What Is Financial Stability

Financial Stability Paper Series
No. 1/March 2008
What is Financial Stability?

by
Abayomi A. Alawode,
Financial Stability Directorate
Central Bank of Bahrain
email: aalawode@cbb.gov.bh
and
Mohammed Al Sadek,
Financial Stability Directorate
Central Bank of Bahrain
email: malsadek@cbb.gov.bh
Alawode and Al Sadek
Financial Stability Papers are published periodically by the

Central Bank of Bahrain (CBB) to improve general
understanding of financial stability issues and to stimulate
policyoriented debate. Readers are encouraged to provide
feedback directly to the author(s) via email.
Views expressed in these papers are those of the author(s) and
should not be construed as representing the official views of the
Central Bank of Bahrain, its Management or Board of Directors.
Table of Contents
Abstract
1. Introduction
2. Definitions of Financial Stability: A Brief Survey

3. Defining Financial Stability in Bahrain
4. Operational and Policy Implications
5. Conclusions
16
18
21
List of Tables
Table 1: Selected Central Bank Definitions of Financial Stability
11
working assumptions adopted by

different
writers.
The
paper
discusses the definition of financial
stability adopted by the Central Bank
Absof Bahrain, analyzing the principles
and assumptions underlying the
trac chosen definition. We then examine
briefly the implications of this
t
definition for the pursuit of financial
stability in Bahrain, including the
This
paper
surveys
differentconduct of financial stability analysis
definitions of financial stabilityas well as the design of an
advanced by two separate schools ofoverarching framework for crisis
thought: i) those who prefer toprevention and management.
define financial instability (as the
antithesis of financial stability); and Keywords: Financial
ii) those who attempt to definestability; financial
financial stability, rather than itsinstability; financial crisis.
absence. It is shown that definitionsJEL classification: E44, E58
vary widely, depending on the
1.
Insurance Supervisors, International

Accounting
Standards
Board,
International Organization of Securities
Commissions and the International
Association of Deposit Insurers. There
Int is also the Counterparty Risk
ro Management Policy Group, a private
du sector organization devoted to
cti fostering financial stability.
on
Well aware of the fiscal, economic

In recent years, financial stabilityand social costs of financial crises,
issues have been receiving prioritymany of these bodies have devoted
attention from policy makers aroundlarge amounts of time and energy to
the world. One main catalyst for this developing various International
trend was the East Asian financial Standards and Codes, which are
crisis of the late 1990s. Followingessentially compilations of best
that turmoil, the World Bank and thepractices in different areas related to
International Monetary Fund (IMF)the objective of fostering financial
introduced the Financial Sectorstability. A substantial portion of
Assessment Program (FSAP) in 1999,these efforts has been directed
aimed at assessing regularly thetowards reinforcing different aspects
strengths
and
weaknesses
ofof financial sector infrastructure (e.g.
framework,
financial
financial systems in their memberlegal
supervision, accounting, auditing
countries.
and financial reporting).
In addition, several international
forums devoted to financial stabilityAt the country level, many central
issues have emerged or becomebanks and regulatory authorities
more active, including bodies such(including the Central Bank of
Bahrain) have also taken financial
as the
Financial Stability Forum, Basle stability more seriously, establishing
Committee on Banking Supervision,Financial Stability Departments and
Financial Stability Institute, Committee introducing the regular publication
on the Global Financial System, of Financial Stability Reports,
Committee on Payment and Settlement focused on assessing potential risks
Systems, International Association of to financial stability (see Cihak, 2006
and Oosterloo, et al, 2007).
5
2.
Definitions
of
Financial Stability: A
Brief Survey
Despite this increased focus on

