financial stability essay

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Financial stability

There are numerous definitions of financial stability. Most of them have in common that financial stability is about the absence of system-wide episodes in which the financial system fails to function (crises). It is also about resilience of financial systems to stress.

A stable financial system is capable of efficiently allocating resources, assessing and managing financial risks, maintaining employment levels close to the economy’s natural rate, and eliminating relative price movements of real or financial assets that will affect monetary stability or employment levels. A financial system is in a range of stability when it dissipates financial imbalances that arise endogenously or as a result of significant adverse and unforeseen events. In stability, the system will absorb the shocks primarily via self-corrective mechanisms, preventing adverse events from having a disruptive effect on the real economy or on other financial systems. Financial stability is paramount for economic growth, as most transactions in the real economy are made through the financial system.

The true value of financial stability is best illustrated in its absence, in periods of financial instability. During these periods, banks are reluctant to finance profitable projects, asset prices deviate excessively from their intrinsic values, and payments may not arrive on time. Major instability can lead to bank runs, hyperinflation, or a stock market crash. It can severely shake confidence in the financial and economic system.

Firm-level stability measures

A common measure of stability at the level of individual institutions is the z-score. It explicitly compares buffers (capitalization and returns) with risk (volatility of returns) to measure a bank’s solvency risk. The z-score is defined as z ≡ (k+µ)/σ, where k is equity capital as percent of assets, µ is return as percent of assets, and σ is standard deviation of return on assets as a proxy for return volatility. The popularity of the z-score stems from the fact that it has a clear (negative) relationship to the probability of a financial institution’s insolvency, that is, the probability that the value of its assets becomes lower than the value of its debt. A higher z-score therefore implies a lower probability of insolvency. Papers that used the z-score for analysis bank stability include Boyd and Runkle (1993); Beck, Demirgüç-Kunt, Levine (2007); Demirgüç-Kunt, Detragiache, and Tressel (2008); Laeven and Levine (2009); Čihák and Hesse (2010).

The z-score has several limitations as a measure of financial stability. Perhaps the most important limitation is that the z-scores are based purely on accounting data. They are thus only as good as the underlying accounting and auditing framework. If financial institutions are able to smooth out the reported data, the z-score may provide an overly positive assessment of the financial institutions’ stability. Also, the z-score looks at each financial institution separately, potentially overlooking the risk that a default in one financial institution may cause loss to other financial institutions in the system. An advantage of the z-score is that it can be also used for institutions for which more sophisticated, market based data are not available. Also, the z-scores allow comparing the risk of default in different groups of institutions, which may differ in their ownership or objectives, but face the risk of insolvency.

Other approaches to measuring institution-level stability are based on the Merton model. It is routinely used to ascertain a firm’s ability to meet its financial obligations and gauge the overall possibility of default. The Merton model (also called the asset value model) treats an institution’s equity as a call option on its held assets, taking into account the volatility of those assets. Put-call parity is used to price the value of the “put,” which is represented by the firm's credit risk. So, the model measures the value of the firm’s assets (weighting for volatility) at the time that the debtholders will “exercise their put option” by expecting repayment. The model defines default as when the value of a firm’s liabilities exceeds that of its assets (in different iterations of the model, the asset/liability level required to reach default is set at a different threshold). The Merton model can calculate the probability of credit default for the firm.

Merton’s model has been modified in subsequent research to capture a wider array of financial activity using credit default swap data. For example, it is part of the KMV model that Moody’s uses to both calculate the probability of credit default and as part of their credit risk management system. The Distance to Default (DD) is another market-based measure of corporate default risk based on Merton’s model. It measures both solvency risk and liquidity risk at the firm level.

Systemic stability measures

To measure systemic stability, a number of studies attempt to aggregate firm-level stability measures (z-score and distance to default) into a system-wide evaluation of stability, by averaging or by weighting each measure by the institution’s relative size. The shortcoming of these aggregate measures is that they do not take into account the interconnectedness of financial institutions; that is, that one institution’s failure can be contagious. The First-to-Default probability, or the probability of observing one default among a number of institutions, has been proposed as a measure of systemic risk for large financial institutions. It uses risk-neutral default probabilities from credit default swap spreads. The probability, unlike distance-to-default measures, recognizes that defaults among a number of institutions can be connected. However, studies focusing on probabilities of default tend to overlook the fact that a large institution failing causes bigger ripples than a small one. Another assessment of financial system stability is Systemic Expected Shortfall (SES), which measures each institution’s individual contribution to systemic risk. SES takes the individual taking leverage and risk-taking into account and measures the externalities from the banking sector to the real economy when these institutions fail. The model is especially good at identifying which institutions are systemically relevant and would have the largest effects, if they fail, on the wider economy. One drawback of the SES method is that it is difficult to determine when the systemically-important institutions are likely to fail.

