Business

The importance of financial system stability

Tony Morison

Wednesday, February 07, 2018

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When you hear the term “financial stability,” words like freedom, retirement and security may readily come to mind. We usually think of financial stability as a synonym or prerequisite for financial independence. When the Bank of Jamaica (BOJ) refers to financial stability, however, it is referring to financial system stability.

Financial system stability is a state in which the components of the financial system – that is, financial institutions, financial markets and payment systems – are all resilient to economic shocks. Such resilience facilitates the continued and consistent intermediation of funds and arrangement of payments by financial institutions, thereby promoting economic activity.

In other words, financial stability can be described as the proper, safe and efficient functioning of the financial system in its promotion of real economic activity.

During the different stages of our lives, financial stability is relevant to us and how we live each day.

A stable financial system is one in which financial institutions are adhering to best practices necessary to ensure that your investment in your first car, first home or first child is protected.

Similarly, if you are focused on retirement, being assured that your pension will be available when you get to the age of retirement is a function of a stable financial system.

Financial stability is important to all of us – it is everybody's business.

YOU NEVER MISS THE WATER UNTIL THE WELL RUNS DRY

Challenges within the financial system can lead to disruptions in the flow of transactions between economic agents. This could have implications for households, the corporate sector, as well as the government.

The disastrous implications of a weak financial system can be seen from the US financial crisis in 2007-2008 that ballooned into a global economic crisis. Those events demonstrated the dangerous possibilities that stem from systemic or widespread financial risks even with the presence of seemingly sound institutions. As such, financial stability provides significant benefits to the general public in the following ways:

• A safe and secure financial system facilitates the conduct of day-to-day financial transactions. These financial transactions include a myriad of essential services, such as the payment of salaries, business transactions, payment of utility bills, as well as household purchases.

• A stable financial system encourages savings and the deposit of funds which can be accessed through various mechanisms, like ATMs and mobile wallets.

• Sound financial institutions have the capacity to mobilise lending to those who need financing for the purposes of consumption and business operations.

• A sound financial system is essential in facilitating foreign transactions, for instance the importation and exportation of goods and services.

• In addition, friends and relatives living abroad can send remittances through financial institutions if there is confidence in the stability of these entities.

The vital nature of financial stability can also be highlighted by referring to the old proverb immortalised in a song by Beres Hammond and Buju Banton: “You never miss the water until the well runs dry.”

WHERE DOES THE CENTRAL BANK FIT IN ALL OF THIS?

The preservation of financial system stability is a primary responsibility of the Bank of Jamaica (BOJ).

BOJ established a financial stability unit in 2002. Subsequently expanded to become today's Financial Stability Department, its work is focused on the development of early warning tools and financial risk assessment models which have been made public over the years in the Bank's annual Financial Stability Report.

In 2015, the Bank of Jamaica was assigned statutory responsibility for the oversight of financial system stability in Jamaica.

The following year, 2016, saw the first meeting of the BOJ-chaired Financial System Stability Committee (FSSC).

The FSSC is a statutory committee established under section 34H of the Bank of Jamaica Act. Its mandate includes reviewing developments in the financial system and the economic environment, providing oversight of financial stability assessments prepared by Bank of Jamaica staff, advising on financial stability policy and engaging with stakeholders.

The main requirement of BOJ's additional institutional responsibility is to incorporate a macroprudential approach in the Bank's oversight of the financial system.

As the prefix 'macro' indicates, macroprudential relates to the whole or significant parts of the financial system rather than just individual financial institutions. The Bank's regular supervisory oversight of individual financial institutions, by contrast, would be categorised as prudential supervision.

Prudence is another word for caution involving forethought, and so prudential supervision relates to actions that promote sound practices and limit imprudent risk-taking. Macroprudential policies, therefore, should help ensure that everyone in the financial system takes a cautious approach to risks that could become systemic, that is, risks that affect the entire financial system.

In fulfilment of this mandate to monitor systemic risk, the Bank undertakes a number of ongoing macroprudential surveillance activities. These include the monitoring of links (or interconnectedness) among different types of financial institutions; assessing the degree of resilience of the system to financial shocks; measuring the extent of overheating in credit and asset markets; and the estimation of common exposures to specific sectors and products.

This macroprudential framework will complement the traditional prudential or institutions-based supervision of regulated entities.

BOJ's institutions-based supervision aims to protect consumers by reducing the likelihood of failure of individual institutions, while its macroprudential surveillance aims to reduce the likelihood of financial system-wide distress and avoid significant losses in real output to the overall economy.

For the fulfilment of its financial stability mandate, the central bank collaborates with other regulatory agencies in the undertaking of risk assessments. BOJ has the ability to request the inspection of any financial institution or issue rules and standards to address systemic risks and imbalances in the financial system. In addition, the BOJ–chaired FSSC is tasked with evaluating systemic risks and making policy recommendations to address any identified exposures.

Prudential supervision of deposit-taking institutions by BOJ, the regulation of the securities industry, the insurance sector and private pension funds by the Financial Services Commission (FSC) and the provision of deposit insurance by Jamaica Deposit Insurance Corporation (JDIC) are all important factors underpinning the macroprudential oversight of Jamaica's financial sector.

In summary, it is imperative to cultivate and maintain a stable financial system so that the system is not only resistant to shocks but, importantly, does not itself become a source of economic shocks and remains characterised by predictability, integrity and sufficient controls in place to mitigate operational risks.

If a vibrant private sector is the engine of growth, then a sound financial system is the fuel it runs on, so the goal of sustained and inclusive economic growth cannot be realised without it.

Tony Morrison is a communications specialist at the Bank of Jamaica. He can be reached at tony.morrison@boj.org.jm.

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