RISKS TO FINANCIAL STABILITY | CENTAL BANKING NOTES
In this post, we will go in detail to the meaning of Financial Stability & the risks related to it for the preparation of the Central Banking paper of CAIIB 2023.
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Now let us begin with our topic:
RISKS TO FINANCIAL STABILITY
Let’s start with definition of Financial stability: a state in which the financial system is not unstable.
It can also mean a state in which the 3 components of the financial system:
- financial institutions,
- financial markets, and
- financial infrastructure
are, in fact, stable.
Let’s go to the specifics:
Stability of financial institutions:
a state where individual financial institutions are healthy enough to adequately perform their function of financial intermediation, without the help of external institutions, including the government.
Stability of financial markets:
a state in which there is no fundamental disruption of market transactions, without a significant deviation of financial asset prices from economic fundamentals, which allows economic entities to obtain and operate funds with confidence.
Financial infrastructure stability:
a state where the financial system is well structured to ensure the smooth functioning of market discipline and where both the financial safety net and the payment and settlement system are functioning effectively.
So, Financial stability can be more broadly said as a state in which the financial system can smoothly facilitate real economic activities and is able to unravel financial imbalances arising from shocks.
And why is financial stability important, you ask?
Financial stability is a prerequisite not only for:
- price stability,
- the goal of the central bank’s policy,
but also for:
- the healthy development of the economy.
All because financial instability carries high costs for the economy, as the volatility of price variables in financial markets increases and financial institutions or corporations may fail. In addition, economic development can be limited at such a time, as economic subjects find it difficult to make rational decisions and the efficiency of resource allocation decreases.
Since the 1980s, many countries have experienced the positive effects of rapid growth in the financial industry due to the progress of financial liberalization but they also experienced periods of dramatic slowdown in economic growth as a result of high economic spending resulting from financial instability or financial crises.
In this context, countries have begun to place great emphasis on financial stability in the implementation of their policies which includes the strengthening of financial sector linkages between countries and the rampant development of complex financial instruments.
So, let us talk about the solid reasons for why Financial Stability is important:
Maintaining financial stability is an integral part of the central bank’s role
When the financial system becomes unstable, such as when financial markets are in turmoil and the health of financial institutions deteriorates, a massive infusion of funds is generally required to resolve the problem.
Therefore, the central bank has naturally fulfilled the role of promoting financial stability because it has the ability to quickly inject huge amounts of liquidity.
Financial stability Increases the effectiveness of the central bank’s monetary policy
The financial system provides much of the information that a central bank needs to implement its monetary policy. It is also the main channel through which the effects of monetary policy are transmitted to the real economy.
- Instability in the financial system causes:
- a decline in the utility of information variables used for monetary policy,
- including price variables and
- movements in financial market transactions,
- and the lending behavior of financial institutions,
- thereby reducing the effectiveness of policy.
The Central Bank therefore places great emphasis on financial stability in order to increase the effectiveness of its monetary policy.
The central bank has a comparative advantage in analyzing the stability of the financial system
The factors causing shocks and the shock transmission paths have become diversified and complex, influenced by the great strengthening of linkages between domestic and overseas financial markets and between financial markets and financial institutions following the progress of financial liberalization and globalization.
In this context, it is necessary not only to analyze the stability of individual financial institutions and individual financial markets, but also to evaluate the stability from the point of view of the overall financial system, taking into account: the domestic and overseas macroeconomic environment.
The central bank is suitable for this need because it has a comparative advantage in analyzing the stability of the financial system. In particular, macro analysis of the entire financial system is considered a fundamental basis for ensuring financial stability.
The central bank seeks to ensure financial stability through the efficient functioning of payment and settlement systems
Financial stability can be maintained by ensuring trouble-free payment and settlement between individual economic entities. This is because failure to make a timely payment or settlement by a particular economic entity can cause delay or paralysis of the entire payment and settlement system, thereby disrupting the financial system as a whole. In view of this, the central bank tries to ensure financial stability by effectively operating and monitoring payment and settlement systems.
Now, what could lead to Financial instability, or what are the risks to Financial Stability?
Liquidity is referred to as the short-term solvency of companies.
Commercial banks are required to hold sufficient liquid assets that can be easily converted into cash. While the company’s inability to meet its short-term obligations fueled liquidity risk.
A study revealed that during the 2008 financial disaster, banks with liquidity risk faced financial instability and affected other banks as well as the economy while another study revealed that “liquidity creation enhances bank stability”. In addition, many studies find a significant negative effect of liquidity risk on the financial stability of banks
Credit risk refers to the possibility of a bank borrower failing to pay its obligations as agreed. If the borrower defaults, the level of credit risk for financial institutions increases, resulting in lower profits.
Numerous studies that have focused on investigating the effect of credit risk on bank stability – have found mixed results & in many among them it has been found that credit risk reduces the stability of banks.
It can be defined as “the probability that a rural bank’s deposit mobilization strategies will fail, or the probability that depositors of a rural bank will withdraw their deposits, leading to deterioration of the bank’s deposits, forcing it to decline. on capital sources of financing”.
In as study, it was revealed that funding risk positively affects the financial stability of banks & further – that if the bank demonstrates a long-term strategy of using deposits, it has a better chance of being stable than its competitors.
So, we understood that liquidity risk and credit risk have a significant negative effect on the financial stability of commercial banks while funding risk does not have a significant impact on stability.
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