In further research, the retrospective SES measure was extended to be somewhat predictive. The predictive measure is SRISK. SRISK evaluates the expected capital shortfall for a firm if there is another crisis. To calculate this predictive systemic risk measure, one must first find the Long-Run Marginal Expected Shortfal (LRMES), which measures the relation between a firm’s equity returns and the returns of the broader market (estimated using asymmetric volatility, correlation, and copula). The model estimates the drop in equity value of the firm if the aggregate market falls more than 40 percent in a six-month window to determine how much capital is needed during the simulated crisis in order to achieve an 8 percent capital to asset value ratio. SRISK% measures the firm’s percentage of total financial sector capital shortfall. A high SRISK% simultaneously indicates the biggest losers and contributors to the hypothetical crisis. One of the assumptions of the SES indicator is that a firm is “systemically risky” if it is especially likely to face a capital shortage when the financial sector is weak overall.

Another gauge of financial stability is the distribution of systemic loss, which attempts to fill some of the gaps of the previously-discussed measures. This combines three key elements: each individual institution’s probability of default, the size of loss given default, and the “contagious” nature of defaults across the institutions due to their interconnectedness.

There is also a range of indicators of financial soundness. These include the ratio of regulatory capital to risk-weighted assets and the ratio nonperforming loans to total gross loans. These are reported as part of the “financial soundness indicators” (fsi.imf.org). Variables such as the nonperforming loan ratios may be better known than the z-score, but they are also known to be lagging indicators of soundness (Čihák and Schaeck (2010).

Another alternative indicator of financial instability is “excessive” credit growth, with the emphasis on excessive. A well-developing financial sector is likely to grow. But very rapid growth in credit is one of the most robust common factors associated with banking crises (Demirgüc-Kunt and Detragiache 1997, Kaminsky and Reinhart 1999). Indeed, about 75 percent of credit booms in emerging markets end in banking crises. The credit growth measure also has pros and cons: Although it is easy to measure credit growth, it is difficult to assess ex-ante whether the growth is excessive.

For financial markets, the most commonly used proxy variable for stability is market volatility. Another proxy is the skewness of stock returns, because a market with a more negative skewed distribution of stock returns is likely to deliver large negative returns, and likely to be prone to less stability. Another variable is vulnerability to earnings manipulation, which is derived from certain characteristics of information reported in the financial statements of companies that can be indicative of manipulation. It is defined as the percentage of firms listed on the stock exchange that are susceptible to such manipulation. In the United States, France, and most other high-income economies, less than 10 percent of firms have issues concerning earnings manipulation; in Zimbabwe, in contrast, almost all firms may experience manipulation of their accounting statements. In Turkey, the number is close to 40 percent. Other variables approximating volatility in the stock market are the price-to-earnings ratio and duration, which is a refined version of the price-to-earnings ratio that takes into account factors such as long-term growth and interest rates.  

Suggested reading:

Beck, Thorsten, Asli Demirgüç-Kunt, and Ross Levine. 2007. "Finance, Inequality and the Poor," Journal of Economic Growth 12(1): 27–49.

Boyd, John, and David Runkle. 1993. “Size and Performance of Banking Firms: Testing the Predictions of Theory,” Journal of Monetary Economics 31: 47–67.

Čihák, Martin. 2007. “Systemic Loss: A Measure of Financial Stability” Czech Journal of Economics and Finance , 57 (1-2): 5-26.

Čihák, Martin, and Heiko Hesse. 2010. "Islamic Banks and Financial Stability: An Empirical Analysis", Journal of Financial Services Research, 38 (2-3): 95–113.

Čihák, Martin, Asli Demirgüç-Kunt, Erik Feyen, and Ross Levine. 2012. “Benchmarking Financial Development Around the World.” Policy  Research Working Paper 6175, World Bank, Washington, DC.

