This document discusses the importance of financial stability and the role of governments and central banks in maintaining it. It identifies several symptoms of financial instability, such as slowing capital and bank deposit markets. It also describes three main types of financial instability: bank runs and panics, securities market crashes, and price level instability. The document outlines various government interventions that can promote stability, including regulations, oversight institutions, and monetary policy tools. Maintaining financial stability is crucial for sustainable economic growth.

1. STABILITY OF FINANCIAL SYSTEM
•Economic Growth and Financial Stability
(Financial stability ensures multiple
opportunities with regard to supply of
different types of capital to all sectors of the
economy in right time, in adequate quantity,
with lower risk and lower cost and under
liberal terms and conditions).

2. • Government Role and financial stability
( A welfare government with mixed economy
has a major role in ensuring a conducive
financial eco system so as to prevent
instances of financial instability and when
ever cases of financial instabilty creeps in,to
take immediate steps to stabilise the system.

3. Symptoms/Signals of Financial
Instability
• Capital market slowdown
• Banks deposit slowdown
• Increasing incidence of NPA
• Poor impact of Central bank’s monetary
policy measures
• Inadequate capital for emerging sectors of
economy

4. • Higher Inflation
• Heavy dependence on public debt both at
the government, banking and corporate
sector
• Reduced inflow and increasing outflow of
Foreign investment
• Lack of any technological innovation in the
financial sector

5. • Higher fiscal deficit
• Increased volatility in the stock market
• Increased volatility in the currency market
• Restrictive terms and conditions on loans
from bilateral and multilateral financial
institutions
• Declining forex reserve.

6. Types of Financial Instability
1. Bank Runs and Banking Panics
• FIs create liquidity through pooling and
netting of claims
• Netting breaks down if all claimants wish
to liquidate at once
• No netting is possible and claims cannot
be made

7. Process of Bank run—
• Problems at bank undermine depositor’s
confidence
• Depositors rush to withdraw deposits
• While the first-cum-first rule is applied, every one
wants to be first
• Once the reserves( only a fraction of the deposits)
are exhausted, the bank can no longer honour its
promise of liquidity and it must close its doors.

8. Banking Panic-
• Bank run is bad for economy but need not have
much effect if confined to that bank only
• Banking panic is a run on the entire banking
system
• When depositors loose faith in the banking system
in general, financial system gets paralyzed and the
consequences on the economy can be severe.

9. Depression During 1930s
• Wide spread default in loans caused many banks
to fail
• Depositors rushed to withdraw money from all
banks including those that were sound
• Many sound banks were unable to meet all
depositors claims and failed
• When banks failed, many SME found themselves
without credit , scaled down their operations, lay
off workers

10. • The resulting fall in spending caused caused
more business to default on their loan and
more banks failed
Of the 24000 banks in USA in 1929, more
than 9000 failed. The combined banks
assets shrank by more than one third.

11. 2. Securities Market Crash
• Secondary market provides liquidity to direct
securities through pooling and netting
• Nets the sale of those wishing to liquidate claims
against the purchase of those wishing to acquire
claims
• If every one wish to liquidate at once, netting
becomes impossible
• If this happens in a secondary market, prices of
securities drop precipitously.

12. 3 Price level Instability
• Banks are adversely affected by price level
instability
• Two types of Price Instability- Inflation ( a
continuous rise in prices) and Deflation( a
continuous ans sustained fall in prices).
• Inflation reduces the value of the promised money
in terms of what it will actually buy, deflation
increases it

13. • Unexpected inflation hurts the lender and benefits
the borrower
• Unexpected deflation hurts the borrower and
benefits the lender
• Uncertainty about the possible future price
level(inflation , deflation or stagflation) makes
loan riskier both for the borrower and the lender
and therefore makes lending less attractive

14. Types of Government Intervention
to Promote Stability
1. Regulations to promote financial stability
• Restricting the behavior of individual banks with
regard to risk taking
• Prohibiting banks from holding certain classes
of assets or engaging in certain types of
activities.
• Limiting the freedom of banks to create money

15. 2. Creating Institutions that Enhances Stability
• Lender of last resorts-FI that stands ready to lend
to banks at times of crisis
• Banking Supervision
• Regulating the Financial System
• Creating and Strengthening the security market
regulations
• Providing the Government Guarantee towards
deposit and credit

16. Monetary Policy and Financial
Stability
• Money creation affects
Interest rates
Exchange rates
Commodity prices
Outputs
Money creation impacts hyperinflation, severe
deflation and moderate inflation—all have
far reaching effects on the fiancial system

17. • Money creation cannot be completely left in the
hands of the banks
• The external impacts of money creation
A banks creates money but does not bear all the
costs of its own actions. The temptation is always
there to create more money
There is need for some type of control on the
bank’s capacity to create money

18. Impact of changes in the quantity of money
supply
• In the short run ,an increase in quantity of
money lowers the interest rate—stimulates
spending and investment—lowers the value
of currency—results in higher output ,faster
growth and larger exports

19. • In the long run, an increase in the quantity
of money leads to higher prices and to
inflation
In the short run, the monetary policy goal is
on short run impact of money on real
economic activity
In the long run, the impact is on prices and
inflation

20. Tools of Monetary policy
• Repo
• Reverse Repo
• OMO
• Bank rate
• CRR
• SLR

21. Goals of Monetary Policy
• Stabilizing Fluctuations in Economic
Activity
Boom-High growth but also uneven
growth
Depression—Lower growth
Monetary policy can stimulate or constrain
growth

22. • Promoting Balance of Trade
Exchange rate adjustment-lowering the
value of currency-increase export
• Promoting Economic Growth
• Stabilising the price level