Module A: Introduction to financial stability

Executive summary

Available to registered (free) and logged in members – The Financial Regulation Forum is, essentially, a membership site

{+}

An overview of this module is provided in the slideshow. This summary is intended for management to Keep Abreast of … and for those familiar with this topic the overview will  provide a review.

For a more in-depth discussion see the article which is provided in different formats.

Article

• HTML version

What is financial stability?

Financial stability can be defined as a condition in which the financial system is capable of withstanding shocks, thereby reducing the likelihood of disruptions in the financial intermediation process which are severe enough to significantly impair the allocation of savings to profitable investment opportunities.

The financial system can be said to be stable if it displays the following three key characteristics:

1. The financial system should be able to efficiently and smoothly transfer resources from savers to investors.
2. Financial risks should be assessed and priced reasonably accurately and should also be relatively well managed.
3. The financial system should be in such a condition that it can comfortably absorb financial and real economic surprises and shocks.

If any one or a combination of these characteristics is not being maintained, then it is likely that the financial system is moving in a direction of becoming less stable, and at some point might exhibit instability.

Understood this way, the safeguarding of financial stability requires identifying the main sources of risk and vulnerability such as inefficiencies in the allocation of financial resources from savers to investors and the mis-pricing or mismanagement of financial risks. This identification of risks and vulnerabilities is necessary because the monitoring of financial stability must be forward looking: inefficiencies in the allocation of capital or shortcomings in the pricing and management of risk can, if they lay the foundations for vulnerabilities, compromise future financial system stability and therefore economic stability.

Increasingly, in many countries, the central bank has a mandate to maintain and enhance the stability of their financial systems. In contrast to price stability where central bank tenets are widely accepted, there is no consensus on how best to define and preserve financial stability, partly because it cannot readily be modelled or forecast.

Macro- and micro-prudential regulation should be carried out by separate institutions since they differ in focus and expertise required. Central banks should be tasked with macro-prudential regulation (i.e. system-wide), financial services regulators with micro-prudential regulation (i.e. bank-level). Improved international coordination is also important. Since financial and asset-price cycles differ from country to country, counter-cyclical regulatory policy needs to be implemented mainly by the “host” rather than the “home” country.

Over the past decade, whilst the increasingly international and adaptive nature of financial markets has brought benefits to economies around the world, it has also led to increasing domestic and global imbalances and significantly increased the risk of disruption and spillover across markets and regions, which materialised over the past two years. As a result, financial stability policy has developed into a broader and much more challenging area of public policy. The global financial crisis has also shed light on some weaknesses in the financial stability frameworks put in place around the world, and new arrangements and policies are being developed to strengthen the resilience of financial systems domestically and internationally.

Currently, central banks usually perform their mandate through risk assessment and risk reduction work, market intelligence functions, payments systems oversight, banking and market operations, including, in exceptional circumstances by acting as lender of last resort, and resolution work to deal with distressed banks.

For emerging market countries, where the surge in capital inflows has led to fears of inflation and asset price bubbles, a pragmatic approach using a combination of macroeconomic and prudential financial policies is advisable.

The role of financial stability in the financial system

Financial stability plays a crucial role in the financial system and in the economy as a whole, as the recent crisis has shown.

People need to have confidence that the system is safe and stable, and functions properly to provide critical services to the wider economy. It is important that problems in particular areas do not lead to disruption across the financial system.

With an increasing number of financial institutions now active in one or more countries or continents, global financial stability has become even more important.

Click to enlarge

The financial system consists of:

• Financial markets, such as the money markets and capital markets. They channel excess funds from lenders, i.e. businesses or individuals who want to invest their money, to borrowers, i.e. those who need capital.
• Financial intermediaries, such as banks and insurance companies. They indirectly bring lenders and borrowers together – but borrowers can also obtain funds directly from financial markets by issuing securities, e.g. shares and bonds;
• Financial infrastructure, which permits the transfer of payments as well as the trading, clearing and settlement of securities.

To protect the financial system and ensure financial stability, the main sources of risk and vulnerability must be identified and all relevant parties, such as financial institutions and supervisors, be made aware of the risks.

Typical risks

• The economy slows down, making it more difficult for businesses to repay their loans (due to falling sales) or households to repay their mortgages (due to unemployment), and the banks then incur losses.
• The prices of assets, e.g. securities, land and buildings or production equipment fall or change abruptly and create uncertainty on the financial markets, with the result that investors lose money.
• Banks may make big loans to a specific industry and then find they are vulnerable to any downturns in that industry.
• Banks may make large-scale investments in, for example, the stock or bond markets and they can then become vulnerable to falling prices in those markets.

Lines of defence

Banks, insurance companies and other financial institutions form the first line of defence against financial crises. It’s their responsibility to remain viable and solvent, and to check the creditworthiness of borrowers and thus to manage the risks they assume.

The measures taken by public authorities to prevent or minimise financial crises constitute the second line of defence. The measures include:

1. prudential regulations that financial institutions have to comply with in order to ensure effective risk management and the safety of depositors’ funds, and to disclose information so as to promote market discipline;
2. prudential supervision, which means making sure that financial institutions follow these rules; and
3. financial stability monitoring and assessment, which identifies vulnerable points in and risks to the financial system as a whole.

If, despite all these measures, financial institutions run into trouble, public authorities may need to intervene.

*** Sorry, further access is restricted to the Administrator and course authors ***
*** Capacity building content being created or updated ***

{++++}

• HTML version
• PDF version
• Audio version

Worksheet/Quiz

There is no worksheet or quiz for this module.

Useful links

© 2012 The Financial Regulation Forum. All Rights Reserved.