On The Mechanisms Underlying Financial Stability

The financial crisis from 2007 to the present has changed the guidance of public opinion and policy philosophy, and the stability of financial system and the role of government in protecting and enhancing it have been attached unprecedented importance. However, there is a need for further studies on the understandings of some basic issues such as the essential causes of financial instability or the main driving forces behind financial cycles, the definition of financial stability itself and the hows of maintaining financial stability. This dissertation argues that financial stability is the stability of financial system as a whole; therefore the methodological propensity of reductionism should be avoided in which the task to effectively understand and safeguard financial stability is simply and arbitrarily decomposed and reduced to understandings and management of individual financial element.This dissertation takes finance as a whole of order composed of interconnected financial elements. The implications of financial system theory for financial stability primarily embody in three points. Firstly, a macro-prudential approach should be adopted to strengthen management of financial system. Regulators and supervisors should set a prudential incentive structure to ensure compatibility between behaviors of financial institutions and the macro-prudential object. And for regulation structures, it is necessary to create a macro-prudential regulation entity taking the responsibilities to identify, assess and address systemic risk, and a micro-prudential regulation entity responsible for safety and soundness of individual financial institution. In the broader sense, a macro-prudential management organization should be established whose tool set includes some economic policies and hence are much more plentiful than those under the control of the macro-prudential regulation entity.Secondly, in the process of designing financial stability mechanisms and managing financial crisis, financial system and financial elements should be distinguishly treated. There are no necessary connections between financial stability and safety and soundness of individual financial institution. It is indispensable to design sound crisis management procedures, especially resolution regimes for troubled financial institutions, and relevant rules for government bailouts to alleviate or eliminate problems due to time inconsistency.Thirdly, because of the interconnections between financial elements, the dynamics of financial variables is characterized by feedback or nonlinear reciprocity, and thus any shock or government intervention can result in unintended macro-consequences. From a dynamic perspective, financial system needs internal and external stability mechanisms for preserving its original stable structure or achieving new stable structure. Financial system management should be coutious in the process of legislations for financial system, and pay attention to the fact that the opposite side of stability mechanisms is instability mechanisms.The design of financial stability mechanisms should be based on general financial system theory, and take basic information of particular financial system into considerations. According to this principle, this dissertation is structured from general to particular or from abstract to concrete. The text besides the introduction consists of five chapters.In chapter one, the general financial system theory is created. This chapter discusses contents and characteristics of financial system, financial structure and financial functions, interconnections between modern financial system and its management and real economy. The emphases include three aspects: 1) the concept of financial structure is expanded, and interconnections between financial elements and relative scale of financial aggregates are distinguished; 2) taxology and identification methods of financial imbalances are found on development level imbalance of financial institutions marked with excess debt or insolvency; 3) the concept of collective action is introduced to modelize financial cycles.The second chapter studies different kinds of financial stability mechanisms in detail. The defination of finacial stability first of all is analysed. On the basis of interconnections between financial structure and financial functions, this paper argues that financial stability in essence is the stability of financial structure, and display continuity of financial services. It is necessary for fostering financial stability to put macro-prudential management into practice, and macro-prudential regulation is just one kind of macro-prudential management policy tools.Financial stability mechanisms are classified as internal and external stability mechanisms. The former includes incentive structure, counter-cyclical mechanisms, entry and exit mechanisms and self-organizing mechanisms. The latter covers regulation philosophy, comprehensive capital regulation, liquidity regulation, conduct of business regulation, financial safety nets, financial crisis management and monetary and fiscal policies.For modern financial system, internal and external stability mechanisms should be designed and maintained by financial system management, and grounded on requirements of the macro-prudential object and prudential operation of financial institutions. There are two requirements of prudence from the perspective of risk management. The first one is that to comprehensively identify risks, an open and flexible stance should be holded. In particular, when financial structural changes occur, some new types of risks may arise, and relative importance of existing risks will change and some of them even disappear. The second is that risk should be sufficiently measured and covered. Cyclical or dynamic characteristics of risk should be especially taken into consideration that is the amount of risk is accumulated during the boom and materialized during the following bust.The third chapter concentrates on five crucial issues, including simplifying financial structure to reduce complexity of financial system, dealing with asset price imbalances, regulating and overseeing systemically important financial institutions (SIFIs), framing and reforming the system of financial system management and paradox of stability policies. This paper indicates that the authorities should simplify financial structure through constrained mixed operation and debts control, restrain the accumulation of asset price bubbles by means of discriminative monetary policies or prudential regulation, implement regulations according to ranks of systemic importance of SIFIs, and design stability mechanisms in accordance with principle of incentive compatibility to mitigate moral hazard by all manner of means.The system of financial system management is the distribution pattern of responsibilities and powers among ministry of finance, central bank and regulators and their organizational structure or governance structure. For the functions of prudential regulation and conduct of business regulation, this chapter establishes new taxology of regulation structure in the light of logical consistency of division standard which is, whether internationally or nationally, fundamental for comparison and selection of regulation structure.In chapter four, seven policy recommendations are identified for the design of stability mechanisms of China's financial system. Specificlly, they are 1) basic principles for the design, 2) to adjust and optimize the financial structure and take constrained mixed operation into effect, 3) to reform China's regulation structure to adapt and strengthen micro-prudential regulation for financial institutions engaging in mixed operation and macro-prudential regulation for financial system as a whole, 4) to constitute a macro-prudential management committee to enhangce macro- prudential management; 5) to establish and improve resolution regimes for troubled financial institutions, 6) to enhance the role of the People's Bank of China (PBC) in promoting financial stability, 7) to standardize and guide financial reform, opening up and development according to purpose or value of financial system.The last chapter provides a systemic explanation for this global financial crisis from the perspective of interactions between real factors and monetory and financial factors, and then points out limitations of this dissertation and further research directions.