The notion of financial stability leads to issues of measurement, issues of choice of instruments to achieve the objective of financial stability and issues on the degree of activism that central banks should adopt in pursuing this objective.
Monetary stability (say maintaining low and stable inflation) leads to financial stability, although, such complementarity hold in the long run, need not hold in the short-run. Monetary stability is an important precondition for financial stability. Reduction in inflation enables inflation expectations to stabilize. Low and stable inflation expectations increase confidence in the domestic financial system. Globally, central banks are concerned with both price stability and financial stability.
A stable macroeconomic environment - with low and stable inflation, sustained growth and low interest rates - can generate excessive optimism about the future economic prospects and often the risks are downplayed. However, macroeconomic stability need not necessarily always place an economy in financial stability, therefore, focused attention is required to achieve financial stability.
Contextually, financial stability in India means
(a) ensuring uninterrupted settlements of financial transactions (both internal and external),
(b) maintenance of a level of confidence in the financial system amongst all the participants and stakeholders and
(c) absence of excess volatility that unduly and adversely affects real economic activity.
Three highlighted structural aspects of financial stability are:
(a). Vulnerabilities to real sector shocks
(b). Political system stability
(c). The size, nature and structure of the economy, level of development and socio political conditions
The sources of financial disturbances are unpredictable due to increased integration of financial markets. Contagions, progressive opening up of economies to external flows, sharp movements in exchange rates for emerging economies need to resort to borrowing in foreign currencies, all contribute to financial instability. Forces affecting financial stability, include:
(a). boom in credit to private sector, both investment and consumption, A particular form of boom and bust cycle is generated by the end of hyperinflation episodes.
(b). highly regulated systems have also suffered crises.
(c). Direct effects of fiscal difficulties.
(d). crisis in one country has a direct effect on economic conditions.
(e). Terms of trade shocks and movements in real exchange rates.
(f). Political instability, unrest, civil conflict.
(g). Policy-induced distortions, government influence over public sector banks;
In financial markets, the herd mentality catches up fast, making markets volatile. There is need to pursue a multifaceted approach towards ensuring financial stability through
(a) payments system oversight,
(b) contingency planning against market disruption,
(c) lender of last resort (LOLR),
(d) share in procedures for financial regulation and
(e) analysis and communication through reports. Overall, a continuous assessment of the health of the financial sector is essential and its ability to withstand various shocks is important.
In the pursuit of financial stability, effective regulatory and supervisory initiatives along with a calibrated approach to financial sector liberalization are critical. The pancha-sutra or five principles are
(a) cautious and appropriate sequencing of reform measures;
(b) introduction of norms that are mutually reinforcing;
(c) introduction of complementary reforms across sectors (most importantly, monetary, fiscal and external sector);
(d) development of financial institutions; and,
(e) development of financial markets. The reforms have aimed at enhancing productivity and efficiency of the financial sector, improving the transparency of operations and made the financial system capable of withstanding idiosyncratic shocks.
Challenge to Indian regulators is to enhance efficiency while avoiding instability. This leads to a role for the regulators to adopt / and develop market-oriented financial system while maintaining independence and credibility and remain accountable to Government, which being the ultimate risk-bearer and sovereign in law-making.
Therefore, the relationship between a regulator and Government must emphasise on:
(a). Operational Autonomy
(b). Harmony with the government policies, due to dense linkage between fiscal and financial sectors
(c). Coordination with government in bringing about structural changes in respect of public ownership and legislative framework.