What is "financial stability"?
Maintaining it is critical for our economy
In a span of three days last March, we saw the second- and third-largest bank failures in U.S. history.
First, on Friday, March 10, the $209 billion Silicon Valley Bank, or SVB, was closed by California state banking regulators. Two days later, on March 12, New York state regulators shut down the $110 billion Signature Bank. That same day, the Federal Reserve, Federal Deposit Insurance Corporation, and U.S. Treasury took decisive actions to reduce the stress in the financial system and support financial stability. Among them: The FDIC protected all depositors in SVB and Signature Bank, and the Federal Reserve established an emergency lending facility, the Bank Term Funding Program, to ensure that banks could meet depositors’ cash needs.
These recent stress events – and others observed in past years, including during the March 2020 onset of the COVID-19 pandemic – underscore the importance of maintaining financial stability.
So, what does the term “financial stability” mean? There are many definitions, but mine is inspired by economists Garry Schinasi, Eric Rosengren, and the Federal Reserve’s overall financial stability framework. To me, a stable financial system is one in which institutions, markets, and supporting infrastructures supply the credit and payment services needed to positively affect the economy. Thus, financial instability occurs when a shock, which can originate from within or outside the financial system, as we saw during the onset of COVID-19 pandemic, severely impairs credit intermediation. That is, the shock causes or amplifies a credit crunch, which could lead to job losses.
Financial stability is not necessarily about eliminating shocks, but measuring resilience
Ensuring financial stability is not necessarily about eliminating shocks to the financial system. Shocks are difficult to forecast. Rather, it is primarily focused on identifying, monitoring, and assessing vulnerabilities in key nodes of the financial system. More specifically, we want to know if key players in the financial system are resilient – can they continue to function even after a shock hits?
Here is a quick example of how things can play out if a shock severely impairs credit intermediation:
Say that a business wants to expand. It borrows money short-term to buy a new building or hire new employees. During “normal periods,” the company can roll the debt over into a new loan when the debt matures, and it can keep growing. However, if a shock to the financial system shuts off that company’s access to credit and they cannot roll over the debt, they might default on the debt and will likely shut down. Now, if many other companies (or just a few large ones) also default and shut down around the same time, that could lead to large job losses and other negative impacts, and the real economy and gross domestic product could be adversely affected.
Some developments I am watching
Following the bank failures in March, Federal Reserve Chairman Jerome Powell repeatedly emphasized that the banking system overall is “sound and resilient, with strong capital and liquidity” positions. Nonetheless, these events demonstrate how problems at some banks could pose serious risks to financial stability. As the Fed’s Vice Chair for Supervision Michael Barr noted in May, SVB’s failure shows “that there are weaknesses in regulation and supervision that must be addressed.” To that end, efforts are underway to strengthen bank regulation, including the “holistic capital review” of the capital at large banks which Barr is conducting.
In addition to developments in the banking system, I remain attuned to developments in certain non-bank financial institutions, or NBFIs, particularly those that engage in “liquidity transformation.” These institutions (such as certain money market mutual funds – known as MMMFs – and private stablecoins) buy long-term assets with relatively shorter-term liabilities, and, thus, are vulnerable to runs. As these entities extend credit to financial and nonfinancial firms, a run can result in credit to these firms suddenly being shut off.
Indeed, as we saw in March 2020, runs on certain types of MMMFs, can amplify strains in the short-term funding markets, which are an important source of short-term cash for businesses. In that situation, the Federal Reserve, with prior approval from the secretary of the U.S. Treasury, established emergency lending facilities to help MMMFs meet large investor redemptions and stabilize the short-term funding markets. The evidence suggests that these facilities helped restore the short-term funding markets. In July, the Securities and Exchange Commission adopted amendments to the rules that govern MMMFs to “reduce the risk of investor runs … during periods of market stress.”
We also need to build a more comprehensive understanding of the interactions between NBFIs, banks, and the broader financial system. This includes developing tools to better assess how strains at NBFIs can impact the financial markets. (For example, the impact of NBFI asset fire sales on banks.)
Our economy is dynamic, and the financial system is also evolving, but the imperative to ensure financial stability is constant. We must continue to prioritize spotting threats before they materialize and resolve to act quickly and decisively when they do.
Kenechukwu Anadu is a vice president in the Boston Fed’s Supervision, Regulation & Credit department, where he co-heads the Supervisory Research and Analysis Unit. He is also the co-chair of the Federal Reserve System’s Monitoring and Analysis Program for the largest, most systemically important banks.
Author’s note: These are my views and do not necessarily reflect those of the Federal Reserve Bank of Boston or Federal Reserve System. I thank Patrick de Fontnouvelle and Andreas Lehnert for their helpful suggestions, and Jay Lindsay for outstanding editorial assistance.