Name: Dominic Waite

Email Address: Waitedominic@gmail.com

Phone Number: +1 (876) 366-3595 / + 1 (876) 845-1913

UWI ID NUMBER: 620130627

 “Financial stability is the capability of a financial system to efficiently

allocate resources, assess and manage financial risks, maintain employment levels close to the

economy’s natural rate, and eliminate relative price movements of real or financial assets that

affect monetary stability and employment levels.” (Bank, 2020). I have brought forward this

preamble to highlight the role and importance of financial stability in financial systems. All

economic agents- firms, consumers and governments, all depend on financial systems to be

financially stable so that they can: facilitate current demand, be successful in legislating fiscal

and monetary policies, and lastly in expanding and preserving resources to satisfy future

consumption. The stability of a financial System is inextricably linked with A) the stability of

the financial system in absorbing economic shocks; B) the stability of the financial system

in predicting future financial risks by leveraging financial prudence and frugality and;

C) the stability of the financial system in accommodating and facilitating the efficient

allocation of resources from savers and investors to those who demand these resources.

If financial systems apply this to their framework and actions, then the economy in which they

operate can experience economic sustainability. According to Hemant Singh “one of the three

pillars to sustaining development is economic sustainability which the ability of an economy to

support a defined level of economic production indefinitely” (Singh, 2019). For economies to

sustain a defined level of economic production, financial systems must be financially stable in

properly distributing their financial assets to facilitate economic production.

Firstly, the stability of a financial system in absorbing economic shocks

depends on how well a financial system deals with changes in aggregate demand and aggregate

supply in an economy. N. Gregory Mankiw describes shocks as “ fluctuations in the economy

due to changes to aggregate demand and aggregate supply which pushes economic output and

employment away from their natural levels” (Mankiw, 2011). If it is that a financial system

does not establish and implement the requisite safeguards to protect themselves from economic
shocks, then these shocks will have adverse effects with setbacks for the financial system in

achieving and maintaining financial stability. The extreme outcome of such an event can result

in the complete collapse of the financial system in its entirety. A real-life example where shocks

in the world’s international financial system resulted in a complete collapse was during the

financial crisis years of 2007-2009. According to a Washington Post business article “The

financial crisis was the worst U.S disaster since the Great Depression of the 1930s. In the U.S,

the stock market plummeted, wiping out nearly 8 trillion in value between the years 2007-2009.

Unemployment climbed, peaking at 10% in October 2008. In all, the Great Recession led to a

loss of more than 2 trillion in global economic growth or a drop of 4% between the second

quarter of 2008 to the first quarter of 2009” (Merle, 2018). In these years, banks began to lose

money on mortgage defaults, credits to business and consumers decreased drastically, bank

reserves and total deposits declined , and additionally, banks lost the ability to engage in

interbank lending with other financial institutions. Moreover, this international economic

slowdown had resulted in the delay of numerous investment projects for firms as it was more

costly to do so, thus stifling entrepreneurship, job creation, and sustaining development. Based

on information previously stated, it is apparent that the economies of then and today were and

still are dependent on the flow of resources in the form of liquidity and credit as it provides

funding for both normal and desired tasks so economic shocks can exert a negative spill-over

to nearly if not every sector of an economy. This misallocation of financial resources in the

2007-2009 financial crisis imposed a challenge on sustaining development for both the current

generation and future generations. International Governments and Global Financial Institutions

did not implement a rational decision- making framework regarding the affairs and sustenance

of financial systems. An adequate decision-making framework should have been consistently

employed in policies to govern the efficient allocation of financial resources and for leveraging
financial prudence and frugality in the handling of financial assets so that the financial crisis

could have been avoided.

Secondly, the stability of a financial system in leveraging financial

prudence and frugality with handling financial assets depends on the consistent

implementation of rational decision-making framework in the affairs of financial systems

and its efforts in achieving financial stability. This is a responsibility for the management of

financial systems and with this they must be able to predict possible risks with engaging in

future financial endeavours. Governors of financial systems and institutions must learn to

leverage frugality in the handling of financial assets. Frugal as defined by the Merriam –

websters Dictionary “is characterized by or reflecting economy in the use of resources”. It is

in the heart of leveraging frugality that sustaining development can be thoroughly achieved.

