With the rapid development and sophistication of financial systems, governments discovered a necessity for a financial institution that would address such an issue. The solution was found in the creation of a central bank or reserve bank that would stand as the monetary authority on the territory of a given country. Bank of Amsterdam that was founded in 1609 and served as a transaction manager between countries, issuer of reserve currency, and bank guilder. Since that time, Central banks developed and became even more powerful instruments used by governments to monitor and stabilize a county’s financial system. Nowadays, reserve banks are the major financial regulators in a country. They function to uphold stability and adequate functioning of the financial system of the whole nation (Mohanty 2014). To develop a firm knowledge about the operation of a country’s financial system it is paramount to research into the methods central banks use to analyse and monitor threats to financial stability.
Financial Stability: Definition, Threats
To form a comprehensive understanding of a central bank’s position in ensuring financial stability there is a need to define that key term. According to Schinasi (2004) Financial stability is a characteristic of the financial system’s status within a country or a region. Such state can be defined through a set of qualities it should possess. Previously, a stable financial system was defined as an environment without financial crises. Later, under the influence of public discussions and events of the world economy, the definition of financial stability has evolved into a more complex concept. To the present time, certain features of financial stability can be defined. Firstly, a stable system must faultlessly and effectively fulfil its duties, including transformation of savings into investments (Adrian, Covitz & Liang 2015). Secondly, stability is defined through resistance to various shocks, including constrained supply, technological developments, inflation, natural disasters and other types of shock. Finally, a sound financial system should produce a positive effect on a non-financial sector of economy. Financial stability also seems to contribute to the development of human potential through raising welfare of citizens in a country. Ensuring security of a financial system is the main priority and a central task of a central bank.
There is a variety of factors that can undermine financial stability of a country. One of them is a general loss of trust towards key financial institutions. This may manifest through failure of major banks operating on the territory of a country with a large number of clients. Such occurrences divert public from using banking services and generate major distrust to financial institutions that greatly impedes credit operations and financial intermediation (Hawkesby 2000). Major disruptions in payment systems can also seriously undermine financial system operation, as transactions cannot be established and secure bank transfers force parties to seek alternative and less convenient options, which results in financial loses and leads to further instability.
It is pivotal to stress, however, that these stand-alone events should be of enough magnitude to cause significant instability and invoke long-term disruptive consequences. It also depends on the ability of the government to manage shocks and mitigate negative consequences of such nature. Other factors can undermine financial stability. Among them is a decrease in capital base. This is indicated by the ability of banks to manage their assets and liabilities. When banks do not have much capital upon request, this could signify financial stability issues. Since most of the bank’s assets are comprised of their clients’ funds, a shortage of capital often means lack of trust or lack of finances in organizations and public. Liquidity shortage in banks as another risk for financial stability is similar to small capital base. If managed improperly, liquidity liabilities could outweigh assets and could lead to collapse.
Lack of information on reliability between financial institutions and major depositors could incur chaos and uncontrollable withdrawal of funds, which further destabilizes financial system. When it becomes challenging to predict whether a bank is reliable and can repay its clients in full, many clients tend to withdraw quickly. Inadequate or infective daily risk managing could also pose a problem for stability. Every day banks encounter risks in connection with legal issues, interest rates, currency exchange, credit, and other sorts of threats. Systematic failure to address them undermines stable functioning of a bank and the system. A long period of stability paradoxical as it may seem can also become a source of threat for financial system. Steady environment often causes financial institutions to relax, forget about risks and become overconfident in targeting profits, which may again lead to disturbances of sufficient magnitude to cause instability.
Irrational behavior on financial markets is another major concern for stability. Inability of players to trade their assets based on the fundamental factors that determine their value and thoughtless mass copying of trading strategies could result in the creation of a large portion of flat assets. This is what market analysts and financial dealers call a price bubble. Financial liberalization and low entry threshold in its way could invoke financial trouble for the system. Growing family incomes in conjunction with low financial literacy may create a massive amount speculation and ill-advised depositions, which, if backfire, may create panic and chaos on the market. It is often the case when market players trade ‘expectations’ placing their trust in the authority of a reliable institution. In a globalized world, where news travel with the speed of light, any slight notion of a problem within such institution often causes a negative reaction in the form of withdrawal of funds. The ability of major players to differ major risks from smaller ones is sometimes what keeps the whole system together.
Lack of supervision or excessive scrutiny of the banking sector could also become a barrier on the path to stability (Houben, Kakes & Schinasi 2004). The former may lead to lower levels of required capitalization, information disclosure, and other negative side-effects. The latter could result in lower responsibility that develops from overly controlling and directive style of management. Inaccurate macroeconomic policy also contributes to instability. Excessively liberal monetary policy encourages market speculation and asset devaluation, while overly restrictive one could incur insufficient credit accessibility and lower domestic demand.
