Part II Toward a Framework for Financial Stability

Garry Schinasi
Published Date:
December 2005
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Chapter 1 expressed in detail the growing importance of safeguarding financial stability, and the absence of a widely accepted definition and framework for analyzing financial-stability issues. In addition, Part I argued that financial stability is a public good that requires private-collective and public policy involvement. Lacking a framework, a set of models, or even a concept of equilibrium, it is difficult to envision a definition of financial stability and a system for safeguarding it akin to what economists normally demand and use. Nevertheless, it would be useful to have a guide that allows for the development of policy frameworks and analytical tools for safeguarding financial stability. The framework proposed in this part of the study is one step in this direction, and is offered for wider debate.

The Meaning of Framework

The notion of a framework, as used in this part of the book, is a set of definitions, concepts, and organizing principles that impose discipline on the analysis of the financial system. As will be discussed and examined in more detail, an important component of safeguarding financial stability is the early identification of risks and vulnerabilities that might threaten the maintenance of stability.

An effective framework requires three important standards:

  • First, there must be rigorous definitions and understandings of key concepts, such as what is meant by the terms financial system, financial stability and instability, and systemic risk, among others.
  • Second, to be most useful for monitoring and policymaking, the framework’s concepts and definitions ultimately must be either directly measurable or correlated with measures—concepts and definitions must have useful and policy-relevant empirical counterparts.
  • Third, the set of definitions, concepts, and organizing principles, along with their empirical counterparts, must ensure internal consistency in the identification of sources of risk and vulnerability and in the design and implementation of policies aimed at resolving difficulties should they emerge.

Many of the relevant concepts of finance and economics necessary for developing the framework were introduced and analyzed in Part I, drawing on the wide range of literature in finance and economics. Many of the links between finance and economics have been highlighted, and in having done so, many of the organizing principles for how to think about financial stability issues and how to design a framework for safeguarding financial-stability have been examined. Thus, much of the necessary conceptual and logical development of the framework has already been provided.

Organization of Part II

What remains to be accomplished in Part II is the development of the basic framework for safeguarding financial stability and an examination of many of its most important parts and features so that it can be applied effectively. To accomplish this, Part II is divided into three chapters.

Chapter 5 proposes working definitions of financial system, financial stability, and systemic risk. It then draws out the important characteristics of the proposed definition of financial stability so as to set the stage for using the definition in setting up the framework and then introducing its main features and objectives.

Chapter 6 develops a comprehensive and practical framework for safeguarding financial stability, particularly for organizing the work for preventing and resolving financial imbalances and crises. It defines the financial-stability challenge, and then places financial-stability work in the context of the broader economic and social system. The chapter then provides an overview of the framework in the form of a schematic representation, then further develops its main features in some detail. The chapter also examines the important measurement and modeling issues in making financial-stability assessments. The final section examines the most difficult remaining challenges, many of them involving analytical and measurement research.

Chapter 7 examines the responsibilities of central banks in ensuring financial stability. While central banks are not the only authority involved in safeguarding financial stability (there are also supervisory and regulatory authorities) the chapter argues that they do have a natural interest, and role to play, in safeguarding financial stability. The chapter draws on some of the experiences in certain advanced countries, particularly in the euro zone, Japan, the United Kingdom, and the United States.

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