financial stability issues, it is notable
that a widely accepted definition of
financial stability does not existDefining financial stability is
and the concept has generated a fair important for the development of
amount of debate among academics,relevant analytical tools as well as for
market participants and policythe design of policy and operational
makers. Within this context, this frameworks
(including
relevant
paper contributes to the search for apolicy benchmarks) (see Issing, 2003;
useful definition of financial stabilitySchinasi, 2004 and Chant, 2003).
by first reviewing the existing However, as mentioned earlier,
literature on the subject beforedefining financial stability has so
proceeding to discuss the definitionfar proven to be a difficult task for
of financial stability adopted by themany of those interested in the topic.
Central Bank of Bahrain (CBB). WeThis difficulty is often explained by
analyze
the
principles
andthe relative infancy of the field of
assumptions underlying the chosenfinancial stability, compared to the
definition as well as the implicationsanalysis of price or monetary
for CBBs work in the area ofstability which has a much longer
financial stability.
history (see Crockett, 1997).
The rest of the paper proceeds as Two schools of thought are clearly
follows: Section 2 reviews variousdiscernible in the literature: i)
definitions of financial stability,writers who prefer to define financial
covering those existing in theinstability; and ii) writers who
academic literature as well as thoseattempt to define financial stability.
appearing in Financial Stability
Reports published by central banks.Definitions of financial instability
Section 3 analyzes the working
definition of financial stabilityMishkin (1999) states that financial
adopted by CBB while Section 4instability occurs when shocks to the
discusses the policy and operationalfinancial
system
interfere
with
implications
of
the
adoptedinformation flow so that the financial
definition. Section 5 concludes.
system can
systemic risk may be manifested in

no longer do its job of channeling funds the form of the failure of market
to those with productive investment liquidity and a breakdown of market
opportunities.
This
definitioninfrastructure. Finally, this definition
emphasizes the intermediation rolealso emphasizes the role of the
of the financial system in providingfinancial system in supporting the
credit to the real sector and stresses real sector through the provision of
the central role of asymmetriccredit and payment services.
information in causing financial

instability (see also Mishkin, 1997Ferguson (2003) described financial
and Mishkin, 2000). Mishkininstability as a situation characterized
suggests that financial stability arisesby three basic criteria: i) some
when shocks cause disruptions toimportant set of financial asset prices
the flow of information. However,seem to have diverged sharply from
since information failures pervadefundamentals; and/or ii) market
functioning and credit availability,
all financial transactions (even
domestically
and
perhaps
without shocks), it is better to
internationally, have been significantly
interpret this definition in terms of
distorted; with the result that, iii)
shocks acting to aggravate existing
aggregate spending deviates (or is likely
information asymmetry up to the
to deviate) significantly, either above or
point where normal financial
below, from the economys ability to
intermediation ceases.
produce. This definition has a couple
of interesting features. First, unlike
Davis (2001) defines systemic riskDavis (2001), Ferguson incorporates
and financial instability as athe distortion of asset prices into his
heightened risk of a financial crisis.
1
definition of financial instability .
A financial crisis is then described as
Second, there is explicit coverage of
a major collapse of the financial system,
the ultimate impact of financial
entailing inability to provide payments
instability on the macroeconomy, in
services or to allocate credit to
terms of the impact on aggregate
productive investment opportunities.spending.
Davis further pointed out that
financial crises would have major
Chant (2003) argues that financial
adverse effects on economic activity
stability could best be understood by
and fostering financial stability is
considering its absence, i.e. financial
tantamount to managing systemic
instability. He defined financial
risk. Although he contends that
episodes of asset price volatility1
See the discussion of Allen and Wood
should be excluded from this
(2006) below.
definition, it is acknowledged that
7
financial crises which are not warranted

instability as conditions in by their previous behaviour and where
financial markets that harm or threaten these crises collectively have seriously
macroeconomic
effects.
to harm an economys performance adverse
through their impact on the working of Financial stability is then described
the financial system. He pointed outas a state of affairs in which an episode
that the term financial instability of financial instability is unlikely to
encapsulates several different kindsoccur. Allen and Wood include
of such instability, ranging fromthe nonfinancial sector in this
banking crises to stock marketdefinition, explaining that financial
crashes. Hence, different forms ofinstitutions are not the only entities
instability affect different parts of thewhich experience financial stress.
financial system and may also differAlthough it has some validity, this
in their consequences. Further,viewpoint results in a rather broad
Chant proposed that financialdefinition of financial stability, as it
instability should be distinguishedincorporates institutions which the
from other forms of instability suchcentral bank cannot expect to
as macroeconomic instability. Theinfluence directly to promote
primary difference is that financialfinancial stability.
instability has its immediate source
in financial markets (broadlyIn addition, Allen and Wood do not
defined)
while
macroeconomicconsider episodes of asset price
instability is often due to aggregatebubbles as financial instability and
2
demand or supply shocks . Finally,they introduced the concept of
Chant points out that financial innocent bystander, suggesting
markets are characterized bythat households and companies
constant changes in prices andsuffer unduly in a financial crisis,
conditions, all of which would noteven though they have learned how
qualify as financial instability. Heto behave in such a way that they are
therefore proposes that financialnot afflicted by financial crises. This
instability should be viewed in termsconcept of innocent bystander is
of the potential impact of changes insomewhat simplistic, as many cases
financial conditions on the realof
economy.
2
Allen and Wood (2006) referred to Chant however admitted that aggregate
demand and supply shocks also have the
financial instability as episodes in potential to affect the financial system
which a large number of parties, through their impact on the financial
whether they are households, companies condition of households and business
enterprises.
or (individual) governments, experience
8
function normally without outside

