Central Banking: Theory and Practice in Sustaining Monetary and Financial Stability

Chapter 10Financial StabilityDefinition, Analytical Framework, and Theoretical Foundation

Learning Objectives

• Define financial stability.
• Explain why financial stability is important as a central banking mandate.
• Explain how weaknesses in the balance sheets of households, firms, and the government could affect financial stability.
• Describe the risks facing a financial institution.
• Describe the risks facing a network of financial institutions.
• Explain why information asymmetry could lead to instability in financial markets.

As discussed in Chapter 4, financial stability has increasingly been recognized as a key mandate of central banks, in addition to monetary stability (and, in the case of the United States, full employment). Given the relative newness of the focus on financial stability, which started in the 1980s,¹ the definition, analytical framework, and operational framework for financial stability are all still very much at the early development stages when compared to monetary stability.²

This chapter first reviews issues surrounding the definition of financial stability. The chapter then proposes an analytical framework that a central bank could use to view financial stability from a practical perspective. The chapter ends with a review of theoretical principles that will be helpful in understanding probable causes of financial instability and how the central bank might deal with them.

10.1 DEFINITIONS OF FINANCIAL STABILITY

Among the three widely cited central ...