What is Financial Stability?
This question can best be answered by considering its absence—the failure to attain it through the
presence of ﬁnancial instability. To answer this question two distinct issues must be resolved: the
basis on which “ﬁnancial instability” can be distinguished from other sources of instability and the
basis for identifying the presence of “instability” in the ﬁnancial sector. Both raise further
questions. With respect to the ﬁrst, ﬁnancial instability is only one form of economic instability to
which an economy can be subject. Are there clear dividing lines between ﬁnancial instability and
other types of instability, such as macroeconomic instability? If so, what distinguishes “ﬁnancial”
instability from the others?
Just as fundamental is the question of instability itself. Market prices and interest rates continually
ﬂuctuate. These ﬂuctuations contribute to the vitality of a market economy by providing the
familiar signalling and rationing functions of markets. But such changes in prices and interest rates
continually alter the balance sheets of both households and business enterprises. Are all
movements of interest rates and prices signs of instability? What criteria distinguish instability
from changes that characterize the normal working of a market economy?
2.1 The ﬁnancial dimension of instability
Financial instability refers to conditions in ﬁnancial markets that harm, or threaten to harm, an
economy’s performance through their impact on the working of the ﬁnancial system. It can arise
from shocks that originate within the ﬁnancial system being transmitted throughout that system, or
from the transmission of shocks that originate elsewhere by way of the ﬁnancial system. Such
instability harms the working of the economy in various ways. It can impair the ﬁnancial condition
of non-ﬁnancial units such as households, enterprises, and governments to the degree that the ﬂow
of ﬁnance to them becomes restricted. It...