FINANCIAL STABILITY -- EXPERIENCES AND CHALLENGES.

• Author: Gjedrem, Svein

Speech by Mr Svein Gjedrem, Governor of the Central Bank of Norway, at the annual meeting of the Norwegian Savings Banks Association, held in Sandefjord on 21 October 1999. (Shortened version)

1. Introduction

   Every day around NOK 150-200 billion change hands through the banks' accounts in Norges Bank. In the course of a week, payments corresponding to our gross national product for an entire year have passed through Norges Bank's settlement system. These payments involve all types of transaction, from a 10-kroner ice cream purchase to securities transactions where a single transaction may involve billions of kroner.

   The banks play a pivotal role in the payment system. Deposits are now the predominant means of payment. Payment settlement is the banks' most important function besides channelling funds from savers to borrowers.

   In other countries, securities markets are of growing importance. They are taking over an increasing share of banks' credit intermediation. This may also occur in Norway. Securities are also increasingly serving as collateral in payment settlement.

   These three elements -- payment and settlement systems, banks and other financial institutions, and securities markets -- make up the financial system. Every day we experience how dependent a developed economy is on the smooth functioning of this system, i.e. on financial stability.

   The volume of foreign payments is substantial and on the rise. Banks and securities markets are becoming ever more closely integrated. For better or for worse, we are increasingly exposed to developments in other countries.

   The banking crisis taught us how costly financial crises can be. We brought the crisis on ourselves. Many other countries have experienced similar problems. The root of the crises can be traced back to overly zealous financial market participants with reduced risk awareness. The authorities' role is to prevent crises in the financial system and -- if they still occur -- handle them with a view to reducing the adverse effects and the likelihood of their recurring. In view of the globalisation of financial markets, international cooperation in this area is crucial.

   The financial system is also important with regard to Norges Bank's conduct of monetary policy. By setting the terms for banks' deposits/loans in the central bank, Norges Bank influences the level of interest rates. Monetary policy is also dependent on financial stability. However, monetary policy is not the topic today. I will focus on the issue of financial stability.

2. What is financial stability?

   Financial stability is the absence of financial crises. The root of a crisis is that exuberance, optimism and greed take precedence over risk and return considerations when investment decisions are taken. The price of financial assets and property rises. Bank loans and household and corporate debt increase. As a result, all agents become more vulnerable if the situation is perceived as taking a turn for the worse. This may in turn trigger a plunge in property and equity prices.

   A stable financial system features solid cushions that reduce the risk of problems spreading from one institution or market to other institutions or markets, or across borders. This risk constitutes a systemic risk, i.e. the risk of failure of the financial system.

   Disturbances that may develop into a systemic risk can be transmitted through financial institutions and financial markets. Stable institutions are solid institutions in which there is general confidence, whereas stable markets are markets where there are no "excessive" price variations.

   The banks are in a special position. They transform short-term deposits into long-term loans. They are responsible for payment settlements, and bank deposits serve as a means of payment. The volume of amounts outstanding in the interbank market is sizeable. As a result, problems in one bank may rapidly spread to other banks. The financial strength of banks is thus important for financial stability. The more capital a bank has the larger the losses it can absorb. The risk of contagion is thus reduced. A bank's capital adequacy ratio is not the only variable that must be taken into account. A bank's earnings provide an indication of the bank's future financial position. Another important factor is the size of a bank's loss provisions.

   Financial unrest spreads through payment and settlement systems. These systems can also be at the origin of risk. This occurs when banks' credit customers before they have received settlement from the payer bank. The settlement of currency transactions is associated with a similar type of risk because settlement often occurs in different countries at different times. The latter risk is referred to as Hertsatt risk, named after the German Bankhaus Hertsatt that closed in 1974. This occurred after the closing of the German settlement system, but before the matching settlement was finalised in the US. Other banks that had settled the German mark portion of the transaction with Bankhaus Hertsatt were running a loss because Bankhaus had not settled the dollar portion of the transaction in the US before it closed. The payment and settlement system must thus be designed to reduce settlement risk.

   It is out of concern for financial stability that financial markets in general and banks in particular are regulated and monitored to a further extent than other industries. A bank failure will as a rule have more far-reaching consequences than a business failure in other industries. Both the contagion effects and the consequences for the real economy are greater. In most countries, the authorities have introduced measures to restrain banks from taking excessive risks in their quest for profits. Another important consideration reflected in regulations is the need for consumer protection.

   Regulations can distort competition and weaken market discipline. For instance a bank's creditor may choose not to assess the risk assumed by the bank because of the safety net established for banks. A bank may thus seek to increase the expected return by taking on higher risk without having to pay for...