Financial Stability in Central Bank

Financial Stability in Central Bank

 

Name

 

Instructor

 

Course Name

 

Date

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Outline

Introduction

Discussion

Conclusion

Works Cited

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Financial Stability in Central Bank

 

Introduction

            Following the impact of the recent financial crisis in the world, authorities around the world have had to reconsider the current financial stability frameworks in their respective central banks. It has been suggested that the central bank should take a major role in the concept of financial stability for three major reasons which include: most of the central banks all over the globe play a significant role in providing the economy with the appropriate liquidity an aspect which is very key in financial stability matters. The macroeconomic environment in a given country can be affected by financial instability, which may cause devastating consequences to the process of monetary policy transmission, price stability as well as other economic activities. The central banks also have a better understanding of financial markets through evaluating monetary policy functions performance, and they are in a better position to determine the infrastructures as well as institutions necessary for purpose of putting into effect a macro-prudential function that is viable.

Before going any further in the discussion of this paper, it is pertinent to define the term financial stability as well as what entails the opposite of financial stability for a better appreciation of the concept. The concept of financial stability refers to safeguarding the sound functioning of the economy. This can be achieved through providing for a safe and efficient mechanism for payment as well as directing savings into investments. According to Acharya and Richardson (23), the term financial stability may be defined as a state of affairs in which the system of finance is capable of absorbing shocks and does not succumb to disruption of the payments processing or savings allocation to opportunities of investment.

On the other hand, Nier and Ursel (34) are of the view that the term financial instability is a state where the central banks and indeed other institutions involved  encounter some notion of externalities or market failure that are more likely than not to interrupt the smooth running of economic activity. Study shows that there are a couple of imperfections in the market that are capable of posing significant threats to the proper functioning of any financial system, if such imperfections are widespread and substantial. These imperfections may include: insufficient risk management, panics, asset price bubbles, bank run, and excessive leverage (Peek, et al 818).

For purposes of this study, the term financial instability will be defined according to Diamond, et al (36) who describes this state as a situation which is typified by three basic decisive factors that include: the availability of credit and market function have been significantly distorted locally and perhaps globally; secondly, there seem to be a significant divergence of some significant set of financial asset prices from the ground rules; and finally there is a possibility of aggregate spending to  drastically deviate  from the ability of the economy to produce, as the deviation may either be below or above the normal rate.

Discussion

It goes without saying that the central bank and indeed other concern authorities have a clear policy interest from the definition of financial instability, to take action in a couple of divergent responsibilities for purposes of achieving financial stability. These two roles include: prevention of financial instability as well as the role of managing the aftermaths of financial instability in the market. In order for the central banks to be able to prevent financial instability, they must be able to design viable policies that are able to promote a macroeconomic environment, with sustainable economic growth as well as a stable and low inflation rate. In the absence of such policies however, there is a very high risk of financial instability owing to the inadequacy or absence of the necessary macro brass tacks. Other ways in which central banks may ensure financial stability include: putting into practice efficient bank supervision, overseeing or operating payment systems that are efficient, and designing suitable financial regulations. Even though all these functions have over the years been performed by the central banks, they play a significant role in mitigating the possibility of financial instability occurrence.

In managing the consequences that follows financial instability, central banks may make some changes or modifications in the monetary policy for purposes of mitigating the impacts of financial instability or to foster financial stability of the economy. As such, central banks can be able to bolster the confidence of the public and make use of their basic tools for purposes of reducing liquidity pressures in the event where such financial instability goes down into a crisis. In an effort to address the issue of liquidity pressures, Bernanke and  Gertler, (254) suggest that depository institutions should be given direct lending by the central banks through a discount window function and also through openhanded provision of reserves operations of open market. In addition, central banks may employ other monetary policy tools to ensure financial instability such tools may include: central banks may decide to reduce the requirements of reserves, and in an effort to boost the economy, central banks can lower policy rates of interest.

Central banks across the world have for obvious reasons had a keen interest in the financial stability. This is because in the event of financial instability, the important objectives of macroeconomic for instance price stability and sustainable growth in output may be faced with severe setbacks. It is against this backdrop, that almost all central banks across the world are mandated to provide a viable solution in the event of a financial predicament. In light of the above statement the role of central banks in addressing monetary predicaments dates back to the 18th and early 19th century.         Central banks in their historical function were recognized as possible assistance to markets and could often provide emergency liquidity via the operations of open market. Sometimes, they (central banks) gave emergency liquidity via discount window lending to certain institutions. For these reasons, central banks had to be very alert in observing any signs of instability in the markets dynamics, and for purposes of giving emergency liquidity when the need arose. In any case the operations of financial markets greatly influence the implementation of monetary policy. In addition, the real economy largely relies on the smooth running of markets and major financial institutions for purpose of transmitting monetary policy. Financial stability can therefore be attained through stable prices in a sustainable real growth within the economy.

