The Stability of Financial System

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The stability of financial
system
- Nabaraj Adhikari, PhD
All rights reserved.

Copyright © Nabaraj Adhikari
Contents
 Liquidity crisis
 Factors that affect stability
 Credit Rating Agency
 Private solution for bank runs and
banking panics
 Government solution for bank runs
and banking panics
 Solutions for market crashes
2
Liquidity crisis
 A liquidity crisis is defined as a sudden and
prolonged evaporation of both market and
funding liquidity, with potentially serious
consequences for the stability of the financial
system and the real economy.
 Market liquidity is defined as the ability to
trade an asset or financial instrument at short
notice with little impact on its price; funding
liquidity, more loosely, as the ability to raise
cash (or cash equivalents) either via the sale of
an asset or by borrowing.
 In financial economics, a liquidity crisis refers
to an acute shortage or ‘drying up’ of liquidity.
Liquidity is a catch-all term that may refer to
several different yet closely related concepts.
3
Liquidity crisis, contd.
 Among other things, it may refer to market
liquidity-the ease with which an asset can be
converted into a liquid medium e.g. cash, funding
liquidity-the ease with which borrowers can obtain
external funding, or accounting liquidity-the health
of an institution’s balance sheet measured in terms
of its cash-like assets. Additionally, some
economists define a market to be liquid if it can
absorb ‘liquidity trades’-sale of securities by
investors to meet sudden needs for cash without
large changes in price.
 This shortage of liquidity could reflect a fall in
asset prices below their long run fundamental
price, deterioration in external financing
conditions, reduction in the number of market
participants, or simply difficulty in trading assets.
4
 The above-mentioned forces mutually reinforce each

other during a liquidity crisis. Market participants in
need of cash find it hard to locate potential trading
partners to sell their assets. This may result either due
to limited market participation or because of a
decrease in cash held by financial market participants.
Thus asset holders may be forced to sell their assets at
a price below the long term fundamental price.
Borrowers typically face higher loan costs and
collateral requirements, compared to periods of ample
liquidity, and unsecured debt is nearly impossible to
obtain. Typically, during a liquidity crisis, the interbank
lending market does not function smoothly either.
 Several mechanisms operating through the mutual
reinforcement of asset market liquidity and funding
liquidity can amplify the effects of a small negative
shock to the economy and result in lack of liquidity and
eventually a full blown financial crisis.
5
 A negative financial situation characterised by a lack
of cash flow. For a single business, a liquidity crisis
occurs when the otherwise solvent business does not
have the liquid assets , i.e., cash necessary to meet its
short-term obligations, such as repaying its loans,
paying its bills and paying its employees. If the
liquidity crisis is not solved, the company must declare
bankruptcy. An insolvent business can also have a
liquidity crisis, but in this case, restoring cash flow
will not prevent the business's ultimate bankruptcy.
 For the economy as a whole, a liquidity crisis means that the
two main sources of liquidity in the economy, banks and the
commercial paper market, severely reduce the number of
loans they make or stop making loans altogether. Because so
many companies rely on these loans to meet their short-term
obligations, this lack of lending has a ripple effect throughout
the economy, causing liquidity crises at a plethora of
individual companies, which in turn affects individuals.
6
Stability
 Financial stability can be defined as a condition in which
the financial system – comprising of financial
intermediaries, markets and market in structures – is
capabilities with understanding shocks, there by
reducing the likelihood of disruptions in the financial
intermediation process which are severe enough to
significantly impair the allocation of savings to
profitable investment opportunities.
 Developed modern economies are so dependent on the
proper functioning of their financial systems that a
breakdown can be disastrous. For example, financial
breakdowns in the United States and in Europe in the
early 1930s led to the worldwide economic slump known
as the Great Depression. In the United States,
unemployment reached 25%, and output fell by a
quarter. Economic collapse in Germany helped the Nazis
to power, paving the way for world War II. The stability
of the financial system is therefore a vital concern of
government policy. 7
Factors that affect stability
 There are various factors which affect the stability

