RDP 9315: The Provision of Financial Services – Trends, Prospects and Implications 6. Conclusion and Implications
December 1993
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The size and structure of the financial system and the balance sheets of the private sector will continue to change. The rate of expansion is unlikely to be as rapid as that of the past decade and the forces driving future changes will differ in many respects to those of the past. Deregulation was a once-off event and the expansionary forces flowing from it are not likely to be repeated. High and persistent inflation encouraged the expansion of debt, was the catalyst for many financial innovations, influenced the pattern of private saving and probably made the system less stable than it would otherwise have been. Sustained low inflation should mean that it will no longer be an influence on financial decisions or undermine financial stability.
The globalisation of markets, innovation and technological change, and encouragement of particular forms of saving will increase competition further and change the competitive position of various institutions. Banks will remain the core of the system partly because of the nature of their traditional business and because they will broaden and expand their activities into other areas.
These changes have implications for the stability of the financial system and monetary policy.
The changes that have occurred have altered the nature of risks in the financial system, reducing some and introducing others. An important one, the risk of system-wide liquidity problems, seems to have been substantially reduced. The removal of interest-rate ceilings and restrictions on how banks can fund themselves have given banks more ability to manage their liabilities, markedly reducing the possibility of liquidity problems for solvent institutions. International integration of markets and the deepening of the domestic market have also improved the liquidity of the system overall but, at the same time, mean that shocks in one market may be more rapidly transmitted to others. The willingness of central banks to step in should the risk of illiquidity arise (for example, the announcement by the U.S. Federal Reserve that it would ensure system liquidity needs following the 1987 stock market fall) also limits (and probably eliminates) these risks. Some innovations which at first glance may have made the system more vulnerable may considerably enhance the marketability and liquidity of bank assets, allowing them to be more easily sold-off in the face of extreme liquidity problems.
New financing techniques and financial instruments allow institutions, in principle, to manage risk better. They rely, however, on the correct assessment and pricing of risk. Based on the experiences of market participants in the 1980s, it can take some time for markets to accumulate experience in accurately determining these risks. The growth of off-balance sheet activities and the complexity of many of those activities, for example, could have exposed banks to greater risks. In response to any such risks banks must now hold capital against the credit-equivalent of their off-balance sheet activities.
The fact that a growing proportion of bank liabilities are owed to the securities markets and institutional investors may offset some of these advances. These funds are more return-sensitive than those of depositors and can be shifted rapidly. This could mean that banks' funding base is more elusive and expensive than it was in the past and that there is more pressure on banks to provide competitive returns.
While financial innovation and structural changes in financial markets provide new choices and benefits to savers and investors, they also introduce new elements of risk and volatility.[41] The challenge for supervisors will be to stay ahead of these developments to ensure the stability of the financial system while not stifling innovation. As the financial system evolves, we are seeing a gradual change in the distinctions between financial institutions which may encourage a move towards a functional rather than institutional approach to supervision.
Financial problems will recur and they will likely be related to the poor decisions of individual institutions, instability in the macroeconomy and large swings in asset prices. Large movements in asset prices can sometimes be driven by misplaced confidence in the underlying fundamentals which may lead to problems when the expectations are not realised. Some of the problems faced by the financial and real economies in many countries today stem from these types of swings in asset prices.[42]
Financial stability will importantly depend on the performance of the macroeconomy and the maintenance of low and stable inflation. Macroeconomic instability increases uncertainty, makes it difficult to assess risk and encourages large swings in asset prices. Inflation has been an important catalyst for innovation in the financial system, benefiting some segments at the cost of others. It has also been an important contributor to the overall expansion of indebtedness and the problems that have resulted from that. By maintaining a stable economic environment and low inflation, monetary policy can significantly enhance the stability of the financial system. Moreover, it can allow the evolution of the system to reflect genuine competitive advantages of the parties involved rather than artificial ones created by the interaction of inflation and a range of other factors.