financial distress have involvedassistance. Hence, it excludes
households and businesses behavingsituations where financial instability
imprudently. While some innocentis only avoided through the
households and businesses willprovision of financial or other kinds
suffer from the adverse effects ofof support to financial institutions by
regulatory
or
political
financial crises (even though theythe
have strong balance sheets), manyauthorities.
more will be culpable as we have
seen in past episodes of financialLager (1999) posits that the objective
of financial system stability could
crises.
therefore be defined, in broad terms, as
the avoidance of disruptions to the
Definitions of financial stability
financial system that are likely to cause
Crockett (1997) expresses financialsignificant costs to real output. He
stability as requiring that the keywent on to say that such disruptions
institutions in the financial system are might have their origins in difficulties
stable, in that there is a high degree of facing financial institutions or in
confidence that they continue to meet disturbances in financial markets.
their contractual obligations without Again, there is emphasis on the
interruption or outside assistance; and impact of financial instability on the
that the key markets are stable, in that real economy and recognition is also
participants can confidently transact in given to disruptions in financial
them at prices that reflect the markets (in addition to cases of
fundamental forces and do not vary distress in financial intermediaries).
substantially over short periods when

there have been no changes in the According to Foot (2003), we have
fundamentals.
Implicitly,
thisfinancial stability where there is: (a)
definition takes account of themonetary stability; (b) employment
condition of financial intermediarieslevels close to the economys natural
and markets, but not financialrate; (c) confidence in the operation of
infrastructure. Also, in contrast tothe generality of key financial
some other writers (e.g. Davis 2001institutions and markets in the economy;
and Allen and Wood, 2006), the and (d) where there are no relative price
statement considers periods of assetmovements of either real or financial
price volatility as evidence ofassets within the economy that will
instability. Finally, it contends that undermine (a) or (b).
financial stability exists if theThis is one of the few definitions
financial system can continue towhich mention monetary stability as
an
9
of facilitating (rather than impeding) the

3 performance of an economy and of
essential part of financial stability .
dissipating financial imbalances that
Foots definition is notable in
arise endogenously or as a result of
interpreting the linkage with the real
significant adverse and unanticipated
sector in terms of proximity to the
events. This statement is unique in
natural rate of employment levels. It
also highlights the importance of viewing financial stability as a
confidence in the operation of thecontinuum, rather than a single,
financial system, a position similarstatic condition (ibid, p. 6). This
to the arguments of Large (2003)implies that financial systems
who described financial stabilityoperate within a corridor, with
mainly in terms of maintaining stability and instability at opposite
confidence in the financial system. ends. Movements towards the
unstable end of the corridor could
PadoaSchioppa (2002) contends thatthen be due to an accumulation of
(or
vulnerabilities)
financial stability is a conditionimbalances
where the financial system is able to within the financial system or
withstand shocks without giving way to because of exogenous shocks. Like
cumulative processes, which impair the some writers cited earlier, Schinasi
allocation of savings to investment points out that instability should
opportunities and the processing of refer to cases where the financial
impedes
the
normal
payments in the economy. Thesystem
emphasis here is on the shockfunctioning of the real economy.
absorbing capacity or resilience of
the financial system, so that it can As many central banks established
continue to carry out its essentialfinancial stability departments and
functions of resource allocation andbegan publishing Financial Stability
provision of payments services. TheReports, they have also adopted
reference to payments services herespecific definitions in order to
is important because like disruptions provide some guidance to their
to the intermediation function,objective of safeguarding financial
disturbances to the payments systemstability. Table 1 below displays
have the capacity to inflict adversesome of these definitions from
effects on the level of economicselected central banks around the
world.
activity (see also Davis, 2001).
Schinasi (2004) offers the following3 There are writers who have discussed the
definition: A financial system is in apossible conflicts between monetary
range of stability whenever it is capable stability and financial stability (see for
example Leijonhufvud, 2007).
10
Table 1: Selected Central Bank Definitions of Financial Stability

