The ultimate objective of economic policy is to create a sustainable level of economic growth through investment, employment and production. This is best achieved when contributions are made from all sectors in the economy. Historically the financial sector has made substantial contributions to the level of economic growth. The responsibility for ensuring healthy contributions from this sector towards sustainable economic growth, are generally split between three parties.
Firstly, government’s responsibility is to create a stable environment and infrastructure of legal rules and practice and timely, accurate information, supported by regulatory and supervisory arrangements that help ensure constructive incentives for financial market participants. Success will promote growth and stabilise the economy on a higher growth path.
Secondly, the central bank is responsible for contributing towards the achievement and maintenance of a stable financial system. Thirdly, the environment and conditions created by the government and the central bank will enable the private sector to create economic growth through investment, employment and physical production.
For many years, central banks have focussed primarily on their monetary policy (price stability) objective. However, the Great Recession that began in 2007 has seen a rethink, with an increased emphasis on financial stability.
The relationship between monetary policy and financial stability is important, not only in looking at what monetary policy, or monetary policy tools, can do about financial stability issues but central banks must also ensure that monetary policy actions themselves do not promote financial instability. For example by keeping interest rates too low because inflation is within the target, such that these low interest rates in turn generate an asset price bubble.
The increasing interdependence of economies and interconnectedness of the global financial system has led to significant financial stability initiatives. These structured initiatives have developed standards that are material to the strengthening of the global financial system. Furthermore, the cost of the recent financial crisis has been significant. According to the International Monetary Fund (IMF) direct costs of banking crises in the past 15 years exceeded 10% of the GDP in more than a dozen cases.
A concerted effort through various international bodies has seen agreement on common standards and principles for financial regulators. This has also resulted in central banks focussing more closely on financial stability and macro prudential analysis.