Financial Stability for Governments and Central Banks

Introduction

A critical analysis of recent research findings and existing literature on financial stability reveals that the issue of financial stability has attracted significant attention from policymakers and academics across the globe. The cause of the increased concern can be traced to the severe economic consequences associated with the financial crises that took place during the late 1990s and between 2007 and 2008. There are also the recent Eurozone sovereign debt upheavals (Acharya 2009). The various crises have shown that the economic, fiscal, and social costs of such events are significantly high. As such, it is important to develop and scrutinise the policies aimed at preventing the occurrence of such economic upheavals and instabilities.

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For example, as a result of the East Asia financial crises, the International Monetary Fund and the World Bank came up with several programs. One of them is the Financial Sector Assessment Program (FSAP). The policy was designed in 1999. Its aim was to evaluate the weaknesses and strengths of fiscal programs on a regular basis. In addition, there are other regulatory authorities that are often represented by central banks (Smets 2013). The authorities focus on differentiating the problems of financial stability from other issues associated with price and macroeconomic stabilities. The result is the setting up of financial stability departments that generate regular reports on financial stability with particular focus on evaluating the associated risks.

The objective of this study is to discuss the various aspects of financial stability. In addition, the importance of this stability to central banks and governments will be reviewed.

Financial Stability, Central Banks, and Governments

Financial Stability: In Search of a Definition

Overview

According to Anatolyevna and Ramilevna (2013), there is an increased focus and interest in financial stability. However, in spite of this focus, a universal definition of this term is lacking. Academicians and central banks offer their own approach in the interpretation of financial stability. Schinasi (2006, par. 8) observes that the term financial stability is associated with various definition difficulties. In addition, there are discrepancies in the measurement of this concept. The discrepancies notwithstanding, it is crucial to have a clear understanding of what financial stability entails. Such an understanding will help in the development of policy and operational frameworks required for the implementation of economic policies (Ferguson 2007, p. 8).

Anatolyevna and Ramilevna (2013, p. 857) identifies two approaches that are used in surveying the various concerns associated with financial stability. The perspectives are easily discernible. The first approach defines financial instability, while the second perspective attempts to conceptualise financial stability. According to the first approach, instability occurs when significant shocks on the financial system are seen to interfere with the flow of information (Acharya & Richardson 2009, par. 5). The upheavals make it hard for the financial systems to channel funds to the entities with productive investment opportunities (Ferguson 2007, p. 7). The definition lays emphasis on the intermediation task or role played by the financial system in delivering credit to the entities that need it. The approach also emphasises the importance of asymmetric information in instigating financial instability.

Financial instability

According to Cihak (2007, p. 13), financial instability and systemic risk are also defined as the escalated risk of financial turbulence. Consequently, a crisis in this respect is viewed as the collapse of financial systems. The collapse entails the inability of the financial systems to avail credit to the entities engaged in productive investment opportunities (Ferguson 2007, p. 18). It can further be argued that in most cases, financial crises have far-reaching and adverse effects on various aspects of economic activity. As such, fostering financial stability can be equated to managing the systemic risk (Ferguson 2007, p. 18). In their efforts to describe financial instability, Anatolyevna and Ramilevna (2013, p. 858) view the concept as a scenario that is characterised by three factors. To start with, the prices of some financial assets may diverge sharply from the norm. Alternatively, market forces may be distorted significantly (Ferguson 2007, p. 7). The distortion occurs with regards to the availability of credit in the domestic and international markets (Pouvelle 2012, par. 2). The result in such a scenario is that aggregate spending is most likely to deviate from the ability of the economic system to produce.

Financial Stability

The second approach entails an attempt to conceptualise financial stability. According to this perspective, stability occurs when fiscal systems can resist economic shocks (Smith & Egteren 2005, p. 161). The system includes the financial markets of institutional networks. As a result, the system can operate smoothly and meet its basic and intended functions. Such functions include the management of risks and intermediation of funds. It also entails the arrangement of disbursements (Smith & Egteren 2005, p. 161).

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According to Anatolyevna and Ramilevna (2013, p. 856), financial stability can be viewed as something that requires the strength of the key institutions within the system. The authors opine that the financial institution should demonstrate a high degree of confidence. In addition, it should be able to continuously meet its contractual obligations without impediments or seeking outside bailouts. Smets (2013, par. 3) observes that the key markets should be stable. In addition, investors should be able to trade in them with prices that are seen as reflecting the fundamental forces of the market (Cihak 2007, p. 17). Again, in the absence of significant changes to the fundamentals, the prices should not reflect any substantial fluctuations in the short term.

Some specific elements of the definition can be delineated. The conceptualisation takes into conceptualisation the periods within which the prices of assets have evidenced instability (Smets 2013, par. 7). In view of this consideration, it can be argued that financial stability can only exist when the system demonstrates the capacity to continue functioning normally without the need for outside assistance. It is noted that financial stability is achieved when there is monetary confidence. In such cases, investors have confidence in the key financial entities. In addition, there are no volatile price movements in real and financial commodities in the economy. Such shifts may undermine the aforementioned state of affairs (Acharya & Richardson 2009, p. 858).

