Financial Stability as an objective of central banks around the world

Central banks have come a long way from being an issuer of currencies few hundred years ago to playing significant roles in maintaining overall financial stability and fostering growth in today's economies. This natural evolution over the last few hundred years has seen central banks assuming more responsibilities and the purview of activities under them has also expanded. In a recent interview with the newly appointed governor of the Central Bank of India (Reserve Bank of India), Mr. Raghuram Rajan said that the primary objective of the central bank is to ensure price stability and financial stability. He went on to add that with the price stability in place, the stage will be set for the growth of an economy as well. While economists having pro-growth stance may term this objective hawkish, there is still a point to be noted here. That is; central banks of emerging economies as well as advanced economies of the world state the goals of financial stability in their objectives. The tectonic shifts in the financial economics around the world in the last few decades has increasingly made economists believe that the stability of financial system cannot be taken for granted and the world at large itself may become a victim of its own deviant actions. The overheating and consequently the bursting of real-estate based assets bubble in Japan in 1980s to the recent subprime crisis in United States in the second half of 2000 is a testimony to the fact that aftermath of such crisis is huge in this age of interdependent economies.

At this point, it is important to pause for a moment and understand the reasons for such crisis in order to appreciate the need for financial stability in today's economies. At a very big picture level, the economy as a whole has financial institutions (investment banks, pension funds, insurance companies to name a few), financial intermediaries like commercial banks, financial markets (that includes capital market, money market), payment and settlement systems, the real economy and the linkage between the real sector and the financial system. This linkage results in spillover from one system to another in the event of overheating of any system.

Few of the reasons as per the literature available on the websites in research section of central banks are as follows:

(a) The failure to mitigate the risks at the level of individual financial institutions can result in destabilizing the entire financial system as a whole. Institutions taking risky positions and then simultaneously unwinding their positions in the market cause prices to fluctuate and result in more than expected expansion or contraction of credit. The US subprime crisis of 2008 was a result of excessive exuberance to own houses that were available during the regimes of low interest rates for a long period of time, investment banks riding on the huge leverage to make money on mortgage backed securities and insurance companies writing credit default swaps for subprime credit. The bubble was in the making and as it was imminent, the bursting of bubble resulted in market transactions getting contracted. Some institutions suffered greater than expected losses and asset prices dropped drastically resulting in the deterioration of real economy thereby aggravating the instability in the financial system as well. There is a similar account of the crisis in Japan in the decade of 1980s. Japan also witnessed an unprecedented increase in the transactions in the property market. It was because of elevated expectations of returns on the part of investors. The bubble was being formed on the expectations of the market that the regime of low interest rates will continue for substantially long period to come. This resulted in the prices overshooting in both residential and commercial estates so much that the central business districts of Tokyo had witnessed huge real estate bubbles and the consequent and inevitable collapse as well. The governments around the world then face the aftermath of such crisis in the form of bail-outs. The new regulations are formed to arrest such events in future; one of the examples is the passing of Dodd-Frank regulations passed after the crisis of 2008.

(b) The second reason of the systemic risks in the financial system is the emergence of a new class of financial products like derivatives and a new class of investors known as hedge funds. The point here is that financial innovation results in challenging the conventional financial products in terms of returns; but thereby introducing the risk of varying degrees in the financial system. 

The above arguments reason the fact that financial stability is indeed an important objective to be pursued by central banks and the lack (or failure) of financial stability can have repercussions in an economy.