Modelling Financial Stability

Alan Greenspan once complained that "we lack the kind of analytical framework for financial stability that we have for monetary policy" - something which is clearly a problem when central banks are in charge of both things, and especially in times such as now, when the consequences from the former spill over into the latter. Alexander Campbell has found one presentation which seems to have studied the phenomenon reasonably closely; it concludes that

• Under-capitalised banks impose an externality on other banks in the system;
• Decreases in net worth increase the number of contagious defaults and this effect is non-linear;
• Contagion risk first increases with the connectivity of the banking system, then decreases;
• More concentrated banking systems tend to be more prone to systemic meltdown.

All of this seems intuitively true, but as Campbell says, "translating that into real-world policy will be tricky". Still, this is clearly an important avenue of research for central banks around the world: it doesn't matter how good your monetary policy is if you're leaving yourself wide open to a banking crisis.