CENTRAL BANK
Central Bank of Argentina
Reserve Bank of Australia
Austrian National Bank
Deutsche Bundesbank
Czech National Bank
DEFINITION
Financial stability is a state
of affairs in which the
financial services
sector can
channel the savings of the
population and
provide a
nationwide payments system
in a manner that is efficient,
secure and
sustainable over
time
A stable financial system is
one in which financial
intermediaries, markets and
market infrastructure
facilitate the smooth flow of
funds between savers and
investors and by doing so,
helps promote growth in
economic activity
In its most concise
definition, financial stability
refers to a situation in which
the financial markets fulfill
their allocation function in a
satisfactory manner, even in
the case of shocks
The Bundesbank defines
financial stability as the
financial systems ability to
perform its key
macroeconomic functions
well, even in stress situations
and during periods of
structural adjustment.
The CNB defines financial
stability as a situation where
the financial system operates
with no serious failures or
undesirable impacts on the
present and future
development of the economy
as a whole, while showing a
high degree of resilience to
shocks
SOURCE
Financial Stability Bulletin
Second Half 2007
http://www.rba.gov.au
http://www.oenb.at/
http://www.bundesbank.de
Financial Stability Report
11
Table 1 (contd.): Selected Central Bank Definitions of Financial

Stability
CENTRAL BANK
European Central Bank
Bank of Finland
Norges Bank (Central Bank

of Norway)
DEFINITION
Financial stability can be
defined as a condition in
which the financial system
comprising of financial
intermediaries, markets and
market infrastructuresis
capable of withstanding
shocks and the unraveling of
financial imbalances, thereby
mitigating the likelihood of
disruptions in the financial
intermediation process which
are severe enough to
significantly impair the
allocation of savings to
profitable investment
opportunities
The financial system is
stable and reliable when it is
able to smoothly conduct its
core tasksincluding the
intermediation of financing,
transmission of payments,
pricing of financial
instruments and allocation of
risks. In addition, the risk
bearing capacity of major
financial institutions and
infrastructure must be
sufficient to withstand even
severe disruptions in the
environment
Financial stability implies
that the financial system is
robust to disturbances in the
economy and can channel
capital, execute payments
and redistribute risk in a
satisfactory manner
SOURCE
Financial Stability Review
1
2
Table 1 (concl.): Selected Central Bank Definitions of Financial Stability

CENTRAL BANK
Bank of Japan
DEFINITION
Financial system stability
refers to a state in which the
financial system functions
properly, and participants,
such as firms and
individuals, have confidence
in the system
Reserve Bank of South

Africa
Financial stability can be

described as the absence of
the macroeconomic costs of
disturbances in the system of
financial exchange between
households, businesses and
financialservice firms
Financial system stability
means a safe and secure
financial system which is
able to withstand external
and internal shocks.
A stable financial system
can be defined as a system
whose individual
components financial
intermediaries and the
financial market
infrastructure fulfil their
respective functions and
prove resistant to potential
shocks.
Central Bank of Sri Lanka
Swiss National Bank
Central Bank of Iceland
Financial stability means

that the financial system is
equipped to withstand
shocks to the economy and
financial markets, to mediate
credit and payments and to
redistribute risks
appropriately.
SOURCE
http://www.boj.or.jp
http://www.reservebank.co.za
/
http://www.cbsl.gov.lk
http://www.snb.ch/
1
3
including its role in channeling

savings into productive investment
An examination of these definitions(e.g. Mishkin, 1999; Davis, 2001;
indicates a gradual convergence ofPadoaSchioppa, 2002) or its central
views on financial stability, at least role in the payments system (Davis,
among the central bankers charged2001; PadoaSchioppa, 2002). Second,
there is recognition that instability
with its attainment:
1 Many central bank definitionsoften arise from unforeseen shocks
attempt to define financialimpacting the financial system (e.g.
stability
(rather
thanMishkin, 1999; PadoaSchioppa,
2002; Schinasi, 2004). Third, many
instability).
2 Many of them place emphasisdefinitions recognize explicitly, the
impact
of
financial
on the key functions of the possible
financial
system
(e.g.instability on the economy at large
provision of credit and(e.g. Lager, 1999; Ferguson, 2002;
Foot, 2003; Chant, 2003; Schinasi,
payment services).
2004; Allen and Wood, 2006). Lastly,
3 There is emphasis on shocks
there is reference to financial
that disrupt the functioning
stability as entailing confidence in
of the financial system and by
the financial system (e.g. Crockett,
extension, on the resilience of
1997; Foot, 2003; Large, 2003)
the financial system to these
shocks.
Aside from the aforementioned
division between those defining
Commonalities and differences in
financial stability and those defining
definitions
instability, there are additional
differences in the definitions we have
Our review of the academic
reviewed. For instance, Mishkin
literature has revealed the wide
(1999) is unique in emphasizing the
diversity in definitions of financial
role of asymmetric information in
stability
(and
instability).
financial crises while Schinasi (2004)
Nonetheless,
some
common
stands out in its view of financial
elements could be identified.
stability as a continuum. Foot (2003)
also explicitly incorporates monetary
First, there is frequent reference to
stability into his definition of
the functions of the financial system
financial stability.
1
4
economics itself is replete with

