Definition and Importance of Financial Stability

Definition of Financial Stability

Financial stability can be defined as “a condition in which the financial system is not unstable". It can also mean a condition in which the three components of the financial system -- financial institutions, financial markets and financial infrastructure -- are stable.

• ‘Stability of financial institutions’ refers to a condition in which individual financial institutions are sound enough to carry out their financial intermediation function adequately, without assistance from external institutions including the government.
• ‘Stability of financial markets’ means a condition in which there is no major disruption of market transactions, with no significant deviation of financial asset prices from economic fundamentals, thereby enabling economic agents to raise and operate funds with confidence.
• ‘Stability of financial infrastructure’ refers to a condition in which the financial system is well structured to ensure smooth operation of market discipline, and both the financial safety net and the payment and settlement system are running effectively.

Financial stability can be more broadly defined as “a condition in which the financial system can facilitate real economic activities smoothly and is capable of unravelling financial imbalances arising from shocks.”

Why is Financial Stability Important?

Financial stability is an essential requirement not only for price stability, the policy goal of the central bank, but also for healthy development of the economy. This is because financial instability entails heavy costs for an economy, since the volatility of price variables in the financial markets increases and financial institutions or corporations may go bankrupt. In addition, economic development can be limited at such a time, since economic agents find it difficult to make rational decisions and the efficiency of resource allocation is reduced.

Since the 1980s, many countries around the world have achieved the positive effects of rapid financial industry growth owing to the progress of financial liberalization. At the same time, however, they have also experienced periods of dramatic slowdown in economic growth, due to heavy economic expenses arising from financial instability or financial crises.

Against this backdrop, many countries have started to place great emphasis on financial stability when implementing their policies. Attention paid to financial stability is growing, as new factors with the potential to generate financial instability, including the strengthening of financial sector links among countries and the rampant development of complex financial instruments, have recently emerged.