The list of possible threats to the financial stability of a country could continue even further as possible threats are near limitless. This once more stresses the frailty and vulnerability of the financial system. Most of the risks are connected and present a need for assessment as a complex system. It also indicates that there is a need for continuous monitoring and management of all possible threats that are currently the task entrusted to central banks.
Central Banks as Guarantors of Financial Stability
Central or reserve banks serve as main financial institutions that observe monetary policy in the country and regulate bank and market activity being able to interfere with almost any financial policy in the country. Despite the wide range of functions, central banks need to carefully weigh every intervention as overregulation also has its costs discussed above. Reserve banks also need to be proactive to address the negative trends that, if left unattended, could lead to major breakdowns in the system. Maintaining that balance between intervention and non-intervention is crucial for financial stability. To achieve it central bank needs a continuous analysis of the financial system that allows identifying threats and elaborating ways to address it (International Monetary Fund 2005).
To be able to stay fully cognizant of a current situation in various branches of economy and finance central banks need to possess the latest information about the key financial indicators. To have that information they require domestic and foreign banks on the territory of a country to submit financial reports that include the information on capital movement, available liquidity, assets and liabilities ratio, capitalization, and other data. Such reports are to be submitted with various periodicity. The US Federal Deposit Insurance Corporation distinguishes consolidated reports of condition and income, also known as “call reports” that are submitted quarterly and Summary of Deposits that are annual documents (Federal Deposit Insurance Corporation 2016). From analysing those documents, central bank understands whether a financial institution is sound enough to continue sole operation or intervention is needed.
Supervision of financial markets is equally important as their collapse not once was proved a threat to financial stability. As far as the array of tools is concerned, Bank of England, for example, monitors financial markets using certain indicators such as bank share prices, bid-offer spreads, credit ratings, market volumes and other measures (Hawkesby 2000). Prices of bank shares are essential to estimate their future potency to gain profit. A falling price of those shares might indicate a lack of trust to a single institution or the whole banking sector (BCBS 2012). Central banks are monitoring the width of the spread between buying and selling price of securities to ascertain whether the situation may become unstable. In this case, an unusually wide spread can become a concern. Credit rating might indicate a level of trust towards an institution from its clients. However, it has become too unstable and volatile nowadays due to easy spread of unreasonable panic inflated by the news (Bank of England 2017). Market volume is another assessment criterion that may exhibit substantial fluctuations during the periods of instability. A stable market volume could signify a stable financial situation on the market and in the financial system.
Assessment of potential threats can also be executed in the macroeconomic domain. Typical indicators of financial stability that central banks usually monitor here include credit growth, capital flows, debt levels, external liabilities, real interest rates, and other factors. Credit growth allows monitoring the threat of lending and borrowing in the aspect of the reliability of the parties that initiate these processes (Dell 2012). Debt levels are deeply connected to credit growth and indicate the possible concern for future crisis if liabilities fail to be honoured due to inadequate liability-income ratio. High external debt that is disproportionate to funds available to service it may have negative implications for the stability of financial system, as international loans become an impossibility (Gropp, Duca & Jukka 2009). High real Interest rates may provoke foreign loans in countries with lower rates, which places a burden on domestic currency having to service these loans.
Monitoring Effectiveness and Possibilities for Improvement
The main task of monitoring of the reserve banks was never a prevention of crises as it is nearly impossible but mitigation of consequences. The effectiveness of monitoring can be viewed by the application of its mechanisms regarding to the latter. Judging by the latest data on qualitative easing application by the Bank of England, the results were profitable (Joyce, Tong & Woods 2011). This may indicate that central bank of the United Kingdom is effective at its tasks as a major regulator and a guarantor of financial stability in the country (Murphy & Senior 2013). However, financial system constantly evolves and changes, which means central banks need to follow. Nowadays, cryptocurrencies present a challenge for the world economy. Since its issue, cover, and transaction is beyond jurisdiction of any nation, central banks should develop new methods and criteria of impact of cryptocurrency on national financial stability.
All things considered, central or reserve banks serve as stabilizing agents of their countries’ financial systems and defend them against threats. To be able to adequately react to challenges and enact appropriate defense mechanisms central banks need to continuously assess and monitor financial system for threats. These threats are numerous and include a wide range of banking-related, macroeconomic, and financial market threats that, if gain sufficient magnitude, could wreak havoc on financial system, banks, organizations and common people. For the purposes of timely identification of those threats, central banks utilize various assessment methods and monitor banks that perform on the territory of their countries, evaluate key macroeconomic performance indices, and pay close attention to major players on the financial markets. When the UK is concerned, so far central bank has been able to address the threats the country faced. However, new challenges such as cryptocurrencies arise and all banks need to make sure they are competent and cognizant enough to face them.
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