concepts and topics for which the
search for a single consensual
definition has been virtually futile.
Must we have a single, widely
For instance, econometrics is a
accepted definition?
well developed subject matter,
Our brief survey of definitionscombining economics with statistical
suggests that a widely acceptedand mathematical methods, despite
definition of financial stability is stillthe fact that no widely accepted
far away (if it will ever be found!). Is definition exists. Commenting on the
this likely to have any implications definition of econometrics, Kennedy
for the conceptual and operational(1995, p.1) writes: Strange as it may
development of this topic? We are of seem, there does not exist a generally
the view that the practical impact accepted answer to this question.
would be minimal. While aResponses vary from the silly
Econometrics is what econometricians
definition would help in the
do to the staid Econometrics is the
continued development of an
study of the application of statistical
analytical
framework
or
for
methods to the analysis of economic
determining
the
operational
phenomena,
with
sufficient
parameters for financial stability
disagreements to warrant an entire
work, the absence of a single,
journal article devoted to this question.
widelyaccepted definition would
More tellingly, economics has no
not
necessarily
prevent
the
single, widelyaccepted definition,
development of such frameworks.
despite the popularity of Lionel
As shown above, central banks are
Robbins definition among many
increasingly settling on individual
students
(and
teachers)
of
definitions which should provide
4
sufficient guidance to operationalintroductory economics .
work at the country level. In
addition, central bank definitions
show certain commonalities, raising
the probability of identifying4 Lionel Robbins defined economics as the
common grounds among policyscience which studies human behaviour as a
relationship between ends and scarce means
makers.
which have alternative uses. See Robbins,
L. An Essay on the Nature and Significance of
nd
ed., London:
worthEconomic Science, 2
Macmillan Co., 1949, p. 16.
On a more general note, it is

noting that the discipline
of
15
characterized by constant change

and continuously influenced by
changes in the domestic, regional
and
global
macrofinancial
3.
Defining
environment. Hence, this definition
would also allow for changes in the
Financial
Stability
incondition of the financial system,
provided it maintains the ability to
Bahrain
function prudently, efficiently and
uninterrupted. This is similar to
As a guide to its task of fosteringSchinasi (2004) proposal that
financial stability in the Kingdom offinancial stability be seen as a
Bahrain, the Central Bank of Bahraincontinuum, rather than a single,
(CBB) has chosen to define financial static condition.
stability, rather than its absence. In

the preface to its Financial StabilitySecond, CBB has started from the
Report, the CBB describes financialpremise that a definition of the
stability as a situation where the financial system is important for
financial system is able to function defining financial stability. For the
prudently, efficiently and uninterrupted, purposes of financial stability work
even in the face of shocks. Thisin Bahrain, we deem the financial
definition contains various keywordssystem as encompassing financial
and phrases which are important forintermediaries (banks and non
understanding
CBBs
overallbanks), financial markets (equity and
markets)
and
financial
approach
to
analyzing
anddebt
(payments
and
maintaining financial stability in theinfrastructure
Kingdom. This definition alsosettlement system). This approach
contains implicit subdefinitionstakes into account the fact that
financial disturbances can originate
which need to be explained.
from different parts of the financial
First, financial stability is viewed in system, despite the overwhelming
terms of a specific, attainabledominance of the banking sector in
condition of the financial system.Bahrains financial sector (see Davis,
However, the financial system is2001 and Davies, 2005).
1
6
inappropriate pricing of risk in

financial markets would not qualify
aas situations of financial stability.
Although we have adopted

