Financial Stability and Central Banks

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Table of Contents

Introduction
Financial Stability and Threats
Monitoring and Measuring Threats to Financial Stability
The Effectiveness of Central Banks in Risk Monitoring
Conclusion
Reference List

Introduction

Financial stability can be listed among the key factors that define the degree to which particular organisations or countries in general are developed. Speaking about financial stability, it is necessary to pay focused attention to the fact that economic systems are extremely sensitive to social and political changes. Therefore, all significant changes that relate to the way that any society is governed have immediate consequences that can include financial instability as well.

When it comes to financial stability, this term is used in order to define the condition of economic systems (that can be presented by companies of the entire countries) that involves as few cases when the latter are unable to operate properly as possible. To put it in other words, financial stability is related to the ability of a financial system to provide companies that constitute various branches of economic activity with enough economic resources to operate properly.

Financial Stability and Threats

The ways that financial systems and their official representatives react to temporary difficulties is also extremely important when it comes to financial stability. Thus, a stable system will always have a few mechanisms helping to prevent the negative impact of unexpected events that relate to natural resources or human resources on the entire nation. If a financial system of a country is stable, it is able to perform its key functions on a regular basis, and the impact of factors that prevent the transformation of household savings into investment is eliminated (Agbloyor et al. 2014).

The key threats to financial stability on a national level relate to the insufficiency of primary capital that banks possess. This threat to the stability of national financial systems is extremely important as those banks that do not have enough assets are unable to operate in an effective manner in case of financial damages. To some extent, a lack of financial resources can be caused by the changing attitudes of the population towards banks and the power that they have.

Another threat to financial stability that needs to be mentioned is related to the current liquidity mismatch risks. It is known that assets that banks can use are not the same in terms of their liquidity, and the significant imbalance between different types of assets that are available to banks in different countries can act as a factor that poses a threat to financial stability. Among liquid assets that banks can use to support their operations, there are precious metals that are often considered as the most reliable type of assets. In addition, liquid assets include money in cash, financial credit documents, traveler’s cheques, the available balance on accounts, short deposits, and short-term government securities (De Angelo & Stulz 2015).

In reference to illiquid assets that banks in all countries have, they can include non-performing loans, buildings, and other types of physical property (Simic, Lauenstein & Prigge 2016). In some situations, banks are urged to liquidate some of their assets to conduct necessary operations, and the imbalance between illiquid and liquid assets can pose a serious threat to financial stability.

Apart from the assets that banks possess and use, there are numerous threats to financial stability that are caused by the relationships between banks and their savers. In fact, specialists from professional financial institutions and common citizens who want to find the safest place where their money can be kept are not equal. They are unequal in terms of the access to information that helps to critically evaluate the position of banks to determine the reliability of banks. The latter can be defined based on reliability ratings of the particular organisations, their structure, and shareholders (Jain, Keneley & Thomson 2014).

Considering that many people have limited access to information concerning difficulties that banking organisations have or they are unable to interpret such information, there is a significant threat of a mass panic of savers due to the dissemination of untrustworthy information that encourages savers to make premature decisions concerning their bank accounts (Caporale & Plastun 2017). It is clear from the example that this threat emerges due to a lack of trust towards banks. Central banks of different countries are to mitigate the threat by providing citizens with the most recent financial information and urging other banks to ensure the security of people’s money.

Another significant threat to financial stability of a country is the fragility that is caused by the irrational growth of investment prices. The latter also causes a financial misbalance as numerous assets become overpriced from time to time. The latter poses a significant threat to financial stability due to the presence of the so-called asset price bubbles that involve the rapid escalation of asset prices (Jarrow 2015). The formation of such cycles is inherent in the behavior of investors who start buying more assets that become more expensive in order to get a financial advantage.

Continuing on the topic of financial stability, it needs to be said that the degree to which financial institutions report the most recent data on their operations and possible threats acts as an important risk to financial stability of any country (Oesterreichische Nationalbank 2005). The quality of information reported by banks is not always monitored by those organisations responsible for the task.

Due to that, people who would like to assess risks that the collaboration with different companies involves have to make decisions based on scarce information that is publicly available. At the same time, it is clear that financial stability can be maintained when all companies in a country operate and report on the results of their work based, following the same rules. To put it in other words, the necessity to strictly follow certain rules deprives organisations of an opportunity to conduct operations that involve enormous risks. Nevertheless, the tendencies that involve the lessening of regulations that all organisations must comply with has an impact on the global economic system.

If the process is too fast, it can involve negative consequences for economic systems in different countries. The process of financial liberalisation can cause instability due to the fact the influence of foreign banks can become stronger (Cubillas & González 2014). On the one hand, there are opinions that the presence of foreign banks does not have a significant impact on financial stability; instead, it is believed to mitigate certain financial threats. On the other hand, it increases the authority of foreign banks which has a range of long-term consequences. Thus, there is a wide range of factors that can cause risks to financial stability of a country. Being connected to various aspects of the economic life of the society, managing these risks requires a number of approaches to monitoring to be implemented by central banks.

Monitoring and Measuring Threats to Financial Stability

Considering that the threats to the financial stability of national economic systems are numerous, there are special institutions that are responsible for monitoring and measuring threats that exist to financial stability in their countries. Any central bank is an institution that is allowed to control the distribution of money to ensure financial stability. There is a large number of risks that can threaten the economic position of people from different social groups, and the analysis of macro-prudential factors is often used by specialists from central banks to conduct an effective risk assessment (Hawkesby 2000).

