Role of the State in Financial Safety and Soundness

It is widely accepted that the state¹ should play an important role in ensuring the safety and soundness of financial systems. This role is seen as deriving from the important functions that financial systems perform and the large negative spillovers and externalities that can arise when financial systems come under stress.² Arguably, it is these negative spillovers and collateral damage—and the possibility that they could be large enough to severely impact the performance of the real economy—that lie behind the recent increased attention to systemic risk beyond the traditional focus on risk at the level of individual institutions, markets, and financial instruments.³

The role of the state as the protector of the financial system is traditionally seen as encompassing two distinct but interrelated elements (Barth et al (2006)). The first, and most visible, involves the establishment by most countries of comprehensive systems of financial regulation and supervision.⁴ Even though these systems will have a number of objectives, their key focus has traditionally been on ensuring the smooth and efficient functioning of financial systems, and avoiding the build up of “excessive” risk. The supervisory and regulatory systems can be viewed as representing the ex ante component of the state's protective role in so far as they are intended to help forestall financial crises before they occur. At least up until recently, these frameworks tended to focus on risk at the level of individual institutions and markets and did not consider the risk of the system as a whole. Implicitly, at least, the view was that if risk was appropriately managed at the micro level then the entire financial system would be safe.⁵

The second element involves the creation of mechanisms to manage situations when risks materialize and substantial chunks of the financial system become impaired (crisis management systems). Arguably, the intellectual justification for these mechanisms is not as well developed as that for ex ante supervision and regulation. The case for state intervention in crisis management is generally seen as being based on a set of collective action problems that prevent markets from achieving a “good” equilibrium during a crisis and the state's monopoly on the provision of the ultimate liquidity in the system (Hoelscher and Quintyn 2003; Boorman et al. 2000; Ghosh 2006; Schinasi 2006). Typically, key components of crisis management systems include mechanisms to provide liquidity to key segments of the financial system, the state's ability to credibly guarantee certain liabilities and assets, and powers to restructure, shift around, and write down troubled financial assets and liabilities.⁶ Especially in the case of systemic crises, the power to introduce extraordinary procedures is frequently also available and the perimeters of crisis resolution mechanisms may be expanded as necessary. Given the close relationship that frequently exists between distress in the financial and the (nonfinancial) corporate sectors, systemic crisis resolution mechanisms may also include “special” procedures for corporate debt workouts.⁷

The holy grail of how best to perform the ex ante and ex post protector of the system role remains elusive, contributing to the large number of costly financial crises in recent years.⁸ Notwithstanding substantial agreement on broad principles, the way in which the supervision and regulation of financial systems should best be conducted remains under debate: the appropriate perimeters of financial regulation have not been clearly identified; financial system procyclicality remains a problem and may have been exacerbated by regulatory and accounting practices; both funding and market liquidity risk remain difficult to control; and dealing with low-probability, high-impact events (tail risk) continues to be very difficult.⁹ In addition, there are important operational issues about how best to deal with risk at the level of the system as a whole (systemic risk) and how the traditional micro focus on supervision and regulation should best incorporate systemic risk considerations that result from significant interconnections and spillovers within financial systems, or the effects of common shocks.¹⁰ There are also questions about whether the agencies assigned responsibility for the oversight of systemic risk will be given real powers or have to rely on the bully pulpit to keep systemic risk under control.¹¹

How systemic crises should best be managed also remains elusive and the recent increased interest in strengthening macroprudential surveillance has not been matched by a revisiting of systemic crisis management.¹² Instead, as discussed in the next sections, only very broad principles have been developed to guide crisis management, and there are few if any “rule books” that provide a step-by-step account of how things might best be done.¹³

Coming out of the current turmoil, account must also be taken of the possible perception that the boundaries of the state's role in crisis resolution have expanded enormously and that virtually any intervention, bailout or guarantee is acceptable in the event of the risk of extreme tail events. Needless to say, this perception (whether right or wrong) can store up problems for the future unless it is credibly addressed.

A key difficulty in crafting boundary rules for systemic crisis management is the problem of time inconsistency.¹⁴ Time inconsistency implies that the crisis management policies it is optimal to announce in advance of a crisis will not necessarily be optimal once the crisis has struck. In these circumstances, the announced policies will lack credibility, as markets will know that they may not be followed in the heat of a crisis. Moreover, given a desire on the part of many policymakers to maintain flexibility in their responses to crises, there is a resistance in many countries to the adoption of rigid “rules” that would limit policy responses. Rather, the preferred approach in many cases has been to strengthen the ex ante supervision and regulation of the financial system—and, in particular, of entities judged to be too large to fail—while implicitly recognizing that systemically important firms might need to be bailed out should a crisis occur (Schinasi 2006). Partly to deal with the moral hazard implications of such an approach, it is not uncommon for policymakers to maintain a degree of constructive ambiguity about their policies toward crisis management and bailouts. Whether, and to what degree, such an approach is the right one is a point of contention. There is a risk that the vast expansion of the boundaries of state intervention during the current turmoil will make the moral hazard problems even more difficult, as it seems to be increasingly recognized that virtually any intervention might be adopted in the next crisis.

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