of financial system
Social factors
Legal factors
Economic factors
Political factors
Technological factors
8
Factors that affect stability, contd.
 Social factors
The social factors of a nation determine the value system
of the society which, in turn affects the functioning of the
financial system. Sociological factors such as costs
structure, customs and conventions, cultural heritage,
view toward wealth and income and scientific methods,
respect for seniority, mobility of labor, etc., have far-
reaching impact on the financial system. these factors
determine the work culture and mobility of labour,
workgroups, etc. thus, social factor includes living pattern
of a nation. It decades the population composition of the
country. Thus financial system is highly influenced by
these factors.
 Legal factors
Regulatory system, and International laws and
regulations, etc.
Non-compliance of above regulations may impose fine and
penalties on financial system. 9
 Economic factors
 Political factors
 Technological factors
 Composition problems
 The three types of instability- banking panics, stock market crashes,
and price-level instability- all involve composition problems. In every
case, behaviour that makes sense for each individual separately leads
to an outcome that is damaging to all.
 In a banking panic, fearing the banks will fail, individuals rush to
ensure their liquidity by withdrawing their deposits. The result of their
actions is the very failure they fear.
 The crash of an market is very similar: fear of a collapse in prices
prompts massive selling. Massive selling leads to a collapse in prices.
 Price-level instability, too, involves a composition problem. When a
single bank increases or decreases its lending, and creates or
destroys money, it has little effect on prices. But when all banks do
this together, the general increase or decrease in the quantity of
money leads to an inflation or deflation. The result is harmful, not
least to the banks themselves.
 In each of these cases, the market fails to provide individuals with the
incentives to act in a way that produces the best outcome for all.
10
 Excessive risk taking

There is another incentive problem that may contribute
to instability. Banks make risky loans. If the loans go
bad, a bank may fail. If the bank bears all the losses that
result from its failure, it will presumably take these
losses into account when making loans-the expected
return will reward it adequately for the risk it bears.
Suppose though that the failure of the bank triggers a
banking panic, which in turn results in a collapse of the
economy. Then the losses due to the bank’s failure
greatly exceed those borne by the bank itself. When the
losses due to the bank’s failure greatly loans are too
risky from the economy’s point of view. The expected
return does not compensate the economy as a whole for
the risks it bears. It would be better from the economy’s
point of view if the bank made loans that were less
risky.
11
 The role of externalities.
Both composition problems and excessive risk taking are
examples of a type of market failure known as an
externality. An externality exists when the costs of an
individual’s actions are not all borne by the individual
himself.
Externalities create an incentive problem. Because the
interests of the individual are not aligned with those of
the economy as a whole, the individual will behave in
ways that harm the general good.
The role of externalities in financial instability may justify
government intervention to promote stability
12
Private solution for bank runs and banking
panics
 A situation that occurs when a large number of
bank or other financial institution's customers
withdraw their deposits simultaneously due to
concerns about the bank's solvency. As more
people withdraw their funds, the probability of
default increases, thereby prompting more
people to withdraw their deposits. In extreme
cases, the bank's reserves may not be sufficient
to cover the withdrawals.
 A bank run is typically the result of panic, rather
than a true insolvency on the part of the bank;
however, the bank does risk default as more and
more individuals withdraw funds - what began as
panic can turn into a true default situation.
Copyright © Nabaraj Adhikari 13

Private solution for bank runs and banking panics, contd.
 Because banks typically keep only a small percentage
of deposits as cash on hand, they must increase cash
to meet depositors' withdrawal demands. One method
a bank uses to quickly increase cash on hand is to sell
off its assets, sometimes at significantly lower prices
than if it did not have to sell quickly. Losses on selling
the assets at lower prices can cause a bank to become
insolvent. A "bank panic" occurs when multiple banks
endure runs at the same time.
 In the United States, the Federal Deposit Insurance
Corporation (FDIC) is the agency that insures banking
deposits. It was established by Congress in 1933 in
response to the many bank failures that happened in
the 1920s. Its mission is to maintain stability and
public confidence in the U.S. financial system.

