The idea of the framework is to integrate the analytical and policy elements of financial stability and provide a framework of practical measures.
It is suggested that a framework for financial stability will have 3 main objectives: To achieve early identification of potential risks and vulnerability of the system | To promote preventative and timely remedial policies to avoid financial instability | To resolve instabilities when the preventative and remedial policies fail. |
The US approach tends to follow the traditional “shock transmission” approach that was the basis of many policy orientated frameworks. In this approach the system was considered to remain in a state of equilibrium if undisturbed or would adjust to a different state if and when a shock was experienced. This approach concord with the view that financial stability is not a defined static state but should be viewed as a continuum in which problems and imbalances may develop or be resolved through the self corrective mechanisms of the financial systems or the imbalances accumulate to the point that outside action would be required.
The ultimate goal of the framework is to prevent problems from occurring or to resolve problems if prevention fails. However there are differences that emanate from differing cultural attitudes. In the US for example, there is more emphasis towards leaving corrections to the market and for the regulator to intervene when the market does not correct the problem.
Financial stability two aspect microprudential and macroprudential supevision.
This was because it was thought that providing the individual institutions were stable, which was the focus of prudential supervision, then the financial system would be stable. This was to ensure that contagion would not occur where the failure of one institution would spread to other institutions in the system.
To build framework to prevent problems arising this requires early warning systems. To do this, indicators of financial stress and strain must be developed and constantly updated and monitored. Risky behavior, risky products and practices and instruments need to be regulated irrespective of where they occur. | The institutions that engage in behavior deemed to pose a threat to financial stability must be addressed irrespective of whether these entities are banks or not. |
Developing a Framework Inside financial corridor is where the financial system is considered to be stable and is likely to remain so in the near future, therefore the policy response is prevention. | Near boundary stability corridor but moving towards instability because imbalances are starting to emerge therefore the policy response is for remedial action either through moral suasion or more intense supervision. | The third area has already moved outside the stability corridor and maybe be unable to perform adequately. The policy actions are reactive to move the system back to stability. | The framework consists of 4 stages The monitoring and analysis of the financial system in search of potential vulnerabilities | Assessing potential threats to financial stability and deciding to take mitigating action. | Implementing measures to actually mitigate vulnerabilities. | Evaluating these actions in order to ascertain to what extent the vulnerabilities have actually been diminished. |
There are basically three lines of defenses. The threats are identified in good time and are mitigated. | Secondly the resilience of the financial system is enhanced to protect it against possible threats. One way of doing this is to build up reserves in good times which can be released when needed (countercyclical buffers). | Thirdly when hit by a crisis and the system is unable to absorb the shock then the last line of defence in crisis management to safeguard the financial stability. This may include liquidity support, deposit guarantees and intervention in management and ownership of institutions in distress. | One way of doing this is to build up reserves in good times which can be released when needed |
Identification and Monitoring of Systemic Risk
.Effective pre-emptive policy action requires the mechanism to identify early and assess the systemic risk.
Work is currently being undertaken within various institutions such as the Financial Stability Board to develop strong analytical tools that will help to identify and measure systemic risk in a forward looking way and thus support policy judgments.
Mechanics of the Framework---There are 3 main elements: Its objective is to limit systemic risk. | It is focused on the financial system as a whole including the interaction between the financial and real sectors. | It uses tools to target the sources of systemic risk both prudential and non prudential tools are used. |