Financial Stability became a topic in the late 1990s, at a time of peak laxity in international financial supervision. The same minds which promoted the Financial Stability Forum (now the Financial Stability Board) also crafted the deeply flawed and destructive Basel II.
I have never understood why Financial Stability should be an objective of public policy. Desirable, measurable outcomes of benefit to the public should be the objectives of public policy. Stability is a silly and impractical goal in a capitalist economy. Success and failure of competitive firms are the basis for economic progress, capital allocation and market pricing. Capitalism requires recognition of failure, and failure always causes economic loss and some instability as past assumptions are re-examined and re-assessed more objectively in light of current painful reality.
The management of failure can contribute to better future outcomes, but only if the costs of failure are born by those who caused the failure and not by those innocent of it. The 1990s policies promoted by regulators during the Great Moderation aimed to forestall failure by disguising it, delaying it, and subsidising it. Since the collapse of securitisation and inter-bank credit markets in 2008, governments have been too willing to socialise the costs of failure (by then magnified with leverage) to taxpayers through serial bailouts.
One strength of the US banking system from the 1930s to the 1980s was that failures were dealt with quickly and certainly. Foreclosed properties had to be sold by banks within two years of repossession, leading to a quick and certain reallocation of assets from failed borrowers to new owners. The FDIC swiftly and mercilessly shut down failed banks. New owners - often buying at distressed prices - were encouraged to invest in making the assets productive and profitable. It was this simple recycling from failed managers to better managers that was largely behind the short recessions and strong recoveries during this period of American economic history. With forbearance now institutionalised at all levels of the US economy, we are seeing Japanification instead of recovery. And it is even worse just about everywhere else where dominant banks are much more influential.
Financial Stability - like national security - can never be objectively confirmed as achieved. It is more often used to disguise the ulterior aims of its proponents, or to misdirect attention in aid of bad public policy that harms rather than promotes the public interest. For example, the Greenspan Put was a brilliant mechanism for ensuring financial stability by preventing any adjustment of the markets in response to the S&L crisis or dot-com bust. The Bernanke Put and Paulson Plan were financial stability solutions to the securitisation fraud crisis that revealed the undercapitalisation of global banks and over-leveraging of real estate. Bank bailouts and special liquidity facilities were financial stability innovations to prevent mark downs of mis-priced and illiquid capital assets.
Rather than review whether massive financial deregulation and promoting concentration in a few incumbents was in the public interest, the Greenspan Put, Bernanke Put, liquidity facility innovations and public bailouts have disguised misallocation of capital by pumping the markets with taxpayer funds and monetary laxity whenever they began to flag. Financial Stability initiatives have therefore taught incumbent bankers that any disruption is an excuse to double down on bad bets as the central banks and state treasuries would flood enough cash to make bad bets come good. MF Global made this bet, and although it (and its clients) won't be collecting, I expect the creditors/counterparties that seized all its collateral assets expect to come out way ahead.
I oppose Financial Stability because it is the most misleading banner for a set of bad, harmful and expensive public policies protecting bad executive management and preventing recognition of realistic market outcomes.
So what would I promote instead? Resiliency and resolution. Resiliency means the ability to withstand stresses and shocks which will unavoidably arise in global, competitive markets. Resolution means the dispersion of assets to creditors - and competitors - when banks fail, in hopes the assets and enterprises will be better managed by other managers than the same ones that led the bank to failure. Together these two principles - if made the basis for public policy - would do more to restore sanity to global banking than anything else I can think of. Resiliency will favour more and better capitalisation, with a focus on marketable assets with transparent price discovery (e.g., traded on transparent markets and recorded on balance sheet). Speedy and certain resolution of failed banks will make management and shareholders conscious of the risks of failure falling first on them, then on unsecured creditors and bondholders, and never on the taxpayer.
We are a long way from adopting principles of resiliency and resolution, as demonstrated by the EU's continued efforts to forestall defaults while protecting incumbent managements and bondholders. Our policy makers continue to chase the chimera of financial stability, and make bad policies worse along the way.