relatively broad definition of the
financial system, it is important to Fourth, financial stability requires
point out that some parts of thethat the system is capable of
its
functions
system have been deliberatelyperforming
omitted. Notably, the definition ofcontinuously and uninterrupted
financial infrastructure in terms ofeven if subjected to shocks
and
exogenous).
the payments and settlement system(endogenous
is a decidedly narrow one, given the Financial stability would not obtain
fact that other components ofif for any reason, the financial system
financial infrastructure could beis unable to perform its functions.
included (e.g. legal frameworks,Indeed, stability of the system
accounting, auditing and financialrequires that the system develops
reporting, or corporate governance).and retains the ability and resilience
We concentrate on the payments and to absorb shocks. We should note
settlement system because of itshere that shocks could be either
central importance to the smoothpositive or negative. While negative
functioning of any market economy,shocks have attracted the most
its importance to interbank financialattention, positive shocks also have
transactions and because of CBBsthe potential to encourage risk
ability to directly influence thistaking and other types of imprudent
component
of
financialbehaviour, thus laying the ground
for subsequent financial turmoil.
5
infrastructure .
Third, the definition emphasizes theUnlike Schinasi (2004) and Allen and
ability of the financial system to Wood (2006), we do not explicitly
carry out its key functions, includingincorporate the potential real sector
savings
mobilization,
resourceimpact of instability into our
allocation, monitoring resource use,definition. Our view is that it is
supporting the exchange of goodsdifficult to determine ex ante,
and services (payments services)whether any financial turbulence
and facilitating risk management(even an isolated one) would have a
(Levine, 1997). It is also stated thatsignificant
these functions must be performed
in a prudent and efficient manner,5 CBB hosts and operates the principal
suggesting that reckless risktakingpayments and settlement systems for
Bahrain, including the new Real Time Gross
by
financial
institutions
andSettlement System (RTGS).
17
large part of the financial system, not

impact on the real sector. Real sector one with potential macroeconomic
data come in with a lag, even in theor welfare costs.
most advanced economies, making it
difficult to detect macroeconomic
4.
Operational
impact of financial instability in the
and
Policy
shortterm.
Implications
Further, frequent convulsions (even

without any visible macroeconomic
impact) will tend to undermineImplications for financial stability
confidence in the financial system analysis
and may over time increase
vulnerabilities and erode theOperationally, CBB has used the
resilience of the system, leading to a definition discussed above to
large financial earthquake (withdelineate the boundaries of its
potentially
substantialfinancial stability analysis. Its
macroeconomic effects). It is possibleFinancial Stability Report (FSR)
for the failure of a small, seeminglypresents this definition in its preface
inconsequential financial institutionand the assessment contained in the
to damage confidence and affectFSR reflects the broad nature of the
incorporating
key
sentiments significantly enough todefinition,
cause wider disruptions in thefinancial intermediaries, markets and
the payments/settlement systems.
financial system.
The FSR also covers developments in
Hence, we argue that the key issue isthe nonfinancial sector (households,
not whether the disruption willbusinesses and construction/real
cause macroeconomic effects, butestate sector). In addition, CBB has
whether it will interrupt the normal developed a list of Financial
functioning of the financial system. Soundness Indicators (FSIs) to be
It is easier to determine if the normal monitored on a regular basis,
functioning of the financial system isincluding indicators for these
being impeded than to determinedifferent components of the financial
whether a disruption will causesystem. Given the role of shocks in
financial
crises,
macroeconomic
shocks.
Wetriggering
therefore define a systemic crisis macroeconomic and real sector
as one with the potential to affect aindicators are included in Bahrains
list of FSIs.
1
8
(see Chant, 2003).

