There is no unambiguous measure of financial stability, and it is not easy to give a brief and precise definition of the concept of financial stability. The Riksbank has chosen to define financial stability as meaning that the financial system can maintain its basic functions and also has resilience to disruptions that threaten these functions.
The term ‘financial system’ refers not only to banks, insurance companies and other financial agents, but also to the financial markets and the financial infrastructure of technical systems, regulations and routines that are required to make payments and exchange securities. The system also includes the financial regulatory framework in the form of legislation, regulation and other standards.
The fundamental functions of the financial system are mediating payments, converting savings into funding, and managing risk. These are described in more detail below. When we say that the system must maintain its fundamental functions, we mean that any disruptions should not lead to poorer functioning that might involve large costs for society. This could involve, for instance, banks not being able to make payments to one another. Another example is a credit crunch, where access to credit is limited, for instance because the banks are unable to fund their lending.
The definition of resilience varies with regard to the different parts of the financial system. Furthermore, what constitutes resilience against disruptions threatening the functioning of the system (eg that the economy is suddenly weaker than expected or a large bank suffers losses that threaten its survival) is a question of judgement that has many dimensions. This can involve, for instance, how much capital there is in the banks, and how good their liquidity is, as well as how vulnerable the financial payment infrastructure is. The publication The Riksbank and Financial Stability (link) describes how the Riksbank, in practice, assesses resilience in the system.
The fundamental functions of the financial system
The Riksbank has chosen to base its definition of financial stability on the functions supplied by the financial system. It is thus important to understand what these functions are, how they are supplied and why they are important to the economy. They primarily concern the mediation of payments, converting savings into funding and managing risk.
Mediation of payments means that the financial system helps households and companies when they need to pay for goods or services. If wages are not paid on time and people are unable to pay their bills, this could soon result in chaos in the economy. In Sweden, it is mainly the banks that mediate various types of payment service and ensure that payments can be made. In addition to the banks, the technical systems used to transfer the payments are essential in ensuring that the mediation of payments functions. There are technical systems for securities transactions, where both the payment and the security change owner, which manage each stage in the transaction from a customer presenting a buy or sell order to their bank and until the deal is complete.
Converting savings into funding means that the financial system takes care of households’ and companies’ savings and contributes to funding consumption and investment in, for instance, homes and production capital. This supply of capital includes all forms of funding, but one important part is made up of various types of credit. Households and companies can save by depositing money with banks or by buying securities of various types. Households and companies that instead want to borrow can do so by taking out a loan from a bank. Larger companies usually also have the possibility of borrowing by issuing securities, what is known as market funding.
When the banks lend money, they convert short-term funding into long-term lending. This means that the banks’ funding – the customers’ deposits and the banks’ market funding – has a short time to maturity or must be repaid on demand, while their lending is for a longer term. This maturity transformation, as it is known, is a very important service, as it gives households and companies the possibility to save at short fixed periods, so that they can use their deposits to make payments, at the same time as they can borrow for a longer period, for instance, when buying a home or investing in a new factory.
Households and companies may also need credit to bridge over gaps between income and expenditure in the short term. For example, a shortage of more long-term credit could force companies to refrain from investment and households to refrain from purchasing homes. The transformation of savings into funding and of short-term funding into long-term lending is thus extremely important to the economy.
Management of risk means that households and companies, in particular financial companies, such as banks, are given the opportunity to manage their risk by diversifying risk and dividing or redistributing risks to the agents interested in taking on risk in return for compensation. Risk management has become increasingly important as the financial markets have developed. Companies and banks that obtain funding on international securities markets can, for instance, insure themselves against interest rate risk and currency risk, that is, the risks caused by changes in interest rate levels and exchange rates, through the financial markets. For example, a pension fund manager investing in bonds may wish to reduce the risk of an interest rate increase by selling this risk on the market, at the same time as the fund manager wants to increase the possibility of a rise in value by buying, for instance, the risk that the Swedish krona will appreciate. If the functioning of risk management were to be impaired, many transactions would be obstructed and perhaps even never be completed.