Cihák, Martin and Schaeck, Klaus, 2010. "How well do aggregate prudential ratios identify banking system problems?" Journal of Financial Stability , 6(3): 130-144.

Demirgüç-Kunt, Asli and Enrica Detragiache, 1997, "The Determinants of Banking Crises in Developing and Developed Countries," IMF Staff Papers , 45: 81–109.

Demirgüç-Kunt, Asli, Enrica Detragiache, and Thierry Tressel. 2008. "Banking on the Principles: Compliance with Basel Core Principles and Bank Soundness," Journal of Financial Intermediation 17(4): 511–42.

Kaminsky, Graciela, and Carmen Reinhart, 1999, “The Twin Crises: The Causes of Banking and Balance of Payments Problems,” The American Economic Review 89 (3): 473–500.

Laeven, Luc and Ross Levine, 2009, “Bank Governance, Regulation, and Risk Taking” Journal of Financial Economics 93(2): 259–275.

World Bank. 2012. Global Financial Development Report 2013: Rethinking the Role of the State in Finance . World Bank, Washington, DC ( https://www.worldbank.org/en/publication/gfdr ).

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Safeguarding Financial Stability amid High Inflation and Geopolitical Risks

Key highlights, chapters in the report, financial stability risks have increased rapidly as the resilience of the global financial system has been tested by higher inflation and fragmentation risks..

Chapter 1 analyzes the recent turmoil in the banking sector and the challenges posed by the interaction between tighter monetary and financial conditions and the buildup in vulnerabilities since the global financial crisis. The emergence of stress in financial markets complicates the task of central banks at a time when inflationary pressures are proving to be more persistent than anticipated. Smaller and riskier emerging markets continue to confront worsening debt sustainability trends. Chapter 2 examines nonbank financial intermediaries (NBFIs) and the vulnerabilities that can emerge from elevated leverage, liquidity mismatches, and high levels of interconnectedness.  Tools to tackle the financial stability consequences of NBFI stress are proposed, underscoring that direct access to central bank liquidity could prove necessary in times of stress, but implementing appropriate guardrails is paramount. Chapter 3 analyzes the effect of geopolitical tensions on financial fragmentation and explores their implications for financial stability—including through potential capital flow reversals, disruptions of cross-border payments, impact on banks’ funding costs, profitability, and credit provision, and more limited opportunities for international risk diversification. Based on the findings, it draws policy recommendations aimed at strengthening financial oversight, building larger buffers, and enhancing international cooperation.

Chapter 1: A Financial System Tested by Higher Inflation and Interest Rates

Financial stability risks have increased rapidly as the resilience of the global financial system has faced a number of tests. Recent turmoil in the banking sector is a powerful reminder of the challenges posed by the interaction between tighter monetary and financial conditions and the buildup in vulnerabilities since the global financial crisis . The emergence of stress in financial markets complicates the task of central banks at a time when inflationary pressures are proving to be more persistent than anticipated . Large emerging markets have so far avoided adverse spillovers, but smaller and riskier economies continue to confront worsening debt sustainability trends.

Chapter 2: Nonbank Financial Intermediaries: Vulnerabilities amid Tighter Financial Conditions

Nonbank financial intermediaries (NBFIs) play a key role in the global financial system, enhancing access to credit and supporting economic growth. Also, NBFIs’ financial vulnerabilities might have increased in the past, amid low interest rates. Case studies presented in this chapter show that NBFI stress tends to emerge with elevated leverage, liquidity mismatches, and high levels of interconnectedness that often spill over to emerging markets. In the current environment of high inflation and tighter financial conditions, central banks can face complex and challenging trade-offs during market stress, between addressing financial stability risks and achieving price stability objectives. Policymakers need appropriate tools to tackle the financial stability consequences of NBFI stress. NBFI direct access to central bank liquidity could prove necessary in times of stress, but implementing appropriate guardrails is paramount.

