Assessing Financial Stability

Financial system stability in a broad sense means both the avoidance of financial institu­tions failing in large numbers and the avoidance of serious disruptions to the interme­diation functions of the financial system: payments, savings facilities, credit allocation, efforts to monitor users of funds, and risk mitigation and liquidity services. Within this broad definition, financial stability can be seen in terms of a continuum on which finan­cial systems can be operating inside a stable corridor, near the boundary with instability, or outside the stable corridor (instability).1

Financial stability analysis is intended to help identify threats to financial system stability and to design appropriate policy responses.2 It focuses on exposures, buffers, and linkages to assess the soundness and vulnerabilities of the financial system, as well as the economic, regulatory, and institutional determinants of financial soundness and stabil­ity. It considers whether the financial sector exhibits vulnerabilities that could trigger a liquidity or solvency crisis, amplify macroeconomic shocks, or impede policy responses to shocks.3 The monitoring and analysis of financial stability involves an assessment of mac­roeconomic conditions, soundness of financial institutions and markets, financial system supervision, and the financial infrastructure to determine what the vulnerabilities are in the financial system and how they are being managed. Depending on this assessment of the extent of the financial system’s stability, policy prescriptions may include continu­ing prevention (when the financial system is inside the stable corridor), remedial action (when it is approaching instability), and resolution (when it is experiencing instability).

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