Monetary stability relates directly to the stability of the price level and the value of the currency. The concept of financial stability is, in general, more controversial, less quantifiable and more difficult to define. Several attempts have been made to come up with a generally acceptable definition.
What financial stability means in broad terms is: the joint stability of the key financial institutions and the financial markets in which they operate. For financial institutions, this generally means that they are sound, i.e. that they have sufficient capital to absorb normal, (and at times abnormal) losses, and sufficient liquidity to manage operations and volatility in normal periods. Financial market stability means less excessive and disruptive volatility, which should have positive real economic consequences. In addition, financial stability would be evidenced by an effective regulatory infrastructure including the laws, regulations, standards and practices that constitute a robust financial regulatory environment. Other elements that would add to financial stability are public confidence and an efficient process of macroprudential surveillance.
The concept of financial stability is most often thought of in terms of avoiding financial crises or managing systemic financial risk. If systemic risk is managed well, that is, firstly by market participants through their private risk management, and secondly by the authorities through their banking supervision, market surveillance and systemic risk management, then systemic financial crises are less likely to occur, or will be more easily managed if they do.
One way of defining financial stability is in terms of the requirements to achieve it. It requires a robust financial system, which may be defined as a system having the ability to prevent, predict and withstand shocks under all types of domestic and international market conditions. Financial stability can further be described as the absence of macroeconomic costs of disturbances in the system of financial exchange between households, businesses and financial-service firms. Another definition used by some commentators is that financial stability is a sustained condition of stability in the financial system that ensures the efficient functioning of institutions and markets and low volatility in prices, interest rates and exchange rates. When the whole or an important part of the financial sector is at risk, the situation can be described as financially unstable.
Financial instability would ultimately manifest itself through systemic risk, banking failures, intense asset-price volatility, interest and exchange rate volatility, and a collapse of market liquidity. The disruption of the payment and settlement system could be a result of these manifestations.