An example where the management of financial institutions failed to leverage financial

prudence and frugality and devise proper policymaking for future financial stability is

reflected with what befell one of the major players in the global investment banking and

financial services industry. They were known as Lehman Brothers or more formally known

as Lehman Brothers Investments Holdings Inc. Their failure resulted in them suffering the

biggest bankruptcy in World’s history. Kimberly Amadeo outlined four underlying causes

that led to the failure of Lehman Brothers. “1. Risk – Risk due to a cash flow problem that led

to its bankruptcy. 2. Culture – It was in their culture to want to stay ahead of competitors

that also used high-risk strategies, and they were overconfident in the company being “too

smart” to fail. 3. Overconfidence – Lehman overconfidence was reflected in how they bought

heavily into commercial real estate and risky loans just because they wanted to achieve quick

real estate growth and instead of selling them right away, it kept them on its books. 4.

Regulator Inaction.: The U.S Securities and Exchange Commission (S.E.C) failed to regulate

Lehman brothers excessive risk actions. In early of 2007, the (SEC) knew the bank was
taking on too much risk and didn’t do anything about it” (Amadeo, 2020). For the sake of

the Lehman brothers, the risk actions they took did not reflect financial prudence. They failed

to overlook the possible risks associated with issuing subprime mortgages by being too

overconfident about their risk actions and this were the beginning of their end. They failed to

leverage financial prudence and frugality with their financial products by encouraging

excessive borrowing even among consumers with low credit ratings, creating risky products

in the process, and by engaging in high-risk behaviour. To combat this, appropriate decision-

making framework regarding financial systems and attaining financial stability must be

employed. In the U.S, the previous Chairman of the Federal Reserve , Ben Bernanke ,

proposed a policy to combat the financial crisis. In an article, he outlined “… In the near

term, the highest priority is to promote a global economic recovery. The Federal Reserve

retains powerful policy tools and will use them aggressively to help achieve this objective.

Fiscal policy can stimulate economic activity, but a sustained recovery will also require a

comprehensive plan to stabilize the financial system and restore normal flows of credit….

High on the list, in light of recent events, are strengthening regulatory oversight and

improving the capacity of both the private sector and regulators to detect and manage risk…

International cooperation is thus essential if we are to address the crisis successfully and

provide the basis for a healthy, sustained recovery” (Bernanke, 2009). An important point to

raise out of this article is where he mentioned that the Federal Reserve will be devising a

comprehensive plan to stabilize the financial system so that normal flows of credit can be

restored. This is reflected in the use of an efficient payment system to allocate resources

between those who invest financial assets and those who borrow these assets.

Lastly, the stability of the financial system in accommodating and

facilitating the efficient allocation of resources between investors and borrowers depends on

the development of an appropriate payment system to facilitate the flow of funds between
savers and borrowers. The financial system is comprised of financial institutions that

intermediate this process to efficiently allocate resources to promote economic growth and

development. A financial system failure to do so will result in the devaluation of financial

products. An example of this was reflected in years of the Great Recession where a failure in

the payment systems worldwide have caused businesses and consumers to encounter

financial difficulties. “When banks started to collapse during the Great Recession,

international payments practically froze – not once but three times. The worst came after the

failure of Lehman Brothers in September 2008, the event is seen as the official kick-off of the

global financial crisis: international banks and businesses were suddenly unable to obtain

dollar financing and couldn't make dollar payments. This caused "sudden stops" in

developing countries, deep recessions in developed countries, and a lasting contraction in

global trade… At the same time, demand for payments massively increased, as investors sold

risky assets for dollars, businesses repaid dollar loans and drew down dollar deposits, and

holders of foreign currencies exchanged them for dollars. As suspicion grew that banks

would be unable to meet payment demands, the entire international dollar payments system

started to freeze” (Coppola,2020). If there is not an efficient payment system to facilitate the

allocation of funds between savers, investors ,and borrowers then this will affect sustaining

development. Imbalances in fiscal and current account deficits coupled with high demand for

funds in these accounts will affect financial stability in financial systems if they cannot be

financed sustainably. Therefore, the allocation of financial resources between savers and

borrowers must commensurate with the rising complexity in consumer demand for financial

products. By consistently improving these financial assets , both current generations and

future generations can always engage in making seamless transactions and this will promote

economic growth and sustaining development.

