Financial stability

What is financial stability and how is it promoted?


Abstract icon One of Danmarks Nationalbank's three main objectives is to contribute to the stability of the financial system. Experience from financial crises shows that financial instability may have serious economic consequences.

What is financial stability?
A well-functioning financial sector ensures financing of activities in society by providing money from savers to borrowers. Danmarks Nationalbank defines financial stability as a condition with an overall financial system that is robust enough for any potential problems in the sector not to spread and prevent the financial system from functioning as an efficient provider of capital and financial services. Financial stability is essential to the overall economy. One of Danmarks Nationalbank's main tasks is to monitor and assess financial stability in Denmark. Focus is on the overall financial system.

In the event of financial instability, the financial system cannot provide the financial services that are crucial to the economy. Financial instability may occur if, for example, a large institution experience difficulties. In addition, problems in a single institution can spread to the rest of the system because the institutions are closely interconnected via interbank exposures. Financial instability may also occur even though the individual institutions seem robust. The reason is that the overall behaviour of the institutions can pose a risk to the entire financial system, i.e. a systemic risk. The individual institution may, for example, find it necessary to sell assets in order to reduce risk, even if prices on assets decline. If many institutions choose to sell at the same time, asset prices decline further, which may lead to a vicious circle and risk of financial instability.

Promoting financial stability
Financial crises have serious economic consequences, due to the interaction between the financial system and the macroeconomy. Therefore, it is vital to prevent and mitigate the risk of periods of financial instability. A precondition for financial sector stability is that the credit institutions are robust overall, including that they have sufficient capital and liquidity reserves to draw on during difficult times. Also, systemic risks in the financial system that are not necessarily obvious to the individual institutions should be allowed for. Systemic risks can be mitigated by means of macroprudential instruments.

Danmarks Nationalbank assesses financial  stability in Denmark and makes specific recommendations to relevant parties in the publication series Financial stability and states its views by way of consultation responses, speeches etc. In addition, Danmarks Nationalbank participates in the Systemic Risk Council.

Crisis management
In the event of financial instability, the aim is to mitigate the negative consequences as much as possible. Therefore, it is vital that the relevant authorities are prepared to manage a crisis.

Danmarks Nationalbank acts as the lender of last resort. If several credit institutions are facing liquidity problems at the same time, e.g. due to a general freeze of the financial markets, Danmarks Nationalbank may decide to expand the institutions' access to loan facilities for financial stability reasons. That was the case in connection with the financial crisis, when Danmarks Nationalbank introduced a number of temporary loan facilities in the period from 2008 to 2012. The collateral basis was, inter alia, expanded to enable the credit institutions to borrow against a larger number of securities and credit claims of good quality, and the credit institutions were given access to raise loans with longer maturities – 6 months and 3 years.

Being the lender of last resort also means that Danmarks Nationalbank may grant emergency liquidity assistance – ELA – to solvent credit institutions that urgently need liquidity and cannot procure it in the market. ELA is granted as an element of compliance with Danmarks Nationalbank's objective to contribute to financial stability. In order to receive ELA, the credit institution must be solvent and creditworthy and thus able to repay the loan when it matures. Furthermore, adequate collateral must be pledged to Danmarks Nationalbank for the full amount granted. In a specific situation, Danmarks Nationalbank will assess whether financial stability considerations justify ELA. No banks are precluded from ELA in advance.

Danmarks Nationalbank also cooperates with other authorities on financial stability and crisis management.

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EXAMPLE OF SYSTEMIC RISK

A systemic risk may be the concentration of risk in a systemically important financial institution (SIFI). If a SIFI is suddenly discontinued, this may give rise to financial instability and have serious economic consequences.​

OVERALL ECONOMIC CONSEQUENCES OF THE FINANCIAL CRISIS IN DENMARK

A study by Abildgren et al. (2011) finds that in the years 2009-13 real GDP was, on average, 2.25-2.5 per cent below the level that would have prevailed in the absence of the financial crisis. This results in a total output loss in the 5-year period of around 12 per cent of GDP, corresponding to approximately kr. 200 billion.​

EXAMPLES OF MACROPRUDENTIAL INSTRUMENTS

An example of a macroprudential instrument is the countercyclical capital buffer. The buffer is to be built up during periods of increasing systemic risk. When risks materialise, e.g. when the financial system is hit by a negative shock, the buffer must be released. Hence, the institutions may use the released capital to e.g. absorb losses. The purpose of the buffer is to prevent that credit institutions constrain their supply of credit to households and firms disproportionally in periods of stress in the financial system.

Another example of a macroprudential instrument is additional capital requirements for systemically important financial institutions (SIFIs). This reduces the risk that SIFIs encounter serious difficulties that may cause financial instability.