It is pertinent to point out that Hence, the analysis contained in
financial stability does not mean thatCBBs Financial Stability Report is
the
financial
system
showsaimed at identifying vulnerabilities
absolutely no vulnerabilities. Itin the system that may grow to cause
describes a state where the financialserious problems down the road. It
system is able to perform its normalalso tries to identify possible
functions even if endogenousshocks/risks that may force open
vulnerabilities exist or if shocks areany identified cracks in the system.
experienced. It is inevitable thatIn determining whether the Bahraini
parts of the system will be financial system is stable or not, CBB
functioning below par at differentconsiders four key issues:
1 What is the current financial
times. The only requirement is that
condition and performance of
any vulnerabilities (or shocks) are
the different components of
not serious enough to cause a
the financial system?
disruption to the normal functioning
2 What is the current financial
of the financial system (or are
condition of the nonfinancial
absorbed and managed by the
sector
(households
and
financial system).
business enterprises)?
3 What are the vulnerabilities in
This approach views financial crises
the balance sheets of both the
as extreme cases or the culmination
financial and nonfinancial
of instability. The lack of financial
sectors?
stability could be seen along a range
4 How are these vulnerabilities
of possibilities, including:
being managed and how
1 Financial
fragility,
where
resilient are the financial and
vulnerabilities are evident
nonfinancial
sectors
to
but the financial system is
shocks?
somehow managing to carry
out its functions
2 Financial instability, whereCBBs analysis strives to evaluate
vulnerabilities are beginningfinancial stability in a forward
to impede the delivery oflooking context, examining how
future endogenous and exogenous
financial services
3 Financial crisis, where thedevelopments might impact the
normal functions of thefinancial system, even if current
system cease. This is the mostconditions and performance do not
serious form of instabilitygive any cause for worry. A key
guiding principle is
19
turbulence, exchange rate crises as

whether any observed vulnerabilitywell as disturbances to the payments
settlement
systems.
The
is serious enough to warrant policy and
or
regulatory
attention.contingency plan also pays explicit
Alternatively, it is possible that theattention to possible responses to
vulnerability is already beingmacroeconomic and real sector
managed (or capable of beingshocks that may impact the
managed) through the interventionoperation of financial intermediaries
and markets.
of market participants.
Ultimately, drawing a conclusion onOne major challenge to contingency
the stability of the financial sectorplanning is the identification of a
using the above criteria involves asystemic crisis. This is important
combination of technical analysisbecause policy responses will vary
and value judgment. Even though according to whether the financial
we rely to a large extent on distress is isolated or whether there
information contained in the FSIs tois a danger of contagion to other
identify threats to safety andparts of the system. As evident from
soundness, it is possible for FSIs to the definitions of financial stability
give conflicting signals, requiringsurveyed in Section 2, many writers
the experience and the judgment ofview systemic crisis as one where
the analyst to reach a meaningful there are real sector effects.
Unfortunately, it is often difficult to
conclusion.
determine ex ante whether a
Implications for crisis prevention disturbance would be contained or
whether it will spread, with serious
and management
macroeconomic effects.
Further, this definition has provided
broad guidance to CBBs policies onThe current era of globalization and
crisisprevention
and
crisisfinancial innovation with close
management. The development of alinkages among financial institutions
and markets has increased the
detailed
Contingency
Plan
for
Crisis potential for contagion substantially,
Management is currently underwaymeaning that trying to determine
and this has been informed by CBBswhether a disturbance would be
overall viewpoint on financialcontained or not becomes academic.
stability (and how it can beRegulatory and political authorities
attained). For instance, a wide rangeare under pressure to take action
of
possible
crises
is
beingregardless of the nature of the
considered,
including
bankingfinancial disturbance. The 2007
crises, credit and stock marketglobal
20
given the fact that left to its own

financial turmoil is a case in point,devices, the financial system may not
good
selfcorrective
where central banks in key marketshave
have been forced to take action evenmechanisms when shocks hit (due to
though the macroeconomic impactinherent coordination problems).
of the crisis was unknown. The

political
intervention
in
theFinally, it should be acknowledged
distressed Northern Rock mortgagethat it is impossible to establish a
bank in the UK is another example. foolproof framework for financial
stability. Financial markets will
always experience volatility and
Responsibility for financial
individual financial institutions will
stability
fail now and again. Hence, the goal
Who is responsible for maintaining of financial stability is not to prevent
financial stability? Crockett (1997)the failure of individual financial
makes a strong case for public policy institutions. The goal of financial
in fostering financial stability. Butstability is to ensure that such
what is the role of the market playersfailures do not result in a significant
in avoiding crisis (or responding todisruption of the normal functioning
shocks) without requiring officialof the financial system.
intervention? Although CBB is

renowned for the high quality of its
5.
Co
regulatory and supervisory regime,
ncl
it still recognizes the occasional role
usi
of moral suasion in encouraging
market
participants
to
take
on
corrective action without resorting
s
to regulatory changes. In addition,
the adoption of the Basel 2Motivated by the lack of a widely
framework in Bahrain has focusedaccepted definition of financial
attention
on
enhancing
riskstability, this paper surveyed
management practices in banks indifferent definitions of financial
particular, to provide a first line of stability advanced by two separate
defense against shocks as well asschools of thought: i) those who
guide
against
vulnerabilitiesprefer to define financial instability
(as the antithesis of financial
emerging in the first place.
stability); and ii) those who attempt
However, regulatory interventionto define financial stability, rather
should be expected in most instancesthan its absence. It is
21
The paper discusses the definition of