Unlike factors that have an impact on particular financial organisations, macro-prudential factors do not refer to those threats that exist only for a limited number of individuals (for instance, the customers of a particular organisation). Instead, they help to identify risks that exist for an entire system. The range of macro-prudential factors that allow central banks to conduct an in-depth study of current financial situation is usually reflected in financial stability reports provided by central banks.

The factors that are taken into account refer to the adequacy of assets, their quality and asset-related risks, the current number of financial organisations, return on average assets, possible risks related to unstable loan rates and average earnings (Ryan 2017). Prior to the global financial crisis that took place ten years ago, the central banks of some countries did not have a right to use these tools to assess the risks of instability as there were special agencies responsible for prudential analysis and supervision (Vazquez & Federico 2015). Nevertheless, after the global crisis, more countries started utilising the model in which central banks supervise financial sector and monitor threats that exist for the entire system.

The Effectiveness of Central Banks in Risk Monitoring

Nowadays, there is a diversity of opinions concerning the necessity to enable central banks in different countries to monitor and analyse potential threats to financial stability. As specialists from the European Central Bank indicate, central banks take an active part in conducting prudential analysis in the majority of countries of the eurozone, and the effectiveness of this approach is often questioned even though the practices that central banks utilise are usually effective (European Central Bank n.d.).

There are some countries that refused to let their central banks conduct prudential analysis even though numerous countries implemented such changes after the global financial crisis. For instance, the authorities in Belgium decided to enable their central bank to monitor threats to financial stability and introduce numerous organisational changes to the latter in order to avoid overlapping of work duties and make the results of regular prudential analysis more effective. There are a number of researchers who claim that enabling central banks to monitor risks using macro-prudential indicators presents an appropriate decision.

For instance, it is believed that the access of specialists from central banks of different countries to sensitive information concerning the state of the entire financial system helps the latter to use more evidence to propose effective changes to monetary policy. Apart from that, the analysis of macro-prudential factors conducted by specialists from central banks is very likely to be accurate and thorough due to the interest of the latter in gaining objective data on possible risks. In case of a financial crisis, the operations of any central bank will be affected, and this is why the access of central banks to such data can have a positive impact on the implementation of financial policies.

The particular sets of indicators used for risk analysis are not the same for different countries; for instance, central banks in some developing countries such as India use the CAMELS Model that includes assessing risk sensitivity (Chakrabarti 2015). As the experience of many countries indicates, the decision to provide central banks with an opportunity to monitor risks can provide positive results for countries with both developing and developed economies.

In terms of possible improvements, it needs to be said that the framework for risk assessment to maintain financial stability in a particular country should be based on the needs of a country and specific threats related to the degree of its economic development. This approach has already been implemented by authorities in some countries. For instance, “Nepal and Kenya use the CAEL Model” that involves assessing only the capital, earnings, assets, and liquidity (Chakrabarti 2015, p. 2141). Thus, the common model helping to conduct a prudential analysis sometimes needs to be adjusted to produce better results.

Conclusion

In the end, the central banks of many countries play a pivotal role in monitoring and assessing external and internal threats to financial stability. Nowadays, central banks use special macro-prudential indicators in order to identify and assess risks that exist for the financial sectors of their countries’ economies. Even though there is a common model that helps to monitor threats, some countries implement changes to this model based on their current levels of economic development.

Reference List

Agbloyor, EK, Abor, JY, Adjasi, CKD & Yawson, A 2014, ‘Private capital flows and economic growth in Africa: the role of domestic financial markets’, Journal of International Financial Markets, Institutions and Money, vol. 30, pp.137-152.

Caporale, GM & Plastun, A 2017, ‘Price gaps: another market anomaly’, Investment Analysts Journal, vol. 46, no. 4, pp. 279-293.

Chakrabarti, M 2015, ‘Risk analysis and management in Indian banking sector: An overview’, International Journal of Informative & Futuristic Research, vol. 2, no. 7, pp.2133-2143.

Cubillas, E & González, F 2014, ‘Financial liberalization and bank risk-taking: international evidence’, Journal of Financial Stability, vol. 11, pp. 32-48.

De Angelo, H & Stulz, RM 2015, ‘Liquid-claim production, risk management, and bank capital structure: why high leverage is optimal for banks’, Journal of Financial Economics, vol. 116, no. 2, pp. 219-236.

European Central Bank n.d. The role of central banks in prudential supervision. Web.

Hawkesby, C 2000, ‘Maintaining financial system stability: the role of macro-prudential indicators’, Reserve Bank of New Zealand Bulletin, vol. 63, no. 2, pp. 38-52.

Jain, A, Keneley, M & Thomson, D 2014, ‘Bank reputation in Australia: a view from the inside’, JASSA, no. 2, p. 31.

Jarrow, RA 2015, ‘Asset price bubbles’, Annual Review of Financial Economics, vol. 7, pp. 201-218.

Oesterreichische Nationalbank 2005. Financial stability report. Web.

Ryan, E 2017, ‘The role of macroprudential indicators in monitoring systemic risk and setting policy’, Quarterly Bulletin Articles, pp. 62-80.

Simic, AK, Lauenstein, P & Prigge, S 2016, ‘Valuation efficiency of secondary markets for formerly illiquid assets: the case of German KG Ship Funds’, Multinational Finance Journal, vol. 20, no. 2, pp.127-179.

Vazquez, F & Federico, P 2015, ‘Bank funding structures and risk: evidence from the global financial crisis’, Journal of Banking & Finance, vol. 61, pp.1-14.

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