What is “Financial Stability”?
Financial stability refers to a condition where the financial institutions, financial markets, and financial infrastructure – the three components of the financial system of a county – are stable. It plays a vital role in the economic development of an economy, efficient allocation of resources, price stability, and the policy goals of the central bank.
In order to ensure the financial stability of the system as a whole, macro-prudential policies have been adopted by countries. These policies aim to lower the financial system’s sensitivity to shocks, by restricting the buildup of financial vulnerabilities and seek to prevent significant disruptions in credit and key financial services that are pivotal for maintaining stable economic growth.
Key Learning Points
- Financial stability includes the stability of financial institutions, markets, and infrastructure
- Financial institutions/banks play a pivotal role in maintaining the financial stability of a country’s financial system
- The banks’ leverage ratio, more specifically, Tier 1 leverage ratio, is used to measure the vulnerability of banks to any sort of crisis, for example, a financial crisis
Financial Stability – Constituents
Stability of financial institutions refers to a condition when such institutions are able to function properly, are resistant to (or can absorb) economic shocks, are adequately capitalized, and carry out their function of financial intermediation adequately or efficiently – without external support.
With reference to financial markets, stability here refers to a condition where there is no significant volatility in these markets, no major deviation of asset prices from economic fundamentals, least vulnerability to earnings manipulation by market players, and no major disruption vis-à-vis market-related transactions.
The stability of financial infrastructure is characterized by sound legal and regulatory infrastructure, the enforceability of contracts, an environment where concerned parties can engage in secured transactions, smooth operation of market discipline, and efficient running of payment and settlement systems.
The stability of financial institutions/banks plays a pivotal role in maintaining financial stability. Basically, banks need to be well-capitalized, in order to tackle any potential financial crisis arising out of the bursting of a speculative asset bubble, currency crisis, stock market crash, a protracted recession (resulting in an unsustainable build-up of non-performing assets), or sovereign default.
Tier-1 Leverage Ratio
To assess the financial soundness of a bank or banks in a country, there is a ratio, known as leverage ratio, more specifically, Tier 1 leverage ratio.
A leverage ratio is a tool that is used by regulators in a country, to ensure that banks are well-capitalized. This ratio is used to place restraint on the degree to which a bank can leverage its capital base. Further, the leverage ratio is highly useful for investors and regulators to assess whether a bank or banks will be able to repay their financial obligations, in the eventuality of a financial crisis or a deep recession – which makes banks vulnerable to significant losses.
The leverage ratio is defined as the capital measure (which is Tier 1 capital) divided by the exposure measure (which includes both on-balance sheet exposure and off-balance sheet items), expressed as a percentage. This ratio measures the core capital of a bank to its total assets.
The formula to calculate Tier 1 leverage ratio is:
Tier 1 Leverage Ratio = Tier 1 Capital/Consolidated Assets x 100
Tier 1 Capital = common equity, retained earnings, and some other instruments.
According to the Basel III Accord on banking regulation, banks need to have a minimum Tier 1 leverage ratio of 3%.
Financial Stability – Tier 1 Leverage Ratio, Example
Given below is an example, where a bank’s Tier 1 leverage ratio is calculated, based on its earnings reported on October 31, 2019. This ratio is calculated by taking the total Tier 1 capital of US$204bn and dividing the same by the bank’s total assets i.e. the adjusted quarterly average assets (US$2,679bn).
The Tier 1 leverage ratio of this bank is 7,6%, well above the minimum requirement of 3%. This indicates that this bank is in a financially sound condition, and its ability to withstand a negative shock to its balance sheet is good. The higher this ratio is, the greater is the likelihood that a bank will be able to withstand such a shock.