Financial stability has become an increasingly important objective in economic policymaking during recent decades.
In the 1980s, direct regulation of credit markets and capital flows was dismantled in many countries. This prepared the ground for an expansion of the financial system at a faster pace than other parts of the economy. In this process, the financial system has undergone important structural changes and become more complex. The instruments have become more intricate, the activities more diversified and the risks more mobile. As a result of increasing cross-industry and cross-border integration, financial systems have also become more interwoven, both nationally and internationally (1).
In parallel with the strong growth of the financial system, we have seen more frequent instances of widespread financial distress. The resulting macroeconomic costs have often been sizeable. Financial crises have typically been associated with boom and bust cycles in asset prices and credit. Due to sharp growth in house prices and household debt in several countries in recent years, the question of whether monetary policy should be used to mitigate such developments has received increased attention.
In the light of these developments, I would like to address four main questions. What do we mean by financial stability, how do we analyse it, how do authorities cooperate in order to support it, and finally, what instruments are available to secure financial stability?
What do we mean by financial stability?
Despite increasing focus in recent decades, there is still uncertainty as to how best to define the concept 'financial stability'. (2)
In order for households and enterprises to obtain optimal consumption and investment over time there has to be a well-functioning financial system that can intermediate between savers and borrowers, carry out payments and redistribute risk in a satisfactory manner. This promotes an efficient allocation of real economic resources across different activities and over time. From this point of view, financial stability can be defined as a situation where the financial system is able to meet these requirements, and thereby enhance economic performance and wealth accumulation
A more narrow approach is to define financial stability in terms of what it is not, i.e. a situation in which financial instability impairs the real economy. This definition is more passive in terms of implying how one should act under normal circumstances, but has the advantage of focusing on the situations we attempt to avoid.
The latter definition is related to the high costs of financial instability in the last few decades. Costs in terms of loss of GDP can be substantial. As illustrated in Chart 1, a study of the economic costs of banking crises concluded that even though such crises have been less frequent in high-income countries than in low-income countries, they have persisted over a longer period and average total output losses have thus been higher. (3)
The preferred definition of financial stability varies from country to country. Recognising the need for a relevant operational definition regardless of the current situation in the financial system, Norges Bank has chosen to adopt the broad definition of financial stability.
How do the authorities analyse financial stability?
Given an understanding of what financial stability should imply, the authorities can analyse potential threats to financial stability. There are two complementary approaches:
In the first approach, we need to focus on risk factors originating within the financial system. Institutions, markets and infrastructures are continuously faced with risk factors such as credit, liquidity and market risks. Analyses have become even more challenging in recent years as the financial system has become more complex and interwoven across both industries and borders.
The increased complexity of the financial system is illustrated by the rapidly expanding market of credit derivatives. This is a relatively new financial instrument that comes in many and complex forms. While contributing positively to greater flexibility in risk management, there is also the possibility that risk is more easily concentrated, and that economic agents can take on risks without being fully aware of their ramifications.
When analysing risk originating inside the financial system, it may be useful to divide the approach into two areas. (4) The microprudential analysis focuses on developments within individual institutions, and is concerned with limiting the distress of individual institutions, thereby protecting depositors. The macroprudential analysis focuses on the financial system as a whole, and aims at limiting system-wide distress and avoiding output costs. An important concept here is systemic risk: the risk that liquidity or solvency problems in a bank may cause liquidity problems or insolvency in other institutions. Thus, correlation and common exposures across institutions are important in the macroprudential approach.
The second approach deals with risks originating from outside the financial system. This field has increasingly been recognised by researchers and policymakers in recent years. Strong growth in debt and asset prices, as well as macroeconomic disturbances like a surge in commodity prices or the unwinding of large imbalances in the world economy, can ultimately affect financial stability in a negative way.
To identify potential sources of instability, we need indicators that contain useful information. With an estimate of the equilibrium values of debt ratios or asset prices, for example, we can study the gap between their current value and their equilibrium value (5). If the gap is wide, the danger of a significant consolidation is present. However, the results must...