Bank of Finland Auditorium, 7 June 2007 

The development of financial sector has long been recognized as a crucial factor to economic growth. Well-functioning financial system helps to ease the exchange of goods and services, channel society’s capital to profitable investment and support continuous technological innovation. Along with the fall of international barriers to the flow of commodities, services, capital and labor, financial globalisation and liberalisation further impact the macroeconomic stability.

Recently, central banks around the world have started to devote renewed attention to the objective of financial stability. This move has been associated, on one side, with the impressive progress made in the fight against inflation; on the other side with the many episodes of financial and currency crises that have continued to challenge the international financial system.

After several decades of passion in terms of large and volatile swings in prices, during the 70s and the 80s, in most industrial countries the inflation rate has been reduced and maintained in quite a narrow and low range. This has occurred in a context of enhancing central bank independency as an essential tool to separate monetary policy from excessive political interference. The consensus view regarded price stability as a primary public good to supply to citizens and an essential ingredient of welfare increasing policies.

However, while inflation was widely brought under control, financial crises and severe episodes of instability in the banking and financial systems have continued to hit different countries around the world, from the North of Europe to the South East of Asia and to Russia. Among G7 countries, Japan experienced a terribly long lasting crisis in the financial sector that asked for an enormous restruc-turing of banks and domestic financial companies, rapidly falling from being the star of growth in the 80s to cope with stagnation and deflation in the 90s and early 2000s. Financial stability was severely challenged also in the US. First, hedge funds such as LTCM were blamed to have put under stress the safety walls built by financial supervisory rules and authorities. Second, as a result of the excessive euphoria equity prices consequently experienced a sharp adjustment. Finally, huge corporate and financial scandals challenged financial stability.

Today, even those central banks that are primarily involved in monetary policy are also associated with the stability of banking and financial systems. The inflation-output relationship and the role of financial intermediaries along with their effective supervision appear to be embedded together in ways that make central bankers and supervisory authorities together involved in financial stability.
The EU gave the opportunity to create a level playing field in the European market but it has also created a lot of challenges which have a bearing on financial stability. Specially, in the banking sector, cross border activities and the consolidation of institutions through mergers and acquisitions are starting to take off. For example, the ownership structure and corporate governance of the pan-Nordic banking group Nordea involve both opportunities and challenges as regards financial stability related issues.

A stable financial system relies on its financial institutions performing their key functions, either as domestic and international intermediation or risk management. Among all the institutions, banks are an important component of well-functioning financial systems. Disruption of banking system will broadly impact the access to funds for different borrowers in order to continue their existing projects or pursue new investment opportunities. Therefore, the stability of both individual banks and the banking systems have called for much attention. This is evident from your program in this meeting.

Stability of financial markets, market interactions, comovement and contagion are also among the crucial issues that have an impact on the overall stability of the financial system. Markets like futures and options involve a large degree of financial innovations, which may potentially transfer a variety of risks to other markets in the financial system.

It is in the interest of financial authorities to intervene in the financial system and make policy decisions in order to avoid financial instability or crisis and achieve long-term growth objectives. Assessing issues related to regulation and supervision thus become necessary for practical purposes.

While central banks have long been recognized to be responsible for pursuing the objective of price stability, a survey of 37 central banks indicates that the maintenance of financial stability is also a core function of central banks. The coexistence of the two objectives may also call for further exploration by academic researchers.

Another stream of issues focuses on the society’s infrastructure which may potentially improve the stability of financial systems. Regulatory environment, including a wide body of laws and regulation; for example deposit insurance law, insolvency law and securities market law, shapes the information disclosure and contractual processes and defines the relative obligations and responsibilities of different market participants. In addition, the accounting system and auditing system can be conducive to the improvement of economic transparency.

Risk management issues have become routine work for central banks. Wide application of numerous financial innovations and large scale movement of capital globally have heightened the concern of risk management. Does financial globalization and liberalization increase or decrease systemic risk across countries? How is credit risk transferred among countries? Does consumer bankruptcy crisis matter? These are some of the questions of key concern.

Though we have only a short time span, we can nonetheless observe some trends in the research of financial stability. For example, it seems that there has been a sharp increase in topics concerning regulation and supervision. This trend could be partly due to the Basel II reform process. Also, increased attention has been drawn to understanding the nexus between macro-economy and financial stability and to developing new methodologies in order to measure related vulnerabilities.

How to assess macroeconomic stability? Factors affecting the stability of the financial system range from heterogeneous perception of individuals to overall market risk, and are also related to the economy’s structural robustness. These may necessitate an integrated approach to unpack the relation between financial stability and macroeconomy.

The stream of research findings given by you today and tomorrow should further our understanding of these issues. I have asked my colleagues in the Bank's research unit not only to take advantage of this meeting but also to summarize the key findings that are applicable to a broader audience including the supervisory and policy making groups among the Finnish financial authorities.

I would like to wish you a very productive and pleasant experience in Helsinki.