The North Atlantic crisis of august 2007 and the European sovereign debt crisis of 2011 are good examples of occasions showing the need for financial stability in the world. In august 2007, there was a rising financial boom which resulted in financial crisis. There were low interest rates and increased accessibility to funds which led to mismanagement of risks. In the long run there were cases of borrowing by investors to finance its assets and to increase leverage.
Bond yields decreased significantly as a result and the value of money decreased as well. Among the investors who brought about the crisis were central banks and governments which accumulated large pools of foreign reserves.
On the other hand, the European sovereign debt crisis also referred to as the Euro Zone crisis is a situation whereby most European nations have not been able to repay government debt without depending on assistance from third parties. This was as a result of increasing debt levels for governments and private sectors. Some of the rising private debts were as a result of property bubble in Europe and led to sovereign debt crisis.
The two cases above had a real threat on financial stability. Financial stability is a situation in which there is a good flow of funds between savers and investors (Arner, 2007). This is facilitated by smooth operations of financial markets, institutions and infrastructures. Therefore, in the two scenarios mentioned above, smooth flow of funds is not enhanced. For instance, the increased access to funds by investors due to low interest rates in the North Atlantic financial crisis leads to increased use of funds by investors while savings reduce. This leads to decreased bank reserves in the long run. Increased sovereign debt also indicates that there is no financial stability in the financial markets.
Central banks play many roles in including the maintenance of finance stability in their respective economies. Despite the fact that the central bank plays many roles, there are roles by the central bank that form part of the most important fields in the central bank functioning than others. One of the central bank’s roles which take pre-eminence over other roles is financial stability. The two financial crisis incidences mentioned in this paper are among many incidences where financial stability is vital. Before we consider farther about the reasons why financial stability is viewed as the most important role of the central bank, it is necessary to look at the other roles of the central bank in clearer perspective so as to determine their significance to the roles of the central bank in general.
One of the traditional functions of the central bank is to act as the government’s bank. In this case, the central bank lends and issues/prints money to the government to finance its core projects. The central bank also acts as the banker’s bank. In this case, other commercial banks borrow from the central bank so as to create their own reserves from where they can lend to their customers. Furthermore, the central bank acts as a bank of the last resort and controls and regulating credit (Khanna, 2005). The central bank controls and regulates credit in a bid to maintain financial stability in the economy. This is done in a process whereby the central bank regulates the rate at which it lends to the commercial banks. In a situation whereby the central bank wants the amount of money available for credit in the economy to reduce, it will lend money to commercial banks at higher rates. This makes the central bank to have little access to credit and hence make the amount of credit available in the commercial banks to reduce as well.
Apart from the traditional functions of the central bank, there are also other growth functions played by the central bank. For instance, the central bank plays the role of boosting economic growth. This is especially the case in situations of economic crisis and in developing countries. Economic growth in countries requires sufficient resources. One of these resources is financial resources. Financial resources for economic growth can be made available and regulated by the central bank. As a banker to the government and as a credit provider and regulator, the central bank ensures that there is monetary expansion and that there are enough funds to invest on public goods and services.
The central bank also maintains price stability and regulates the amount of inflation to desirable levels (Scheller, 2004). In this case, the central bank reduces the amount of money supply to the economy during inflationary period so as to investment demand and increases money supply during depression so as to stimulate the levels of investments in the economy. This is often done through central bank’s monetary tools such as monetary and fiscal policies. One of the monetary policies is the issue of treasury bills and bonds during an inflation so as to take away money from the public and reduce money supply (money available in circulation).
Another bank of the central bank is that it provides training facilities and acts as a financial advisor to the government (Masciandaro, 2005). In this case, the central bank develops talents in the banking and financial sector by organizing for training and development seminars, workshops, conferences and educational courses for learners to understand and appreciate the significance and activities of the financial sector in the economy. The central bank also advises the government on financial matters so that the government may understand where to place its funds and where not to. The central bank also advises the government on how to acquire funds, how to manage them, when and how to invest as well as how to meet financial debts of the governments. The central bank as an advisor to the government lays down appropriate steps to be taken by the government in order to solve certain financial crisis and to stimulate the economy. This is based on the prevailing financial market conditions and the needs of the government as well as the needs of the public.
All these functions are not material if the central bank is not able to maintain financial stability in the economy. This then forms the core significance of the central bank in maintaining financial stability in the financial system of the economy (Arner, 2007). The central bank should maintain financial stability so as to be able to act as the banker of the last resort or as the government’s bank. In order to lend to provide funds to the government as the government’s bank, the central bank has to function in a financially stable system. For instance, the central bank will not be acting competently if it issues money to the government when there are levels of inflation in the economy. Similarly, the central bank cannot afford to refuse funds for the government when it needs it for development purposes. Therefore, there should be appropriate financial stability in the economy so that the central bank can carry out its roles appropriately.
Financial systems where financial markets are characterized by financial institutions trading in funds are full of inherent financial risks. These risks result in disturbances in the financial market (Siklos, Bohl & Wohar, 2010). This is what led to the happenings of the North Atlantic financial crisis and the European sovereign debt crisis. These risks cannot be mitigated in any other way except for the central bank to maintain financial stability in the economy. Financial stability seeks to mitigate financial risks that may destabilize the economy. This role cannot be performed by any other role of the central bank. In fact, for the central bank to perform other roles, it needs to keep financial stability at desirable levels first. For instance, in order for the government to set up appropriate monetary policies aimed at regulating the levels of economic growth, it has to stabilize the financial system first; otherwise the economic system may go in different directions than expected during the setting of the monetary or fiscal policies.
Financial stability acts as a store of confidence for investors. This is because financial stability reduces the chances of having a disturbance in the financial sector which often impacts negatively on investors. Financial stability therefore enables investors to build confidence and invest more (Schinasi, 2005). The same is the case for savers who depend on a stable financial system to put their funds on profitable savings so as to get enough interests on their savings. In order for the financial system to work appropriately, it therefore needs a financially stable system. Since the central bank’s roles revolve around financial markets and financial instruments, the stability of the financial system therefore becomes the most appropriate and most important role of the central bank over all other roles. Therefore, financial stability should primarily be the main priority of central banks over all other functions.