SS3 Second Term Economics Lesson Note – Consolidation of Financial Institutions

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Understanding Financial Consolidation

Consolidation of all types of business activities has been a prominent feature of the economic landscape for at least the past decade. The financial sector has participated actively in this development. Indeed, the last few years have witnessed an acceleration of consolidation among financial institutions.

In recognition of the importance of this marketplace evolution, and especially its potential effects on a wide range of public policies, the finance ministers and central bank governors of the Group of Ten nations in September 1999 commissioned a major study of the possible effects of financial consolidation on matters of policy concern to central banks and finance ministries in the G-10. Major findings and their implications.

The G-10 Study of Financial Consolidation

The G-10 study had two primary objectives. It attempted to isolate the effects of consolidation from those of other powerful forces transforming our financial systems and to identify key areas in which financial consolidation requires new or accelerated policy development. The diversity of the economies involved–even among the G-10, Australia, and Spain–and the interdependent nature of many of the forces affecting our financial systems made achieving these objectives difficult, to say the least

Monetary Policy

One of our more important policy concerns in designing the study–and the issue of greatest relevance to the participants in this conference–was the potential effect of financial consolidation on the conduct and effectiveness of monetary policy. There were three broad areas of concern. First, it seemed possible that consolidation could make it more difficult for central banks to implement policy if it reduced the efficiency of the market for central bank reserves or the markets used in the conduct of monetary policy operations. For example, consolidation might reduce the liquidity or increase the volatility of the reserves market, making it more difficult for central banks to keep their policy rate near its target. The second possibility was that consolidation could affect the transmission mechanism linking changes in the policy interest rate to the real economy. Consolidation could do so if it affected the liquidity or volatility of key financial markets and so the arbitraging of interest rates across instruments and maturities. Moreover, consolidation could, at least in theory, alter the credit channels of monetary policy.

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