Moral Suasion

Moral suasion is the use of persuasion and of informal pressure by a central bank or other authority to influence the behaviour of financial institutions, in place of or in addition to formal rules. Moral suasion is a form of communication-based policy that relies on the authority and the reputation of the institution.

Concept

Moral suasion operates through the influence of the authority on the decisions of the institutions that it supervises or regulates. The authority may issue statements, hold meetings with the institutions, or use its influence to encourage particular behaviour.

The effectiveness of moral suasion depends on the authority of the institution, on the willingness of the institutions to cooperate, and on the credibility of the authority's signals. It is more effective when the objectives are shared and when the institutions value their relationship with the authority.

Applications

Moral suasion has been used in several contexts. Central banks have used it to influence the growth of credit, encouraging banks to moderate lending during periods of rapid credit expansion and to maintain lending during periods of stress.

Supervisory authorities have used it to encourage institutions to strengthen their risk management and to comply with prudential standards. The authority may communicate its concerns and its expectations, and it may follow up with measures if the institutions do not respond.

Moral suasion has also been used in the context of monetary policy, where the central bank seeks to influence the expectations of the public and of the markets. The communication of the policy stance is a form of moral suasion, and its effectiveness depends on the credibility of the central bank.

Advantages and Limitations

The advantages of moral suasion are its flexibility and its low cost. It does not require the introduction of new rules or the commitment of resources, and it can be adapted to the circumstances.

The limitations are also significant. Moral suasion relies on the willingness of the institutions to cooperate, and it may be ineffective when the interests of the institutions differ from those of the authority. It is also difficult to verify compliance, since the behaviour is not required by a rule.

The use of moral suasion raises questions about accountability and about transparency. Since the pressure is informal, it is not subject to the same scrutiny as formal rules, and it may be used in ways that are not transparent. The design of the framework must address these concerns.

The Broader Context

Moral suasion is one of a range of instruments available to authorities, alongside rules, prices, and other measures. The choice of instrument depends on the objective, on the circumstances, and on the institutional framework.

The effectiveness of moral suasion is enhanced when it is part of a coherent framework that includes other instruments. The combination of communication, of rules, and of other measures is likely to be more effective than any instrument alone.

Moral Suasion in Central Banking

Central banks have long used moral suasion as an instrument of policy. In the past, when the instruments available were less developed, the central bank relied on its influence over the banks to guide the growth of credit and to manage the conditions in the money market.

The use of moral suasion declined as the instruments of monetary policy became more developed, and as the emphasis shifted towards the use of the policy rate and of market operations. The instrument has, however, retained a role, particularly in the supervision of banks and in the management of financial stability.

The central bank may use moral suasion to encourage banks to strengthen their risk management, to moderate the growth of credit during periods of rapid expansion, and to maintain lending during periods of stress. The effectiveness depends on the authority of the central bank and on the willingness of the banks to cooperate.

Moral Suasion and Communication

The communication of the central bank is a form of moral suasion, since it influences the expectations of the public and of the markets. The publication of the decisions of the policy committee, of the minutes of its meetings, and of its projections are all elements of the communication strategy.

The effectiveness of communication depends on the credibility of the central bank and on the clarity of its message. A credible central bank can influence expectations through its statements, which affects the behaviour of households and firms and thereby the economy.

The design of the communication strategy is a subject of research and of practice. The strategy must provide information that is useful to the public without creating confusion or unnecessary volatility in the markets.

Moral Suasion and Financial Stability

Moral suasion is used in the management of financial stability, where the authorities seek to influence the behaviour of financial institutions. The authorities may communicate their concerns about the build-up of risk and encourage institutions to take measures to strengthen their resilience.

The use of moral suasion in this context is complementary to the use of formal instruments, including the macroprudential measures that constrain the behaviour of institutions. The combination of communication and of formal measures is likely to be more effective than either alone.

The design of the framework must address the accountability of the authorities, since the use of informal pressure is less transparent than the use of formal rules. The framework must ensure that the use of moral suasion is subject to appropriate scrutiny.

Summary

Moral suasion is the use of persuasion and of informal pressure to influence the behaviour of institutions, and it is used in central banking, in supervision, and in the management of financial stability. Its effectiveness depends on the authority and the credibility of the institution that uses it.

See also

• Central Banking
• Monetary Economics
• Regulatory Arbitrage