24 May 2016 (updated on 15 August 2016)
Financial stability has become an ever more common term since the financial crisis. Experts may define it slightly differently, but they largely agree on its importance. For the ECB, financial stability means the ﬁnancial system can withstand shocks without major disruption.
In other words, people can still access their bank accounts, businesses can still make and receive payments, investors can continue to trade, and banks can refinance themselves by borrowing from each other or the central bank.
Stability is all about balance. The financial system features a complex web of dependencies and interactions between different actors. Banks and insurance companies act as intermediaries by directing funds from those willing to lend or invest to those who want to borrow. Financial markets such as bond and money markets also directly bring together lenders and borrowers. Meanwhile, payment and security settlement systems, the “plumbing” of financial markets, ensure the safe flow of money and financial assets.
Risks can arise at different levels and in different forms. An economy-wide slowdown leaves homeowners with high levels of debt and declining property values, while the banks that financed their mortgages may face customers who cannot repay their debts. A slowdown in emerging markets may harm the economy, for example, by lowering demand for goods, leading to job losses in affected industries. It could also trigger sharp sell-offs in debt, equity and foreign exchange markets that in effect make it harder for businesses to fund themselves, constraining economic growth.
So risks and vulnerabilities affecting one actor can impact many others, throwing the system out of balance and threatening overall financial stability.
We constantly monitor the financial system to detect potential risks and vulnerabilities early on and assess what needs to be done. Macroprudential policies can stave off such risks – at the level of a country, a sector or a financial institution. For example, to help stave off a potential housing bubble, national authorities can require euro area banks to tighten their credit standards, e.g. ask customers to put more cash on the table when taking out mortgages. Such measures must be notified to the ECB, which can object, if necessary. The ECB can also demand banks to hold capital beyond the minimum requirements (the precise levels are laid down in EU rules) to strengthen their defences against possible shocks.
While these tools focus on the financial system as a whole, the ECB’s new banking supervision function watches over individual banks so that the banking sector remains safe, and, ultimately, to enhance financial stability in Europe.