Financial stability and why it
matters
3. The clearest definition of financial stability
is that used by the Swedish financial authorities who describe
financial stability as meaning "the ability of the financial
system to maintain its basic functions without disruptions that
entail significant economic costs.[5]
When we first took evidence in February 2007 from representatives
of the "Tripartite authorities" with responsibility
for financial stability in the United Kingdom—HM Treasury,
the Financial Services Authority (FSA) and the Bank of England—Mr
Jon Cunliffe, then Managing Director, International Finance, HM
Treasury, defined financial stability by reference to the objective
of "seeking to ensure that the financial system can operate,
can play the role that it needs to play in the economy as a whole".[6]
Sir John Gieve, Deputy Governor of the Bank of England, told us
that it was actually easier to define financial instability than
financial stability, and went on to state that
the instability that we are concerned about is a
loss of functionality in the financial system which would damage
the wider economy because it no longer functioned to bring savings
and investment into balance or to transmit money effectively round
the system.[7]
4. On that occasion, Mr Hector Sants, then Managing
Director, Wholesale Business Unit and Institutional Markets, FSA,
and currently the FSA's Chief Executive, drew a distinction between
threats of financial instability relating to "risks to market
infrastructure"—for example, as a result of terrorism
or a pandemic—and "financial market risks".[8]
In this Report, we are largely concerned with the latter—in
other words, with instability arising from within financial markets.
5. The definitions that we have cited above draw
attention not simply to the internal functioning of financial
markets, but to the impact on the wider economy of financial instability.
Financial instability of the kind that has been experienced since
early August 2007 affects the capacity and willingness of lending
institutions to provide credit to businesses and individuals,
the spreads on such credit and the conditions attached to credit.
Financial instability also imposes a more direct price on those
with financial investments, including those with long-term investments
such as holdings in pension funds. The period of turbulence in
financial markets, and especially credit markets, since August
2007, and its potential impact on people in general and the real
economy, has propelled the issue of financial stability to the
top of the agenda, not just of supervisory authorities, but of
public policy makers more generally. It has highlighted the importance
of maintaining financial stability and the cost to people and
the economy of financial instability.
6. One problem with defining financial stability
in terms of the basic functions of the financial system, as defined
by the Sweden Authorities, is that these basic functions often
differ across time as well as across countries. Thus, it may also
prove useful to look at the issue in terms of the impact of financial
instability, which Professor Wood explained:
as episodes in which a large number of parties, whether
they are households, companies, or (individual) governments, experience
financial crises which are not warranted by their previous behaviour,
and where these crises collectively have seriously adverse macro-economic
effects.[9]
7. The
market turbulence since August 2007 has propelled the issue of
financial stability to the top of the political agenda. The terms
"financial stability" and "serious threat to financial
stability" are used in the Banking (Special Provisions) Act
without a legal definition. There is a continuing lack of clarity
about what is meant by financial stability as well as what events
constitutes a "serious threat to financial stability".
We believe there is a need for clarity from the Tripartite authorities
about how they define financial stability so that stakeholder
can assess whether particular events constitute a threat to financial
stability. This clarification should be in advance of Parliamentary
consideration of the Banking Reform Bill. Such a step would ensure
that policy interventions to maintain financial stability would
in future take place against a more objective backdrop and would
be particularly important in aiding the work of the tripartite
authorities in promoting financial stability.
The international dimension
8. In our previous Report we were concerned with
the impact of financial instability on one United Kingdom institution—Northern
Rock—and on the British banking system. Although some of
the effects of the market instability since August have been peculiar
to the United Kingdom, it is evident that the instability with
which we are concerned is an international phenomenon. As we will
see, its trigger lies to a significant extent in developments
in the United States, most notably in the growing linkage between
the markets for complex financial instruments and the US market
in "sub-prime" mortgages. Banks in Germany and France
were affected by these developments before British banks.
9. In July 2006, we referred to the possible risks
to the world economy associated with "global imbalances",
in other words with the continued rapid growth in Asian economies
not being off-set by an appreciation of Asian currencies against
the US dollar.[10] Since
then the rapid rise in the value of oil has exacerbated these
imbalances, and countries which have them now also include the
major oil-exporting countries. Despite continuing concerns about
these imbalances, it is notable that the current period of instability
has its origins firmly in the most developed markets, most notably
that of the United States. The Governor of the Bank of England
drew attention to this feature of the current period of instability,
telling us in December:
I think the problems we are facing are international
in nature … It has been a very salutary lesson, because this
crisis has become international in nature. It is not a crisis
of emerging market economies or failed macro-economic policies
in the rest of the world, this crisis goes right to the heart
of the financial centres of the three big developed parts of the
world.[11]
The international nature of the recent problems reflects
the global nature of financial markets and the instantaneous nature
of world communications, which make national borders largely irrelevant
to the transmission of some shocks. In this Report, we examine
the international dimension of the problems, and the international
dimension of possible solutions.
1 Speech by the Governor of the Bank of England at
the Northern Ireland Chamber of Commerce and Industry, Belfast,
9 October 2007, pp2-3; BNP Paribas, press release, 9 August 2007 Back
2
Treasury Committee, Fifth Report of Session 2007-08, The run
on the Rock, HC 56-I Back
3
Ibid., paras 2-5 Back
4
HC (2007-08) 56-II. All references to oral evidence (in the form
Q … or Qq …) or to written evidence (in the form Ev)
are to such evidence published in that Volume unless otherwise
stated. Back
5
Memorandum of Understanding between the Government offices (Ministry
of Finance, Sveriges Riksbank and Finansinspektionen) regarding
cooperation in the fields of financial stability and crisis management,
June 2005, p 1 Back
6
Treasury Committee, Oral evidence, Thursday 1 February 2007, Financial
Stability, HC 292-i, Q 14 Back
7
Ibid. Back
8
Ibid. Back
9
Defining and Achieving Financial Stability, William A.
Allen and Geoffrey Wood, Cass Business School, City University
Back
10
Treasury Committee, Ninth Report of Session 2005-06, Globalisation:
the role of the IMF, HC 875, paras 6-8 Back
11
Q 1697 Back
