognition in the community scale. Over the past three years, we have that the normal growth path of an economy witnessed the Asian economic crisis, the depth is not smooth. We have all lived through a of which is largely due to the collapse of number of business cycles, and although we financial systems in these countries. Although wish that the cycle could be abolished, most it is not well known in Australia, the Nordic of us are resigned to the fact that expansions countries (Sweden, Norway and Finland) cannot go on forever, and they will be followed went through a similar experience a by a recession. Provided that these recessions decade ago.2 Table 1: Cost of Recapitalisation Country Period Cost as per cent of GDP Spain 1977–1985 16.8 United States (Savings and Loans) 1984–1991 3.2 Scandinavia Finland 1991–1993 8.0 Norway 1987–1989 4.0 Sweden 1991 6.4 Latin America Chile 1981–1983 41.2 Mexico 1995 13.5 Asia Indonesia 1997–1998 34.5 Korea 1997–1998 24.5 Malaysia 1997–1998 19.5 Philippines 1981–1987 3.0 Thailand 1997–1998 34.5 Sources: Caprio and Klingebiel, World Bank, July 1996; World Bank, Asian Growth and Recovery Initiative, 1999. 1. See, for example, Bernanke (1983) and Romer (1993). 2. See Llewellyn (1992). 35 The Stability of the Financial System August 1999 In short, it is possible to have a normal By the end of the 19th century, the Bank of business cycle where financial stability England was well practised in acting as the remains intact. These are usually quite mild lender of last resort. In the 1850s and 1860s, cycles. It is also possible to have cycles where following the bursting of speculative bubbles financial instability plays a large role. These in the US and UK railroad sectors, it lent are usually very severe. Thus, there are very freely to institutions to prevent financial panic, good reasons for a country to do what it can as it did during the Barings crisis of the 1890s. to avoid financial instability. History shows In France, the unravelling of speculative that it does not happen very often, but when positions in the stock market in 1882 led the it does, its effects can be devastating. Banque de France to provide secured loans Another direct and measurable cost of to the Paris Bourse. In Italy, the collapse of a financial crises is the cost to taxpayers of fixing building boom in Rome and Naples in 1893, them. When there is widespread failure of and the resulting failure of one of Italy’s largest banks and other deposit-taking institutions, banks, prompted the creation of the central the government invariably pays out depositors bank, the Banca d’Italia.3 in full or in part, whether or not there is a Financial stability considerations also played formal system of deposit insurance. Financial a role in the development of central banking institutions also have to be recapitalised in in Australia, although less explicitly than in order to allow them to start lending again. The the United States. In the early decades of this cost to the budget of both these types of century, there were strong advocates for a assistance can be enormous, as shown in central bank along the lines of the Bank of Table 1. Note that the figures given for Asian England. Progress, however, was hampered countries are only estimates as the final bill by ideological debates about the role of private has not yet come in. The outcome could be banking, and by concern that a central bank lower or higher, depending largely on how would out-compete private banks. While the quickly Asian countries resume their Commonwealth Bank did take on some growth path. central banking functions in the 1920s, including note issue and the provision of settlement accounts, the watershed was the Central Banks and Financial 1936 Royal Commission. Stability It is here that we return to Professor R.C. Mills. In between establishing the economics department of the University of Sydney and The idea that a central bank should have chairing the University’s Professorial Board, responsibility for financial stability has roots Professor Mills played a prominent role as a deep in the history of central banking. Indeed, member of the Royal Commission. As in many countries, financial stability S.J. Butlin notes in his biography of Mills, the considerations were the original reason for the structure of the Commission’s Report and its formation of the central bank. Perhaps the best drafting owes much to Mills’ hard work and example is the United States. The his ability to argue and persuade. Mills was an establishment of the Federal Reserve System advocate of a strong central bank with in 1913 was a direct response to the bank runs responsibility for ensuring the overall stability and financial panic of 1907. It was only later of the financial system and the economy. He, that an explicit monetary policy role was and his colleagues on the Royal Commission, grafted onto the Federal Reserve’s financial argued that the private banks had intensified stability responsibility. economic fluctuations by lending aggressively Elsewhere too, financial stability issues during the boom of the late 1920s and then played a significant role in central banking. contracting lending harshly during the 3.