The Importance of Financial Stability to Governments and Central Banks

Overview

The financial crisis that took place between 2007 and 2009 had substantial impacts on the global economy. The impacts included an increase in government debts, inflation, and high rates of unemployment (Pouvelle 2012, par. 3). Caprio (2012, p. 11) opines that the financial crisis made it apparent that price stability may not always lead to financial cohesiveness. Under such circumstances, financial stability exists when the system can withstand adverse shocks. The fiscal system can continue with its smooth operation in the intermediation process (Cihak 2007, p. 18). As a result, the importance of financial stability cannot be ignored. It is a major concern for central banks and policymakers working for governments and other entities around the world. It is important to understand this concept as a mitigating factor under significant disturbances to the financial intermediation process. Such a disruption could have severe impacts on the allocation of funds to profitable investment opportunities in the economy.

Acharya and Richardson (2009, p. 23) argue that upholding financial stability requires the identification of the sources of risk. It also calls for the identification of the various areas that are vulnerable to the disruptions. Such sources of risk may be characterised by inefficiencies and irregular allocation of financial resources. They may also entail the mismanagement of critical financial risks (Acharya & Richardson 2009, p. 33). The identification of vulnerabilities and risks is essential because the evaluation and monitoring of financial stability should be ‘forward-looking’. The inefficient allocation of capital and the shortcomings associated with the pricing and the management of risk can compromise the future of the financial system. In return, the situation may have far-reaching impacts on economic stability.

The importance of financial stability to central banks

One of the impacts of the current fiscal crisis is the renewed appreciation of the role of central banks in maintaining economic stability. Previously, most analysts and other stakeholders focused on conventional monetary concerns. Such concerns included the adjustment of interest rates as a way of controlling inflation (Pouvelle 2012, par. 8). After the crisis, the role of financial stability has become prominent. To start with, central banks assumed the critical role responding to the crisis through the provision of liquidity support. The support is provided to various entities. They include systems that are significantly affected by the fiscal predicament (Pouvelle 2012, par. 9). In other instances, the banks assume the responsibility of direct regulation in dealing with the affected entities. The central banks also play a significant role in shaping the post-crisis regulatory realities across the globe. As a result, it can be argued that financial stability is closely associated with the role of the central banks. It affects the ability to understand and monitor the fluidity of the institution with regards to its regulatory role. Such a move helps in forestalling the crisis that may emerge if the market forces are not managed properly (Acharya 2009, par. 2).

The importance of financial stability to governments

The importance of financial stability to the policymakers working for the various governments around the world cannot be understated. Caprio (2012, p. 32) points out that the analysts working for the central bank and the government need information on financial stability to formulate and put in place the appropriate instruments and tools required to safeguard the economy. Such tools include a wide range of essential regulatory requirements associated with risk management in the financial industry. They involve liquidity and capital standards. In most cases, such standards are referred to as structural prudential instruments (Caprio 2012, p. 22). The tools are meant to promote and support a robust financial system in the country.

It is also noted that policymakers are interested in exploiting the potential of the macro-prudential instruments that are used as targeting methods when responding to the evolving risks (Smith & Egteren 2005, p. 149). Examples of such tools include the maximisation of loan-to-valuation ratios. The maximisation is especially common in property lending. It is also used as a counter-cyclical capital buffer (Smith & Egteren 2005, p. 149). The view was highlighted in the Bassel 111 standards (Smith & Egteren 2005, p. 167). The standards were targeted at the general credit cycle. For example, in Australia, the APRA has taken a pro-active approach to market regulation. The entity ensures that the risks that may affect the banking sector are thoroughly understood and adequately managed in a timely manner (Anatolyevna & Ramilevna 2013, p. 857).

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According to Pouvelle (2012, par. 8), the key position that central banks occupy in the financial markets can be used to reveal early signs of monetary stress. To this end, reports on financial stability may provide information on the state of monetary distress among players in the market (Pouvelle 2012, par. 2). It is noted that reports and studies on financial stability are crucial to the function of central banks and governments. The information that can be used as early warning systems in the market. It can also be used to monitor and regulate the volatility and stability of the financial industry and the economy at large (Pouvelle 2012, par. 9).

Conclusion

In this paper, the author defined financial stability and instability. The paper also focused on how reports on financial stability can be used by central banks and governments to manage the economy. Financial stability is viewed as the state where the fiscal system can withstand fluctuations in the market. Such systems include financial markets and systems. The system can withstand the shocks and continue to play the roles it is designed for. Ultimately, what is important is how policies touching on financial stability are implemented by the stakeholders concerned. In most cases, that role remains under the auspices of the central banks and other regulatory agencies established by the government.

References

Acharya, V 2009, A theory of systemic risk and design of prudential bank regulation, Web.

Acharya, V & Richardson, M 2009, Restoring financial stability: how to repair a failed system, John Wiley & Sons, New York.

Anatolyevna, M & Ramilevna, S 2013, ‘Financial stability concept: main characteristics and tools’, World Applied Sciences Journal, vol. 22, no. 6, pp. 856-858.

Caprio, G 2012, Handbook of safeguarding global financial stability: political, social, cultural, and economic theories and models, Academic Press, Madrid.

Cihak, M 2007, ‘Systemic loss: a measure of financial stability’, Czech Journal of Economics and Finance, vol. 57, no. 2, pp. 5-26.

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Ferguson, R 2007, International financial stability, Centre for Economic Policy Research, Geneva.

Pouvelle, C 2012, Bank credit, asset prices and financial stability: evidence from French banks, Web.

Schinasi, G 2006, Safeguarding financial stability: theory and practice, Web.

Smets, F 2013, Financial stability and monetary policy: how closely interlinked?, Web.

Smith, T & Egteren, H 2005, ‘Interest rate smoothing and financial stability’, Review of Financial Economics, vol. 14, no. 2, pp. 147-171.

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