shown that definitions vary widely,financial stability adopted by the
depending
on
the
workingCentral Bank of Bahrain, analyzing
assumptions adopted by differentthe principles and assumptions
writers. We argued that it is not underlying the chosen definition. We
mandatory to arrive at a single, then discuss briefly the implications
widely accepted definition and aof this definition for the pursuit of
stability
in
Bahrain,
multitude of definitions will notfinancial
necessarily hamper the ongoingincluding the conduct of financial
development of a useful analyticalstability analysis as well as the
overall
framework
for
crisis
and policy framework.
prevention and management.
2
2
and
Financial
Law,
Washington, D.C., October 23
27.
Refe
renc Crockett, A., (1997), Why is
es
Financial Stability a Goal of
Allen, W. and Wood, G. (2006),
Defining
and
achieving
financial stability, Journal of
Financial Stability, June, pp.
152172.
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in
Maintaining
Financial
Stability in a Global Economy,
Symposium
Proceedings,
Federal Reserve Bank of
Kansas City, August, pp. 55
96.
Borio, C. (2005), Monetary and

Financial Stability: So CloseDavies, H., (2005), Two Cheers for
and Yet So Far?, National
Financial Stability, William
Institute Economic Review,
Taylor Memorial Lecture No.
No. 192, April, pp. 84 101.
9,
Washington,
D.C.,
September.
Central Bank of Bahrain, (2007),
Financial Stability Report, December. Davis, E. (2001), A Typology of
Financial
Instability,
Oesterreichische
Chant, J. (2003), Financial Stability
Nationalbank (Central Bank
as a Policy Goal, in Essays on
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European Central Bank, (2005),
Cihak, M., (2006), Central Banks
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Conceptual Boundaries and
Survey of Financial Stability
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(2005),Econometrics, 3 Ed., Blackwell
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Australia Bulletin, October.
Fell, J. and Schinasi, G., (2005), Assessing
Large, A., (2003), Financial Stability:
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Maintaining Confidence in a
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complex world, in Bank of
Institute Economic Review, No. 192,
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Ferguson, R., (2003), Should Financial
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Stability Be an Explicit Central Bank
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Objective?, in Monetary Stability,
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(1997),
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Mishkin, F., (1997), The Causes and
Issing, O., (2003), Monetary and Financial
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2
5
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What Is Financial Stability

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Financial Stability Paper Series

No. 1/March 2008

What is Financial Stability?

Alawode and Al Sadek

What is Financial Stability?

Financial Stability Papers are published periodically by the

Alawode and Al Sadek

What is Financial Stability?

2. Definitions of Financial Stability: A Brief Survey

Alawode and Al Sadek

What is Financial Stability?

working assumptions adopted by

Alawode and Al Sadek

What is Financial Stability?

Insurance Supervisors, International

Well aware of the fiscal, economic

Alawode and Al Sadek

What is Financial Stability?

Despite this increased focus on

Alawode and Al Sadek

What is Financial Stability?

systemic risk may be manifested in

information in causing financial

Alawode and Al Sadek

What is Financial Stability?

financial crises which are not warranted

Alawode and Al Sadek

What is Financial Stability?

function normally without outside

substantially over short periods when

Alawode and Al Sadek

What is Financial Stability?

of facilitating (rather than impeding) the

Alawode and Al Sadek

What is Financial Stability?

Table 1: Selected Central Bank Definitions of Financial Stability

Reserve Bank of Australia

Austrian National Bank

Czech National Bank

Financial Stability Report

Alawode and Al Sadek

What is Financial Stability?

Table 1 (contd.): Selected Central Bank Definitions of Financial

Norges Bank (Central Bank

Financial Stability Report

Financial Stability Report

Alawode and Al Sadek

What is Financial Stability?

Table 1 (concl.): Selected Central Bank Definitions of Financial Stability

Reserve Bank of South

Financial stability can be

Central Bank of Sri Lanka

Swiss National Bank

Central Bank of Iceland

Financial stability means

Financial Stability Report

Alawode and Al Sadek

What is Financial Stability?

including its role in channeling

Alawode and Al Sadek

What is Financial Stability?

economics itself is replete with