It is worth stressing at this point that the structure and role of central banks may be at variance in light of their particular mandate. Nevertheless, there is consensus among scholars and financial experts to the effect that the concept of macroeconomic stabilization is a key function which is common among all central banks. It therefore, follows that even though the role of financial stability by central banks may not be expressly mentioned under the statutes governing financial institutions, the role is implied by the mandate given to central banks to safeguard macroeconomic stability. Consequently, there are a wide range of instruments as well as policies that central banks may employ for purposes of preserving financial stability notwithstanding the fact that they may not have the authority over other banks in terms of supervision. To this end, Manning, et al (44) suggests that in preserving financial stability, central banks bear at least five key roles.

To begin with, through the surveillance and research function of central banks they are able to get comprehensive information concerning any risks associated with financial stability, and as such, they have the ability to preserve financial stability and maintain it. The central bank is able to detect potential shocks and vulnerabilities in the financial sectors that may bring about undesirable impacts on financial stability. The central bank can achieve this by conducting a macro- prudential surveillance (Bernanke and Gertler 200). The vulnerability of the financial sector can be detected by the central bank through conducting a research and developing useful macro-prudential indicators and tools. Central banks have a wide range of surveillance and research subjects which may include among others; payment system, financial sector, developments in global economy, real economy, as well as the fiscal and monetary policies. From the surveillance and research conducted by central banks, they are able to give viable recommendations to the relevant authorities on means and ways through which stability in the financial system can be preserved.

Secondly, central banks can be able to maintain stability in the financial system through nurturing the reliability of various financial institutions particularly banks. Central banks can achieve this role through exercising their regulatory and supervisory powers. It logically follows that since the leading shares in the financial sector of many economies are held by banks, the function of the economy may be interrupt in the event of any instability in the financial system caused by failures of the banks. Such failures by the banks may be prevented through effective regulation and supervision by central banks thus preventing economic crisis. According to a study conducted by Adrian and Hyun, (33) ineffective regulation and supervision of banking were the major causes of instability in the financial system as well as banking crises.

It is also within the powers of central banks to alleviate market discipline through regulation as well as supervision. It has been argued that the economies with strong and stable financial systems have sound market discipline (Adrian and Hyun 45).  Through protecting the rights of stakeholders as well as creditors, the central bank is able to preserve financial stability in the sense that both the stakeholders and the creditors will have confidence with the system of finance, an aspect which is necessary for the stability of a financial system that is sustainable. In instances where central banks do not have the power to regulate and supervise other banks, all is not lost as they may use monetary policies as well to foster stability in the financial system.

Thirdly, central banks such as that of the United States and Indonesia have tools which are primarily meant to maintain stability in price. These tools include; open market operations and interest rate. The central bank can utilize these tools to influence stability in the financial system through influencing the economy demand and also through intermediary processes. Setting of interest rates by the central banks is used to stabilize inflation; stabilizing inflation can be a viable instrument to ensure stability in the financial system.

As a lender of the last resort, central banks have a net role of monetary safety. Through this role, central banks can be able to manage the crisis and preserve stability in financial system. The lender of the last resort involves the central bank giving liquidity in times of financial predicaments and in normal period. The central bank should nevertheless be cautious in providing liquidity to avoid   behaviors of excessive risk taking by banks and moral hazard (Diamond 412).

To ensure financial stability, the central bank of Indonesia has designed a framework based on four pillars which include: crisis management, research and surveillance, regulation, and cooperation and coordination. The pillar of surveillance and research involves monitoring, assessment, and quantifying developments of stability in the national financial system. A major tool for stabilizing financial system in Indonesia is through micro-prudential and macro -prudential indicators. The second pillar that the central bank of Indonesia has used to stabilize the financial system is cooperation and coordination with other authorities.The role of ensuring financial stability in Indonesia has been shared out with other fiscal authorities and not a sole responsibility of the Indonesian central bank (Nier, Ursel 334). Other authorities involved in the stability of the national financial system include: the Supervisory Authority, Ministry of Finance, other government agencies, and the Deposit Insurance Scheme. The third pillar of used by the central bank of Indonesia to preserve financial stability is crisis management. The bank acts as a lender of last resort both in times of crisis and normal times. The final pillar used by the Indonesian central bank for purposes of ensuring financial stability is effectual prudential regulation. Through imposing such regulations, the bank of Indonesia is able to alleviate market discipline.

It goes without saying that the concept of financial stability has been incorporated in most if not all charters of central banks as this concept is an important objective that cannot be overlooked. In the United States for instance, the concerns of financial stability in the Federal Reserve were included in the statutory law that governs the Federal Reserve. The Federal Reserve Act provides for the roles and functions of the Federal Reserve to include: providing viable ways of commercial paper rediscounting, to ensure that the banking system in the United States is effectively supervised, and to provide a currency that is elastic(Manning et al 54). These functions basically embody stability of the financial system as the primary aim of the Federal Reserve Bank of the United States.

