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Tuesday, 27th November 2007

Financial Stability: What It Is and Why It Matters

Financial Stability: What It Is and Why It Matters (PDF; 216 KB)
Source: C.D. Howe Institute

Financial stability has justifiably attracted increased attention from central bankers, government policymakers and, indeed, the general public. And not surprisingly: the last few decades have seen a number of serious episodes of international financial instability. While financial crises are not new, in recent years the combination of serious macroeconomic shocks and financial crises has resulted in large losses in several countries, including significant spending by governments to rescue failing financial institutions, focusing increased attention on the costs of financial instability.

Yet a definition of financial stability remains elusive and questions concerning the appropriate roles for central banks, other public sector agencies and the private sector in promoting or protecting financial stability remain largely unresolved.

This Commentary addresses these issues. It provides a working definition of financial stability as the following: a stable financial system is robust in the face of a reasonably wide range of adverse circumstances; that is, it can efficiently provide its usual range of financial services when under significant stress. Macro-financial instability, on the other hand, occurs when interdependencies or spillovers produce knock-on effects, or financial sector and real sector interactions that create or reveal financial system fragility and lack of robustness to shocks. The main concerns involve the effects of a real or financial shock to the economy, transmitted by financial institutions or markets, and the macroeconomic outcomes.


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