Research Discussion Paper – RDP 1999-05 Trends in the Australian Banking System: Implications for Financial System Stability and Monetary Policy
March 1999
Abstract
Financial system stability is defined in terms of the expected macroeconomic losses that arise from financial system disturbances. This captures both the probability of various financial disturbances and the size of the macroeconomic costs arising from such disturbances. Because of the links between the real sector of the economy and the financial sector, monetary policy needs to be cognisant of the potential for financial system stability. We develop a general framework for policy analysis which highlights the trade-off between financial system stability and efficiency. We use this framework to analyse the potential impact on stability and efficiency of three current pressures in the Australian financial system. Namely, consolidation among the largest banks, the formation of large financial conglomerates, and greater opportunities for smaller niche institutions provided by technological developments. We develop a simple model to show that consolidation might reduce system stability through a loss of diversification – which is important in the case of idiosyncratic shocks to individual financial institutions. Offsetting this effect, consolidation might increase system stability if contagion is an important source of failure of financial institutions. Conglomeration has two offsetting effects in terms of system stability: diversification across different financial services can reduce the probability of failure of an individual institution; and contamination, which can lead to contagion flowing from failure of an unhealthy arm of the conglomerate.