Chapter 3: Geopolitics and Financial Fragmentation: Implications for Macro-Financial Stability

Rising geopolitical tensions among major economies have intensified concerns about global economic and financial fragmentation, which could have potentially important implications for global financial stability. Fragmentation induced by geopolitical tensions could affect the cross-border allocation of capital, international payment systems, and asset prices. This could pose macro-financial stability risks by increasing banks’ funding costs, reducing their profitability, and lowering the provision of credit to the private sector. Greater financial fragmentation could also exacerbate capital flow and macro-financial volatility by limiting international risk diversification. Policymakers need to be aware of potential financial stability risks associated with a rise in geopolitical tensions and assess and quantify geopolitical shock transmission to financial institutions. Financial institutions may need to hold adequate capital and liquidity buffers against rising geopolitical risks. The global financial safety net also needs to be buttressed through adequate levels of international reserves held by countries, central bank liquidity swap arrangements, and precautionary credit lines from international financial institutions.

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Essays on Financial Stability: Lessons for Macroprudential Supervision and Regulation

--> Whyte, Kemar (2019) Essays on Financial Stability: Lessons for Macroprudential Supervision and Regulation. PhD thesis, University of Sheffield.

Banking regulation and, in particular, macroprudential regulation have gained significant interest since the crisis that began in 2007. At the centre of banking regulation is a deep-rooted concern that the economic and social costs of systemic crises are significant and their implications are far-reaching. Banks play a number of crucial roles in the functioning of any economy. However, the banking system in which they operate is inherently fragile, and after many painful experiences, regulators are quite convinced that this is particularly true during economic downturns. As such, it is important to explore and assess prudential policies that could be designed or improved to prevent banking crises from occurring and to make the system more resilient. This thesis uses panel micro-econometric methods to explore factors that could have an impact on financial stability and suggests policies that could be used to address them. The first essay empirically analyses how the capital buffer held by banks behave over the business cycle after financial factors have been accounted for. Using a large panel of banks for the period 2000-2014, it documents evidence that capital buffers behave more pro-cyclical than previously found in the literature. Furthermore, it also shows that this relationship is more pronounced for large commercial banks where access to bail-out and equity markets incentivise an increase in credit exposure and reduced capital reserves accordingly. The second essay notes that a common feature within a lot of corporate income tax systems is the long-standing bias towards debt finance. That is, the cost of debt has been deductible as an expenditure when calculating taxable profits. An unintended consequence of this tax distortion is the creation of under-capitalized firms - raising default risk in the process. Using a difference-in-differences technique, this essay demonstrates that with a more equal treatment of equity and debt, banks capitalisation significantly improves. The essay takes advantage of the exogenous variation in the fiscal treatment of equity and debt as a result of the introduction of an Allowance for Corporate Equity (ACE) system in Italy, to identify whether an ACE positively impacts banks’ capital structure. The results demonstrate that a move to an unbiased corporate tax environment leads to better capitalised banks, fuelled by equity growth rather than a reduction in lending activities. The change also triggers a decrease in the risk-taking of ex-ante low capitalised banks. The third essay analyses the impact of liquid asset holdings on bank profitability. Using a large sample of banks, the essay documents evidence of a non-linear relationship between additional liquid asset holdings and bank profitability. That is, banks’ profitability is improved with the holding of some liquid assets. However, evidence suggests that there is a point at which holding further liquid assets diminishes profitability. The essay also finds that growth in credit and asset prices is more important for bank profitability than output growth, suggesting that bank returns respond to the financial and not the business cycle. Another important finding of this essay is that long-term interest rates tend to increase bank profitability, whilst short-term rates tend to lower bank profits - via increasing funding costs. These findings are homogeneous across countries with different development status as these results appear consistent for advanced and emerging market economies. Overall, the findings from this thesis provide important implications for regulators seeking to provide stability and resilience to the financial system. They provide further evidence that supports the call for the use of countercyclical capital buffers, but more importantly, they highlight the need for a more rigid approach to the setting of the countercyclical capital buffer rate. The thesis also suggests that an allowance for corporate equity system that eliminates or significantly reduces the tax-induced distortions in banks, might be worth considering as a macroprudential policy tool that targets capital standard. Finally, it also highlights the importance of finding the right balance between policies geared toward mitigating liquidity risk and maintaining bank profitability.

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Essays on Financial Stability

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Date of exam, date of publication, involved institutions, citable links.

