A stable financial system is one that can provide crucial services to households and businesses in bad times as well as good.
What is financial stability?
What role does the financial system play in the economy?
Money is a vital resource. It needs to flow to where it can be used best. The financial system allows this to happen.
The financial system is made up of different parts. These include banks, other institutions (such as insurers) and the financial markets that connect them together.
You can think of the financial system as the wheels of the economy. It provides crucial services which keep the economy moving:
- It offers a way for us to make payments so we can buy and sell goods and services
- It allows us to manage and insure against risks
- It gives us a way to manage our savings
- It allows households and businesses to borrow money to invest and grow
Financial stability might sound confusing but it’s just a way of describing the financial system when it’s fulfilling its basic roles. With a stable financial system, the wheels of the economy keep turning, even when the conditions get difficult.
What happens when the financial system is unstable?
It can be difficult to spot when things are unstable. It might only become obvious when road conditions gets tougher and things start to go wrong. Hidden weaknesses can leave the financial system vulnerable if financial institutions are not prepared for unexpected events.
If one area of the financial system is weak, problems can start to spread or multiply. This can disrupt the services which households and businesses rely on for their day-to-day needs.
For example, you might find it harder get a mortgage or save enough for your retirement. The financial crisis of 2007/08 showed that financial instability can severely affect people’s jobs and lives.
How can the financial system be made more stable?
Here at the Bank of England it’s our job to maintain financial stability. We do this through two bodies: the Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA).
The FPC are the mechanics of the financial system, working to keep everything moving smoothly. They identify risks and flaws in the financial system, assessing how bad they might get and acting to remove or reduce them.
The PRA are the safety engineers who regulate and oversee financial institutions.
There are three elements which contribute to financial stability:
1. A reliable mechanism must be built with a strong and well-designed structure. Financial institutions are expected to meet very high standards of resilience. This is achieved by setting tough regulations which are checked by the PRA. New rules aim to encourage honest behaviour and limit excessive risk-taking with other people’s money.
2. The ability to change gears is necessary when the road gets tougher. Financial institutions must be able to adapt their level of resilience to new risks that might be developing. This is why banks go through stress tests every year to make sure they have enough financial resources (called capital) to provide financial services in bad times as well as good.
3. A car’s shock absorbers reduce the impact of bumps in the road. The FPC has developed tools to dampen and contain shocks when they occur so that they do not get worse. For example, we have put limits on the amount of mortgages lenders can approve that are 4.5 times or more the size of a borrower’s income. This helps us reduce the risks from household borrowing should the economy suffer a downturn.