Safeguarding Financial Stability: Theory and Practice, by Garry J. Schinasi. Washington, D.C.: International Monetary Fund. 2006. Paper: ISBN 1 58906 440 2, $28.00. 311 pages.
In this book, the author presents a broad framework to promote financial stability. In doing so, he puts forward good points but one can see the tension that runs through the book because of his willingness to apply standard economic tools to the analysis of financial fragility. In the end, if Schinasi argues in favor of leaving most regulation of the financial system to the "market" by reducing market imperfections, one is forced to recognize that his case rests on weak foundations.
The whole argument of the book is based on the standard contemporary approach to economics. The author views the financial system as a pooling mechanism that redistributes a "fixed supply of flat money" (p. 55) by leveraging upon it via the creation of credit instruments. By doing this, the financial system facilitates intertemporal choices through the allocation of real resources from savers to investors, the allocation and assessment of risks, and the provision of liquidity (pp. 36, 85, 123). Market imperfections (externalities, public goods, asymmetries of information), however, push the financial system above or below optimality (p. 59). This, combined with the intrinsic incompleteness of financial contracts induced by the uncertainty of human trust, makes regulation and supervision a must in order to avoid financial instability.
Given this traditional equilibrium/optimality analysis, the second part of the book provides a general policy framework to promote financial stability (financial instability is defined as the capacity of the financial system to perform its three tasks simultaneously (pp. 82ff.)). However, in doing so the author attempts to introduce history into the equilibrium analysis. Indeed, "the traditional 'shock-transmission' approach that is the basis of many existing policy-oriented framework" presumes that a system remains "in a state (or path) of equilibrium if undisturbed or adjusts to a different, perhaps less desirable, state (or path) of equilibrium" (p. 98). Instead, we should approach financial stability "as a continuum" (p. 98) process in which "the building up of vulnerabilities" (p. 98) is more of a concern than the shock triggering financial instability.
One should make an assessment of the strength of the financial system by defining a corridor of...