• Handle: https://hdl.handle.net/20.500.11811/6371
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Household Financial Stability

• Center for Household Financial Stability
• The Demographics of Wealth
• "Tipping Points" Household Debt Symposia

Essay No. 2: Education and Wealth

The Demographics of Wealth How Age, Education and Race Separate Thrivers from Strugglers in Today's Economy Essay No. 2: Education and Wealth

Hello. This video focuses on the second essay in a series that we call The Demographics of Wealth, how age, education, and race separate thrivers from strugglers in today's economy. The first essay examined the connection between race and wealth. The subject of this one is education.

Our researchers, Bill and Bryan, have poured over data from more than 40,000 interviews. These were conducted with heads of households between 1989 and 2013 by the Federal Reserve for its Survey of Consumer Finances. Bill and Bryan looked at how income and wealth have changed, for the better or worse, over those 24 years for households headed by people with four different levels of educational attainment. First, less than a high school diploma; second, a high school diploma, GED, or vocational or technical certificate; third, a two or four-year college degree; and fourth, a graduate or professional degree.

In contrast, those families with only a high school diploma saw their income fall 16%. High school dropouts lost 1%. Even those with a two or four-year college degree saw a loss of 5%.

Those with a two or four-year degree fared better when it comes to wealth, that is, assets minus liabilities. They saw their wealth rise by 3%. The best educated, however, saw their wealth jump 45%. In contrast, the two lower levels of educational attainment saw their wealth plummet by 36% and 44%. We want to stress that while there is a strong correlation between education and financial success, there is no guarantee that more formal education will make you wealthy.

The connections are less straightforward than many people realize. What you learn in school as reflected by your diploma or degree is just one of many determinants of your wealth.

Among the other factors is what is called assortative mating. That just means that people marry someone like themselves.

The opposite is likely to happen if you are not well educated and marry another person who is also not well educated. Another important factor is native ability, which encompasses the brain's attitudes and skills that you inherited from your parents, as well as the environment in which you were raised.

Speaking of inheritances, the money that your parents leave you when they die is yet another factor. Better educated people tend to inherit more. Additional factors are listed in the essay.

Our research found not only striking differences in the income levels among the four education groups, but also, significant differences in the health of the group's balance sheets and in the wisdom of their financial decisions. Combined, these three measures have a huge influence on wealth. Those who have high incomes, strong balance sheets, and good options for their financial decisions and choose wisely among those decisions are going to be much wealthier than those who don't do well in these areas. The resulting wealth gaps among our four groups are even wider than the income gaps.

There are many ways to gauge the strength of a household balance sheet. Among them are measures of liquidity, asset diversification, and leverage. In all three of these areas, better educated families outperformed less educated families.

More liquidity, in other words, more cash on hand or cash that can be quickly obtained, can buffer a family against financial shocks.

If you invest in stocks or own at least part of a business, you are likely to get higher returns than if your assets consist just of your house, cars, and other low-return investments.

As for leverage, a higher ratio of debts-to-assets can lead to less wealth for two reasons. More debt means more borrowing, and as we all know, borrowing can be expensive. Second, more debt means more risk of losing it all when a family experiences some kind of economic shock.

There are several other trends in education that our research brought to the surface. In general, Americans level of educational attainment has been increasing. The percentage of families headed by someone with a graduate degree has risen from 10% to 13% over the past quarter century. Those who have a two or four-year degree have jumped from 16% to 25% of the population. The share of families headed by high school graduates has increased from 44% to 50%. And the ranks of those without a high school diploma has dropped from 31% to 12%, another good sign.

If you read our essay, you will also find some interesting information on gender, generational, and racial differences in educational attainment. As we hope you realize by now, there are many factors involved in wealth accumulation. A graduate degree is no guarantee that you will become a millionaire, but in today's economy, the less education you have, the less likely you will become financially successful. The next installment in this series will focus on the connection between wealth and age.

The essay and companion video will be available on the website of the St Louis Fed Center for Household Financial Stability. There, you will find other information on our research into the finances of American households. Thank you.

Executive Summary

New research by the Center for Household Financial Stability shows that there's a strong correlation between education and money. More of the former often leads to more of the latter. However, correlation is not causation—there is no guarantee that more education will lead to more wealth. Many other factors might be in play, such as natural ability, family environment, inheritances and even health. It's entirely possible that what's learned in the classroom has much less influence on lifetime earnings and wealth accumulation than most people believe. In fact, your ability, family background, inheritances or health might be responsible for some—perhaps a large part—of your success even if you hadn't received the education that you did.