 The clearinghouse association
The failure of one bank, because it reduces confidence in
banks in general, can trigger runs on other banks. Such
contagion gives banks a strong incentive to organise into
an association that will monitor the behaviour of
individual members. Instead, before government
regulation replaced it, such self-regulation was common
among banks.
The vehicle for this self-regulation was generally the
clearinghouse association. Clearinghouse are set up for
quite a different purpose, once in existence, however,
they provided a natural framework for self-regulation.
A bank could join the clearinghouse only by satisfying
certain standards. Membership in the clearinghouse
increased public confidence in a bank and made it easier
for the bank to attract deposits. This advantage, plus the
advantage of actual clearing, made the costs of
membership
worthwhile. 15
 Mutual aid and the provision of liquidity.
The clearinghouse did more than just monitor its
members. In a crisis, it would organise mutual aid. If
the problem was local- a run on one or a few banks- the
clearinghouse would arrange for other members to lend
reserves to the bank or banks under pressure. Because
of the fear of contagion, the other banks were more
than willing to help.
If the crisis developed into a full-fledged panic, the
clearinghouse would act to defend the system as a
whole. Its first step would be to substitute the credit of
the association as a whole for the credit of individual
banks. Information about individual banks would be
suppressed (individual banks were not permitted to
publish their balance sheets). Instead, the balance
sheet of the whole association would be made public to
indicate both the system’s soundness and its unity.
16
 Mutual aid and provision of liquidity, contd.
If this failed to restore confidence, the clearinghouse
would increase the liquidity of member banks by means of
loan certificates. Issued to member banks against collateral,
these certificates could be used in place of cash to clear
payments between banks. Their use freed the banks’ cash
reserves for payment to the public.
 Suspension of convertibility.
In severe panic, the measures just described proved
inadequate. The loss of reserves continued to the point that
banks were no longer able to convert their deposits into
currency. In such a situation, the clearinghouse would
declare a partial suspension of convertibility for all banks in
the association. Cash withdrawals by depositors would be
restricted to a certain amount per day (except for employers
who needed cash to pay wages).
17
Private
solution for bank runs and banking panics, contd.
 Mutual aid and provision of liquidity, contd.
Despite the suspension, payments by check could be made in
the normal fashion, and the clearing process proceeded
normally. During the suspension bank deposits usually traded at
a discount against currency. That is, if you paid by check, you
had to pay more than if you paid in cash.
The suspension of convertibility was certainly harmful. It
reduced public confidence in the banking system by casting
doubts on its ability to provide liquidity when liquidity was most
needed. However, it was the lesser of evils. Without a
suspension, the banking system would have been wiped out,
doing much greater harm.
 Private guarantees
State deposit insurance system- The state of the country
organise a safety fund for its banks. Banks have to make
contributions that will be used to guarantee creditors if a
member bank failed. In essence, banks are to provide a mutual
guarantee to one another’s liabilities.
18
Government solution for bank runs and banking panics
 Government intervention in banking can be justified on the
grounds of a kind of market failure called an externality. Bankers
take risk that seem reasonable from their own point of view but
may be excessive from the point of view of society.
 The composition problems that underlie runs and panics involves a
kind of externality.
 The Government can use its ability to create money to provide the
banking system with liquidity in a crisis. The institution that does
this is known as a Lender of last resort.
 The principles of operation of the lenders of last resort were
molded by the principles suggested by two British economists.
Henry Thornton and Walter Bagehot. The principles that include
1)‘the lender of last resort should lend only against good
collateral’, 2) ‘it should accept all good collateral’, 3) ‘it should
charge a penalty rate of interest on its loans’, and 4) ‘these
policies should be made known to the public’.
 Principle 1 makes it clear that the lender of last resort will help
illiquid banks and not insolvent ones. A bank that is solvent has
assets that are worth more than its deposits. It can therefore use
these assets as collateral with the lender of last resort and borrow
enough to pay off all its liabilities.
19
