Executive summary
Financial stability requires a careful balance between expanding financial services and safeguarding the system against shocks, with policy frameworks aligning development, regulation, liquidity, and risk management to prevent systemic crises. This article outlines the development–stability trade-offs, key risks and early-warning signals, liquidity management foundations, supervisory approaches, and bank risk management practices in an integrated, academic framework.
Development vs stability
Financial development deepens intermediation, improves risk sharing, and supports growth, but unchecked expansion—especially via leverage, complex products, and lax underwriting—can amplify fragility and procyclicality. The relationship is non-linear: at low and intermediate levels, development typically raises efficiency and resilience, while beyond thresholds it may elevate systemic risk without commensurate welfare gains. Policy aims to optimize this curve by sequencing reforms, strengthening institutions, and embedding macroprudential guardrails.
Risks to stability
- Macro-financial risks: credit and asset-price cycles, interest rate and term-premium shocks, exchange rate volatility, and abrupt capital flow reversals can strain balance sheets and funding markets.
- Micro-prudential risks: underwriting slippages, high borrower leverage, sectoral and concentration risks, cyber and operational disruptions, and governance failures degrade bank resilience.
- Market structure risks: liquidity illusion in shallow debt markets, collateral interlinkages, run-prone nonbank funding, and margin spirals in derivatives can transmit stress rapidly.
- Nonbank and fintech risks: regulatory perimeter gaps, maturity transformation outside banks, and operational dependencies on critical service providers raise contagion channels.
Early warning signals and action
- Signals: rapid credit-to-GDP gap widening; outsized property and equity price appreciations; deteriorating loan vintage performance; rising NPLs and Stage 2 assets; funding concentration and short-term wholesale reliance; widening CDS and interbank spreads; margin calls and collateral haircuts; elevated LCR–NSFR dispersion; spikes in cyber incidents and payment failures.
- Tools: countercyclical capital buffers; sectoral risk weights and LTV/DTI caps; dynamic provisioning; liquidity add-ons and maturity ladders; exposure limits and large-borrower caps; stress-test-informed supervisory actions; targeted communication and transparency measures.
Liquidity management
- Principles: maintain robust high-quality liquid assets, diversified funding across tenors and counterparties, and conservative intraday and contingency buffers aligned to stress outflows.
- Metrics: Liquidity Coverage Ratio for 30‑day survival; Net Stable Funding Ratio for one‑year stability; internal cash-flow gap ladders; name and market-triggered outflow scenarios; collateral eligibility, encumbrance, and rehypothecation controls.
- Practices: pre-position collateral at central banks/CCPs; maintain committed facilities; monitor market depth and haircuts; strengthen intraday liquidity dashboards; conduct regular fire-drill funding simulations.
Regulation and supervision of banks
- Prudential core: minimum and buffer capital aligned to risk-weighted assets; leverage ratio backstop; Pillar 2 add-ons for idiosyncratic risks; comprehensive credit, market, operational, and interest rate risk in the banking book frameworks.
- Liquidity and funding: binding LCR/NSFR, stable retail deposit focus, wholesale funding concentration limits, and robust collateral management across secured funding channels.
- Governance and conduct: board effectiveness, risk culture, model risk controls, remuneration alignment, and fit-and-proper standards, complemented by fair conduct and consumer protection norms.
- Supervisory methods: risk-based supervision with proportional intensity; thematic reviews (e.g., real estate, unsecured retail, NBFC linkages); system-wide stress testing; recovery and resolution planning with credible bail-in and transfer tools; data-driven surveillance integrating market and supervisory information.
Risk management in banks
- Credit risk: through-the-cycle rating systems, PD/LGD/EAD estimation and validation, concentration and correlation limits, early-warning triggers, covenant and collateral discipline, and portfolio stress tests; stage migration governance for expected credit loss provisioning.
- Market and IRRBB: hedging of rate and basis risks, earnings-at-risk and economic value sensitivity limits, robust VaR/ES complemented by scenario analysis, and careful optionality management in retail products and embedded features.
- Liquidity risk: integrated cash-flow projections, collateral optimization, intraday limits, and pre-agreed contingency funding plans with quantitative triggers and playbooks.
- Operational and cyber: end-to-end risk and control self-assessments, loss data and scenario analysis, third-party and cloud concentration oversight, cyber threat hunting, and incident response with recovery time objectives.
- Model and data: model lifecycle governance, challenger models, stability monitoring under regime shifts, and data lineage with control points to reduce procyclical decision errors.
- Climate and ESG: exposure mapping to physical and transition risks, sectoral heatmaps, borrower-level disclosures, and long-horizon scenario analysis feeding into capital and strategy.
Policy implications for balanced growth
- Calibrate development with resilience by sequencing market deepening alongside macroprudential buffers and credible resolution regimes.
- Address perimeter risks through activity-based oversight for systemic nonbanks and critical third parties, supported by data-sharing and incident reporting.
- Enhance system-wide liquidity resilience by broadening high-quality collateral pools, strengthening CCP risk management, and improving transparency in corporate bond and repo markets.
- Institutionalize forward-looking stress testing, integrating climate, cyber, and market–funding spiral dynamics, and link results to supervisory and capital planning actions.
- Foster responsible innovation with sandboxes and guardrails for leverage, margining, and retail access to complex products, aligning incentives and consumer outcomes.
This integrated approach—combining macroprudential discipline, rigorous supervision, and bank‑level risk governance—supports a financial system that can expand access and efficiency while remaining resilient to shocks across cycles.
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