Financial stability: what it is and why it matters.(Financial Services)(Report)

Financial stability in general has been a concern of public sector entities for many years. (1) But what is meant by macro-financial stability? Why is it important? Why is the term being used much more frequently? Can we measure it or model it for predictive purposes? What is the role of the central bank and other government agencies in bringing about financial stability? What are the implications for the private sector? What are the links to monetary stability?

As central banks continue to monitor and respond to tightened credit markets stemming from problems in the asset-backed commercial paper market, these questions are timely. Set against the financial crises of the last few decades and the challenges posed by such factors as the increased volume and complexity of financial transactions, they take on broader significance.

This paper examines these and other questions with a view to clarifying current challenges to financial stability and the roles that central banks, other public sector agencies and private sector entities can appropriately play in pursuing it. In the next sections of the Commentary, we look at the definition of macro-financial stability, then discuss why we should care about it. We examine the factors behind the increased attention being paid to macro-financial stability and focus on issues related to its measurement and modelling. Then we look at the role of central banks and other public agencies as they try to achieve and maintain financial stability, and discuss in more detail the activities of central banks in promoting macro-financial stability, including the publication of financial stability reports that address the potential issues affecting macro-financial stability. We discuss how the analysis of macro-financial stability could be used by the private sector; in particular, in what way financial stability reports can help the decision making of those working in financial institutions and financial markets. Finally, we focus on the possible links between monetary stability and financial stability, and offer some concluding remarks. (2)

What Is Macro-Financial Stability?

The issue of how financial stability should be defined has been the subject of debate for some years (3) and remains an open question. Unlike the definition of monetary stability, on which there seems to be broad agreement, a widely accepted definition of financial stability seems to be some way off. British economist and former Bank of England Monetary Policy Committee member Charles Goodhart (2004) wrote that, "There is currently no good way to define ... financial stability." Goodhart further noted that when a group of experts was asked to define the term, "the most persuasive responses were that it was just the absence of financial instability." The financial stability reports (FSRs) of some central banks offer a definition of the term, (4) while others do not give an explicit definition but describe the circumstances that can arise and cause concern. (5)

Andrew Crockett (2000), a former executive director of the Bank of England and former head of the Bank for International Settlements (BIS), argues that financial stability has two dimensions--micro-prudential and macro-prudential. He suggests that the macro-prudential objective is to "limit the costs to the economy from financial distress, including those that arise from any moral hazard induced by policies pursued [by governments or their agents]." This could be thought of as limiting systemic risk and would involve minimizing the likelihood, and the associated costs, of the failure of significant parts of the financial system.

The micro-prudential objective involves "the limiting of the likelihood of failure of individual institutions" (or limiting idiosyncratic risk). While one can argue that crises are the most readily identifiable aspect of financial instability, focusing on crises does not allow for different degrees of financial instability (6) or for changes in the source or nature of financial instability over time and in different countries.