The global financial crisis of 2007 was one of the shocking economic disasters of the last one hundred years. Large numbers of banks in the advanced countries were failed causing irreparable damage to the financial system and to the real economy. Central banks learned that banks have to be well regulated and well capitalised so that they can withstand any crisis.
The financial crisis thus provided a valuable lesson to the western countries who boasted that they always have the sophisticated economic system. After the crisis, they introduced a large number of policies for the banking system including strong regulations that were unprecedented in history for them.
Failure of banks leaves long scars on the economy as a whole. A bank failure is the failure trust, which cannot be rebuilt. Hence financial institutions should be kept stable and healthy.
After the crisis, central banks across the world are strengthening measures like regulation and supervision to keep the banking system stable. Most central banks including the RBI have added financial stability as a core objective of monetary policy. The concept of financial stability or the situation where banks remains healthy, without any weaknesses, became an important priority for central banks after the crisis.
What is financial stability?
Financial stability means financial institutions individually and collectively are being able to deliver their functions properly, withstanding external shocks and avoiding internal weaknesses. ‘India Financial Stability Report’ published by the Reserve Bank of India (March 2010), defines financial stability: “From a macro prudential perspective, financial stability could be defined as a situation in which the financial sector provides critical services to the real economy without any discontinuity.”
During the time of the global financial crisis, RBI has made many unconventional measures to protect the banking system. Liquidity support was provided abundantly so that no banks should face stress. The RBI since 2010 is publishing India Financial Stability Report to assess financial stability scenario in the country. Financial stability is now one of the three important objectives of monetary policy besides price stability and credit support.
In its monetary policy statement in May 2008, the RBI mentioned that sometimes, the objective of financial stability becomes more important than the objective of price stability.