The role of Central Bank in provision of financial stability: Case of Turkey

Although there is a certain quantitative definition of the concept of price stability, there is not a ceratin quantitative definition of the concept of financial stability in the literature. By this reason, many definition of the concept of financial stability can be encountered in the literature.In generally, the concept of financial stability is defined as a clockwork circumstance that the economy?s mechanisms for pricing, allocating and managing of financial risks are processing properly in order to contribute to the performance of the economy.Financial stability policies are classified as preventive, remedial and solventive policies. Financial regulation and supervision operations are employed in the scope of preventive and remedial policies. On the other hand, solventive policies consist of safety nets. These are lending of last resorts and deposit insurances. Nowadays, while the financial regulation and supervision operations are performed by independent and authonomous instutions, central banks are assisting these institutions and performing the lending of last resorts. On the other hand governments provide deposit insurance.The relationship between desing of monetary policy and financial stability is examined at the framework of monetary policy strategies.Recently, central banks prefer price stability as a final objective. Besides, duties of central banks contain the provision of financial stability in the financial markets. In the literature, the relationship between price stability and financial stability is being examined by Conventional Approach and The New Environment Hypothesis. While Conventional Approach points out that there is a synergy between price stability and financial stability. However, notwithstanding price stability is provided, financial instability may emerge. The New Environment Hypothesis indicates that this relationship may emerge as a trade-off.The second factor which determines the relationship between desing of monetary policy and financial stability is monetary policy strategies. At this point, the effects of exchange rate targeting and inflation targeting strategy on financial stability are examined.Under the exchange rate targeting, economic agents increase the borrowing with foreign currency. It causes the moral hazard problems. Furthermore under this strategy, central banks can not realize the lending of last resort during the financial crisis.The relationship between inflation targeting strategy and financial stablity is examined in three types. The first one to provide stability in financial markets affects inflation targeting strategy positively. The second one depends on sensitivty of central banks to asset price baloons in financial markets. According to Conventional Approach, central banks should not respond to asset price baloons, central banks should only focus on price stability. On the other hand, according to approaches those advocate flexible inflation targeting central banks should respond to assest price baloons when it emerges. The thrid one depends on the relationship between floating exchange rate and financial stability. Under the floating exchange rate regimes, there is not expectation of excessive borrowing of economic agents by foreign currency. By this reason, floating exchange rate regime prevents moral hazard problem. Furthermore contrary to fixed exchange rate regimes, central banks can realize the duty of lending of last resort during the financial crisis. However, although emering market countries perform officially floating exchange rate regimes, the central banks of these countries control the foreign exchange rate in practise because of ?original sin phenomenon?. By this reason emerging market countries conducted with ?fear of floating?.In the scope of this study, developments in Turkish banking sector are examined. After Letter of Intend which was signed in December 1999, fragility of balance sheet of Turkish banking sector increased. This Letter of Intend depends on exchange rate targeting. Crowding band regimes which was employed at this pereiod caused to increase the foreign currency denominated liability of banking sector. Consequently Turkish banking sector encountred the liquidity crisis in November 2000. After November 2000 crisis, exchange rate targeting strategies was maintained. By this reason Turkish economy encountered to currency crisis in February 2001. After the crisis, in May 2001, Turkey?s Transition To Strong Economic Program (TSEP) was signed. Structural reforms those are realized in the frame of TSEP, affected financial structure of banking sector positively. However, foreign currency debt of banking sector increased after 2002. By this reason, Central Bank of Turkish Republic (CBTR) took under control the excessive volatility in foreign exchange rate market. In other words, CBTR conducted with fear of floating.