 In conclusion, it is apparent how financial stability is crucial in sustaining

development. As time goes by, with advances and consistent increases in the demand for

financial resources, the management of financial institutions worldwide are tasked with more

roles and responsibilities to adequately and economically allocate the supply of their

resources among financial institutions, financial markets, and financial infrastructures in an

effort to bring about economic development and then through that, sustaining development.

Financial stability is imperative to properly allocating money among financial institutions,

financial markets, and financial infrastructure and it is achieved firstly; by ensuring that

financial systems are stable in absorbing economic shocks; secondly ; by ensuring that

financial systems are stable in predicting future financial risks by leveraging financial

prudence and frugality, and thirdly; by ensuring that financial systems are stable in

accommodating and facilitating the efficient allocation of resources from savers and investors

to those who demand these resources. The financial crisis of 2007-2009 resulted because the

management of financial systems exercised overconfidence about the rising profitability in

mortgage-backed securities. They didn’t evaluate the risk to reward ratio in issuing excessive

loans as well as the negative impacts it could have on the stability of the system and all those

that demand the resources of their systems. In addition to that, they did not employ the

appropriate decisions and policy legislative framework that reflected financial prudence and

frugality with financial assets and when the demand for mortgage backed securities went

down, financial systems and by larger extent , all the economies world-wide destabilized –

some going into a recession while some others into a depression bringing about lasting

negative effects on current and future generations. “In all the countries affected by the Great

Recession, recovery was slow and uneven, and the broader social consequences of the

downturn—including, in the United States, lower fertility rates, historically high levels of

student debt, and diminished job prospects among young adults—were expected to linger for
many years” (Duignan, 2020). Financial systems must be financially stable so that economic

sustainability and development can be achieved and maintained. It is only then that sustaining

development can be achieved and maintained.

REFERENCES

1. Amadeo, K. (2020, April 16). How the 2008 Lehman Brothers Collapse Affects You

Today. Retrieved November 08, 2020, from https://www.thebalance.com/lehman-

brothers-collapse-causes-impact-4842338

2. Bank, W. (2020). Financial Stability- The World Bank Group. Retrieved 2020, from

https://www.worldbank.org/en/publication/gfdr/gfdr-2016/background/financial-stab

3. Bernanke, B. (2009, January 13). The Crisis and the Policy Response. Retrieved

November 08, 2020, from

https://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm

4. Coppola, F. (2020). The Great Recession: Why International Payments are Unlikely

to Freeze Again. Retrieved 2020, from https://www.americanexpress.com/us/foreign-

exchange/articles/international-payments-freeze-unlikely/

5. Duignan, B. (2020). Great Recession. Retrieved November 11, 2020, from

https://www.britannica.com/topic/great-recession

6. Mankiw, N. G. (2009). Chapter 9: Part 4. In Macroeconomics (7th Edition ed., p.

278). 41 Madison Ave. , New York: Worth Publishers

7. Merle, R. (2018, September 10). A guide to the financial crisis — 10 years later.

Retrieved November 07, 2020, from

https://www.washingtonpost.com/business/economy/a-guide-to-the-financial-crisis--

10-years-later/2018/09/10/114b76ba-af10-11e8-a20b-5f4f84429666_story.html

8. Singh, H. (2019, March 30). Sustainable Development: Background, Definition,

Pillars, and Objectives. Retrieved November 09, 2020, from

https://www.jagranjosh.com/general-knowledge/sustainable-development-

background-definition-pillars-and-objectives-1446807134-1