WHAT IS FINANCIAL STABILITY
Financial System Stability (FSS) does not in fact have any standard international definition. Instead, multiple definitions are in use essentially stating that a financial system becomes unstable when economic activity is hindered and the system is endangering the economy itself. The following are examples of definitions quoted from various sources:
FSS means that the financial system has the capability to allocate funds efficiently and absorb shocks as they arise, thus preventing disruption of real sector activities and the financial system.
FSS is a condition represented by a strong financial system capable of withstanding economic shocks, one that is able to ensure intermediary function, settlement of payments and diversification of risk.
FSS is a condition in which the economic mechanisms of price formation, funds allocation and risk management operate properly in support of economic growth.
Despite the absence of a uniform definition, a deeper understanding of FSS can be gained by looking at the factors likely to disrupt stability. Financial system instability can be triggered by turmoil and many other causes. In most cases, instability results from combination of market failures caused by structural factors or behavior of market players. Market failure itself can be brought on by external and domestic conditions. In a financial system built on markets, institutions and infrastructure, the predominant risks include credit risk, liquidity risk, market risk and operational risk.
The technology-driven trend towards financial sector globalization has led to the emergence of an integrated, borderless financial system operating in real time. Innovative financial products have mushroomed, creating an added dimension of complexity. These developments have not only vastly expanded the possible sources of financial system instability, but may also increase the challenge of bringing such instability under control.
As a rule, the sources of financial system instability are identified through a forward looking process to ascertain the potential risks that could influence the future condition of the financial system. Once identified, these risks are analysed for their potential for heightened threat, contagion effect and systemic impact that could devastate the economy.
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