Overall, the best way to preserve financial stability and improve the balance between economic and financial risk-taking is to put in place policies that enhance the transmission of monetary policy to the real economy

Preserving financial stability has been acknowledged as a crucial part of maintaining macroeconomic and monetary stability as well as in attaining sustainable growth.

Financial stability denotes the ability of the financial system to smoothly fulfill its key economic functions at all times, including in stress situations and periods of structural upheaval.

In particular, it refers to the efficient allocation of financial resources and risks along with the provision of a well functioning financial infrastructure.

Central banks have a fundamental role in safeguarding financial stability. It was during and in the period following the global financial crisis of 2007-08 that the demands accelerated for central banks to restore and safeguard financial stability, primarily through actions directed at containing systemic risks.

In many instances, central banks were urged to act despite ill-defined responsibilities and the dearth of necessary powers and tools to do so.

The financial crisis prompted a major reassessment of policies towards financial stability. The framework of regulation and supervision of financial intermediaries shifted from a micro- to a macro-prudential orientation.

Correspondingly, focus shifted from the stability of individual institutions to that of the system as a whole and from partial to general equilibrium analysis. Simultaneously, the view that a monetary policy exclusively focused on short-term price stability is fully adequate to support financial stability was increasingly been debated.

In the process, financial stability policy proceeded on a journey back to its historical origin, in which its macroeconomic roots were more evident.

In pursuit of financial stability, central banks are confronted with a number of challenges. One of them relates to transparency where the monetary authorities are often the first to obtain early signals of emerging risks to financial stability.

There are, however, limitations in disseminating such information when there is a high risk that it would trigger a confidence crisis leading to extreme volatility in the financial markets or bank runs that ultimately have self-fulfilling impacts.

At the other extreme, a financial crisis may erupt which could have otherwise been circumvented.

Concerns with ensuring the effectiveness of policies to react to financial stability threats may also dictate that advance consultation and full transparency are sometimes detrimental, especially when they are likely to undermine the intended effects of the policy by inducing an escalation of speculative activities in asset markets.

There is also the fear that the prominent role of central banks in financial stability would raise the scope and potential for policy conflicts.

The inherent conflicts between monetary policy and financial stability are well recognized.

While there is acknowledgement of the valid role of monetary policy in preserving financial stability, concerns have been raised on the potential for reputational damage to and the erosion of the independence of central banks in the conduct of monetary policy.

All in all, the financial stability role of central banks has gone up in prominence since the crisis.

This can be evinced through several instances. Central banks played an instrumental role in the initial crisis response by offering emergency liquidity support to institutions and markets under pressure.

In the case of Nepal Rastra Bank (NRB), promoting financial stability has been one of its the principal objectives.

As per the NRB Act, 2002, the central bank has been formulating and publicly announcing annual monetary policy with the objectives of maintaining price stability and external and financial sector stability to facilitate high and sustainable economic growth, with the inter se priority among the objectives shifting from time to time depending on the macroeconomic circumstances.

Though directives and circulars relating to capital, asset quality, liquidity, corporate governance, and risk management have been regularly issued by the NRB for safeguarding financial stability along with guidelines on stress testing and macro-prudential regulations, there still exist a number of issues that need to be focused upon.

In the first place, the rapid pace of growth of the cooperative sector, combined with deteriorating asset quality, has adverse consequences to financial stability. Two, capital market in the country is quite shallow and vulnerable to sudden price movements that may undermine confidence in their integrity.

In this respect, the development of the domestic investor base, measures to address market illiquidity, and improvements in market infrastructure are important building blocks.

Three, adequate human capital, training programs that promote continuing professional development and a sound legal framework are prerequisites for attaining and maintaining an effective program of financial sector supervision and regulation that conforms to international standards.

Overall, the best way to preserve financial stability and improve the balance between economic and financial risk-taking is to put in place policies that enhance the transmission of monetary policy to the real economy thus promoting economic risk taking and address financial excesses through well-formulated macro-prudential measures.

Dr. Pant is Director at Nepal Rastra Bank.