Creating a stable financial environment

Abstract

Monetary and financial stability are of central importance to the effective functioning of a market economy. Stability in the financial sector improves the climate for channelling savings to investment and promotes the efficiency of the payment system. Disruptions in the financial sector can have severe adverse effects on economic activity and even on political structures. Maintaining stability is therefore the key objective of the financial authorities. Financial stability has been defined as a condition where the financial system is able to withstand shocks without giving way to cumulative processes that impair the allocation of savings to investment and the processing of payments in the economy. Severe financial instability, worse still a crisis, can be very costly. Output and growth opportunities are foregone. Severe financial distress can numb the effectiveness of standard macroeconomic tools, such as monetary and fiscal policies. The very social fabric of society can also come under strain as the experience of a number of emerging market economies attests. Over the past twenty years various countries experienced a banking crisis, with average costs ranging between 15% and 25% of GDP. Countries affected included developed, transitional and developing countries alike. A crisis can hit a country irrespective of the size of its economy. The fiscal costs of a crisis in emerging market economies tend to be higher than those in developed countries, although a crisis in a large economy normally has a higher financial impact and/or a contagion effect on other countries. Therefore, the latter would be more of a threat to global financial stability. Higher interest rates, deterioration in banks’ balance sheets, stock market declines and increases in uncertainty are among the factors that bring about financial instability. If all of these factors occur at the same time, and are substantial, the situation is likely to escalate into a full-scale financial crisis, with the consequent negative effects on the real economy.