The Federal Reserve is charged with the responsibility of researching as well as supervising other banks for purposes of safeguarding stability in the national financial system. Through research, the Federal Reserve is able to get comprehensive information concerning any risks associated with financial stability, and as such, the Federal Reserve is able to preserve financial stability and maintain it. In addition, through macro- prudential surveillance the Federal Reserve Bank is able to detect potential shocks and vulnerabilities in the financial sectors that may bring about undesirable impacts on financial stability (Adrian and Hyun 16). Further, the Federal Reserve uses tools such as open market operations and interest rate to preserve stability in the financial system. This is achieved through influencing the economy demand and also through intermediary processes. For purposes of maintaining stability in the financial system, the Federal Reserve Bank acts as a lender of the last resort. The lender of the last resort involves the giving liquidity in times of financial predicaments and in normal period. In all, the Federal Reserve has a net role of monetary safety. Through this role, Federal Reserve can be able to manage the crisis and preserve stability in financial system.

 

Conclusion

For reasons that need not be overemphasized,Central banks across the world have had and still have a keen interest in the concept of financial stability. Traditionally, central banks have undertaken a number of roles for purposes of ensuring stability in the financial system which include: putting into practice efficient bank supervision, overseeing or operating payment systems that are efficient, and designing suitable financial regulations. In order for central banks to preserve stability in the financial system, there are a couple of roles that should be carried out by all central banks. These two roles include: prevention of financial instability as well as the role of managing the aftermaths of financial instability in the market (Acharya and Tanju 30).

In order for central banks to be able to prevent financial instability, they must be able to design viable policies that are able to promote a macroeconomic environment, with sustainable economic growth as well as a stable and low inflation rate. In the absence of such policies however, there is a very high risk of financial instability owing to the inadequacy or absence of the necessary macro brass tacks. In managing the consequences that follows financial instability, central banks may make some changes or modifications in the monetary policy for purposes of mitigating the impacts of financial instability or to foster financial stability of the economy. As such, central banks can be able to bolster the confidence of the public and make use of their basic tools for purposes of reducing liquidity pressures in the event where such financial instability goes down into a crisis (Nier, Erlend et al 2034).

            Even though the role of financial stability by central banks may not be expressly mentioned under the statutes governing financial institutions, this role is implied by the mandate given to central banks to safeguard macroeconomic stability. Consequently, there are a wide range of instruments as well as policies that central banks may employ for purposes of preserving financial stability notwithstanding the fact that they may not have the authority over other banks in terms of supervision.

Through surveillance and research, central banks are able to detect potential shocks and vulnerabilities in the financial sectors that may bring about undesirable impacts on financial stability. In addition, through protecting the rights of stakeholders as well as creditors, central banks are able to preserve financial stability in the sense that both the stakeholders and the creditors will have confidence with the system of finance, an aspect which is necessary for the stability of a financial system that is sustainable (Diamond and Raghuram 34). Finally, as a lender of the last resort, central banks have a net role of monetary safety. Through this role, central banks can be able to manage the crisis and preserve stability in financial system.

 

 

 

 

 

 

 

 

 

 

 

Works Cited

Acharya, Viral., and Richardson, Matthew., “Restoring Financial Stability—How

            to Repair a Failed System,” New York: Wiley 2009 print.

Acharya, Viral., and Tanju, Yorulmazer. “Too Many to Fail – An Analysis of            Timeinconsistency in Bank Closure Policies,” Journal of Financial      Intermediation, 16, 2007. pp. 1–31.

Adrian, Tobias and Hyun Song. “Financial Intermediaries, Financial Stability and

            Monetary Policy,” Paper presented at the Federal Reserve Bank of Kansas City

Symposium, Jackson Hole, WY, 2008 print.

Bernanke, Ben., and Gertler, Mark. “Should Central Banks Respond to Movements in

Asset Prices?” American Economic Review, Vol. 91, 2001. pp. 253–257.

Diamond, Douglas. “Financial intermediation and delegated monitoring,” Review of

            Financial Studies, Vol 51, 1984. pp. 393–414.

Diamond, Douglas., and Raghuram Rajan. “Money in a Theory of Banking,”

            American Economic Review, Vol. 96 (1), 2006. pp. 30–53.

Manning, Mark et al. “The Economics of Large-Value Payment and Settlement: Theory   and Policy Issues for Central Banks,” London: Oxford University Press, 2009    print.

Nier, Erlend and Ursel Baumann. “Market Discipline, Disclosure and Moral Hazard in

Banking,” Journal of Financial Intermediation 15 (2006), pp. 333–362.

Nier, Erlend, et al. Network models and Financial Stability, Journal of Economic   Dynamics and Control, 31, 2007. pp. 2033–2060.

Peek, Joe, et al. “Does the Federal Reserve an Exploitable Informational Advantage?”   Journal of Monetary Economics, 50, 2003. pp. 817–839.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Use the order calculator below and get started! Contact our live support team for any assistance or inquiry.

[order_calculator]