What is 'financial stability'? The need for some common language in international financial regulation.

Author:Allen, Hilary J.
  1. INTRODUCTION II. THE CURRENT LACK OF CLARITY III. THE NEED FOR CONSENSUS A. Consensus as a Precondition for Harmonization B. Consensus is Valuable Even for Harmonization Skeptics C. Some Practical Consequences of Consensus Failure IV. WHAT DO WE MEAN BY "FINANCIAL STABILITY"? A. What Constitutes Stability? B. The Functional Dimensions of the Financial System C. The Geographical Dimensions of the Financial System V. CONCLUSION I. INTRODUCTION

    International financial regulation has developed as a response to the recognition that the financial system is truly global, and that actions taken by a financial institution on one side of the world can have important ramifications for people living on the other. (1) If this was not already self-evident prior to 2008, it became abundantly clear during the Financial Crisis, when the subprime mortgage crisis in the United States acted as a trigger for a global bank run. (2) The post-Crisis international regulatory discourse has thus focused squarely on promoting the stability of the financial system, with the aim of avoiding or mitigating the global negative externalities that can result from the failure of financial institutions and markets. (3) However, despite an overwhelming consensus around this goal, there is no clear agreement at the international level about what "financial stability" is. (4)

    In the post-Crisis era, it is probably true that there is some level of amorphous shared understanding of "what kind of thing financial stability is about," (5) but a detailed consensus on the meaning of "financial stability" is lacking. Some view financial instability as largely a "First World problem," (6) while others see it as a matter of global concern. (7) Similarly, some view "financial stability" as synonymous with addressing "too big to fail" banks, (8) whereas others argue for more imagination in anticipating the sources of future instability.9 Schisms in approaches to financial stability also result from cultural differences and divergent national interests. (10) For example, European countries tend to view the failure of even one financial institution as unacceptable instability, while the United States is more tolerant of such failure. (11) As such, international financial regulation should not proceed on the assumption that a consensus regarding the meaning of "financial stability" exists.

    This Article argues that international financial regulation needs to be much more preoccupied with the content of the term "financial stability." A lack of clarity regarding the goal of "financial stability" undermines efforts to harmonize financial stability regulation, and this will become increasingly apparent as international financial regulation embraces more goal-oriented, macroprudential tools. (12) Determinations of functional equivalency, the operation of transnational supervisory colleges, and the conduct of Financial Sector Assessment Programs (FSAPs), are other practices that may be undermined by conflicting interpretations of "financial stability." (13) Therefore, in order to improve the efficacy of financial stability-related standards and practices, it is essential that the international financial regulatory community work towards developing a shared understanding of what "financial stability" is. (14) To that end, this Article proposes the following definition of "financial stability," which reflects both technical notions about the state of financial institutions and markets during periods of stability, and a value-based assessment of the function of the financial system as a means to broader economic prosperity, rather than an end in itself: (15)

    The term "financial stability " shall mean a state of affairs wherein (i) financial institutions and markets are able to facilitate capital intermediation, risk management, and payment services in a way that enables sustainable economic growth; (ii) there is no disruption to the ability of financial institutions or markets to carry out such functions that might cause harm to persons (wherever they may be resident) who are not customers or counterparties of those financial institutions, nor participants in those financial markets; and (in) financial institutions and markets are able to withstand economic shocks (such as the failure of other markets and institutions, or a chain of significant loses at financial institutions) so that (x) there will be no disruption to the performance of the functions set forth in (i) and (y) no harm will be caused to the persons set forth in (ii). Of course, this is not the only possible construction of "financial stability." However, this Article aims to achieve two things in promulgating a plausible working definition. First, it seeks to focus attention on the technical and social aspects that should be considered in developing any definition of the term. Second, it intends to inspire a debate about the content of such definition. The expectation is that such debate will elicit people's different conceptions of what is meant by "financial stability," and thus shatter any implicit assumptions that there is consensus with regard to the goal of international financial stability.

    The remainder of this Article proceeds as follows. Part II briefly explores the lacunae in international financial regulation with respect to the concept of "financial stability," and Part III explains why these lacunae are problematic. Part IV then works through the issues that inform this Article's definition of "financial stability" before exploring some of the implications of such an expansive definition for regulatory legitimacy and resource allocation. Part V concludes.


    International financial regulation has been described as a series of standards, propounded by informal networks of technocrats from around the world. (16) These networks include the Financial Stability Board (FSB), (17) the Basel Committee on Banking Supervision (BCBS), (18) the International Organization of Securities Commissioners (IOSCO), (19) and the International Association of Insurance Supervisors (IAIS). (20) Also participating in international financial regulation are the more formalized institutions of the International Monetary Fund (IMF) and the World Bank. (21) When looking for the sources of international financial regulation, we look to the standards promulgated by these institutions, and to their foundational documents.

    Unfortunately, the standards, charters, and mandates that have been published to date provide little clarity or context regarding the meaning of "financial stability." For example, the Charter of the FSB--which emerged from the Financial Crisis as a body with oversight over the BCBS, IOSCO, and IAIS (22)--states that "financial stability" is its core mission. (23) Members of the FSB also commit to "pursue the maintenance of financial stability," (24) yet there is no attempt to define what is meant by "financial stability." Similarly, the BCBS has a mandate "to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability," (25) but that mandate does not make clear what is meant by "financial stability" either. The Basel III standards promulgated by the BCBS do note that their objective is to "improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy." (26) This language is somewhat helpful, but Basel III focuses narrowly on the banking sector and therefore does not give much guidance as to what is meant by stability for the financial system as a whole. And while Article IV of the IMF's Articles of Agreement provides that "a principal objective is the continuing development of the orderly underlying conditions that are necessary for financial and economic stability," (27) it again gives no indication of what "financial stability" means. The key sources of international financial regulation, then, are lacking any clear statement about what is meant by "financial stability."

    This is not a situation where the domestic law of the key financial players offers much assistance, either. The Dodd-Frank Act, passed in the United States in the wake of the Financial Crisis, refers to "financial stability" no less than ninety-seven times without ever defining the term.28 Section 1A of the United Kingdom's Bank of England Act of 1998 notes that protecting and enhancing the stability of the U.K. financial system is one of the objectives of the Bank of England without giving any color as to what is meant by such stability. (29) At the European Union level, the regulation establishing the new European Systemic Risk Board does not define financial stability, but it does give some guidance in the form of a definition of "systemic risk" as "a risk of disruption in the financial system with the potential to have serious negative consequences for the internal market and the real economy." (30) Nonetheless, this regulation still assumes a shared understanding of what constitutes the "financial system" when there is no such understanding at present.


    The previous Part made it clear that international financial regulation does not proffer any formal definition of "financial stability." This Part explores why the absence of consensus regarding the meaning of "financial stability" is, in fact, problematic.

    At its most basic level, "a good definition is a prerequisite for good policy." (31) Given the prominence of financial stability as a policy goal, it is important that thought be given to its meaning so as to enable the formulation of cohesive policy solutions to achieve it. (32) Furthermore, situations will arise where international financial stability regulation will require national regulators to sacrifice some national interest (often financial industry...

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