Government solution for bank runs and banking panics, contd.
 Principle 2 ensures that no solvent bank will be allowed to
fail for lack of liquidity. Rather than having to liquidate its
assets at fire-sale prices, a solvent bank will be able to
borrow against them at their fair market value. Raalising
this, depositors who know a bank is sound have no reason
to withdraw their deposits, even if uninformed depositors
do so. This makes a run less unlikely. Moreover, if there is
a run on a sound bank, no harm will be done.
 Principle 3 ensures that the lender of last resort really is a
last resort. Managing liquidity is costly. If liquidity is
readily available at low cost from the lender of last resort,
why bother with expensive alternatives? If banks were to
rely entirely on the lender of last resort for their liquidity,
they would hold fewer liquid assets, and the inherent
liquidity of the system would be reduced. If borrowing
from the lender of last resort is expensive, banks will rely
on their own resources for normal liquidity management;
only banks with no other choice will go to the lender of
last resort for a loan.
20
Principle 4 recognises that to maximise
the benefit of having a lender of last
resort, the public needs to know it is
there. Knowing that the lender of last
resort is ready to provide support
increases public confidence and
lessens the chance of a panic. Any
doubt about the lender of last resort’s
intentions or commitment reduces its
value.
21
 The discount window
As lender of last resort, the central bank stands ready to
lend against suitable collateral to banks in trouble. In
addition, it also makes a variety of nonemergency loans.
 Adjustment credit is available to banks having
temporary difficulty in meeting their reserve
requirements; such loans are usually for only a few
days.
 Extended credit is available for longer periods to small
institutions with seasonal demands for credit and poor
access to the money market- for example, small
agricultural banks and small banks in regions of
tourism.
 Borrowing from the central bank is called borrowing at
the discount window. The rate the central bank charges
is called the discount rate.
22
 Deposit and Credit Guarantee Corporation
 It is a system that protects depositors against the loss of their
guaranteed deposits placed with BFIs in the case of unlikely event of
the BFIs failure.
 DCGC has given the statutory responsibility to perform both the deposit
guarantee and credit guarantee function through Company Act.
 The major objective of DCGC is Guarantee the deposit of the natural
person depositors held with the commercial banks and financial
institutions licensed by Nepal Rastra Bank and to compensate the loss
to the depositors in case of legitimate bankruptcy of the member
institution.
Briefly
 Central Banking
– To bail out solvent banks facing runs
 Deposit insurance
– To prevent runs
 But this generates Moral Hazard
– And the need for regulation, inspection and capital
requirements
23
Solutions for market crashes
 Sometimes the market mechanism that provide a market
with liquidity can be swamped by a rush of selling. The result
is a crash.
 Securities markets are subject to crashes. Crashes are
similar in some respects to bank runs and banking panics- a
breakdown of liquidity mechanisms, a degree of self-fulfilling
expectations, and contagion. However, crashes, unlike runs
and panics, are to some extent self-righting.
 The best way to understand what drives such a rush of
selling is to imagine how you yourself would behave in the
same circumstances.
Solutions
 Restricting credit to traders
 Restricting short sales
 Reducing trading
 Circuit breakers
 Surviving market crashes- rather than trying to prevent crashes, policy
should focus on limiting the damage when they do occur.
 Crashes as a threat to the economy
 Crashes as to threat to market makers
 Strengthening market infrastructure 24
Assignments
1. What do you mean by liquidity crisis? Explain the liquidity
crisis in detail.
2. Define the financial stability. Give details the factors
affecting stability.
3. Explain in detail the private solution for bank runs and
banking panics.
4. What do you mean by Government solution for bank runs
and banking panics? Clarify the Government solution for
bank runs and banking panics.
5. Why do market crash? What are the respective
contributions of investors, market makers, and market
institutions? What are the parallels with bank runs and
banking panics?
6. What are policies to reduce market instability? Discuss
their benefits and costs.
Good luck.
Copyright © Nabaraj Adhikari 25

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 The above-mentioned forces mutually reinforce each

 There are various factors which affect the stability

 Excessive risk taking

Copyright © Nabaraj Adhikari 13

Copyright © Nabaraj Adhikari

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