These and other connections that may exist between education and wealth are examined in this second essay in our “Demographics of Wealth” series. ( Read the first essay, which looked at the link between race and wealth .) All of the essays are the result of an analysis of data collected between 1989 and 2013 through the Federal Reserve’s Survey of Consumer Finances.  More than 40,000 families were interviewed over those years.

For this essay, only those heads of families  at least 40 years of age were studied – because by age 40, the vast majority of adults have completed their formal education. These family heads were broken down into four groups: those without a high school diploma; those with only such a diploma, a GED or a vocational/technical certificate; those with exactly a two- or four-year college degree; and those with a bachelor's degree plus a graduate or professional degree.

Our key findings:

• The median income for those without a high school diploma in 2013 was $22,320, down 1 percent from 1989; for those with such a diploma, etc., $41,190, down 16 percent; for those with a two- or four-year degree, $76,293, down 5 percent; and for those with an advanced degree, $116,265, up 4 percent. (All dollar amounts are adjusted for inflation.)
• When looking at wealth (net worth, or assets minus liabilities), the median in 2013 for those without a high school diploma was $37,766, down 44 percent; for those with such a diploma, etc., $95,072, down 36 percent; for those with a two- or four-year degree, $273,488, up 3 percent; and for those with an advanced degree, $689,100, up 45 percent. (The median wealth levels of the top three groups generally increased until the mid-2000s, after which they declined due to the bursting of the housing bubble and to the Great Recession.)
• Those with more education had stronger balance sheets—more liquidity, a better mix of investments and lower leverage.
• In most categories, women are outpacing men in educational attainment.
• When it comes to race or ethnicity, Asian-Americans have the highest graduation rates at every level of schooling, followed by whites, blacks and Hispanics.
• As for the contributions of successive generations to rising educational attainment, members of Generation X and Generation Y have lifted college-degree levels less than did the Baby Boomers before them.

Read all the essays and watch all the videos in this series »

Why Financial Stability is Important in Life

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There are two types of financial stability. One relates with our personal finances. The other has a broader, wider implication and concerns businesses and countries.

In this article, let’s discuss why financial stability is important in life. I mean personal financial stability.

Let me put it this way.

Have you ever gone broke and didn’t have money to afford a meal? Or fallen short of cash when you needed it the most? I’ve seen people go through these real life scenarios. And trust me, they are a living nightmares.

An old proverb says money can’t buy you happiness. Very true. I’ll agree with this. But money can definitely keep away unhappiness. That’s the main reason why financial stability is important in life.

American author, financial advisor and TV host Susan (Suze) Orman says: “A big part of financial freedom is having your heart and mind free from worry about the what-ifs of life.”

These ‘what-ifs’ that Suze speaks of are various regrets in life that can arise due to financial instability. Therefore, to understand financial stability, let’s first understand what’s financial instability?

Defining Personal Financial Instability

In my humble yet honest opinion, financial instability is not just temporary money shortage. Financial instability means not having proper income for any reason. This translates as no savings, no investments and possibly no source to get money or other resources when absolutely necessary.

Financial instability also means dependence upon others for daily, basic needs and colossal loans and credit due to spending beyond limit. To me, financial instability also means a general unwillingness to rise out of such situation.

There could be lot many definitions, but I prefer to stick with my own.

Now, let’s see why financial stability is important in life.

Importance of Financial Stability in Life

Financial stability doesn’t automatically mean a stress-free life or one without problems. Stress and problems are integral part of our life. Hence, financial stability has several different features.

1. Financial Stability Buys Respect

Whether or not we agree, but the common tendency is to avoid people that are always asking for money or stuff or narrating their problems due to lack of money. We avoid such people. Regardless of how qualified or good natured they are, the tendency is to shun such people.

Now assume you are the person asking for money or things and complaining about hardships. Would you get any respect from people including close relatives? Definitely not. The modern society respects only people that are financially stable. Even a shady character loaded with money gets respect. Hence, financial stability buys respect.

2. Physical & Mental Wellbeing

Another reason why financial stability is important to life is for life itself. Generally, people that are financially unstable suffer from stress and emotional disorders. Over a period of time, these affect the body. A financially unstable person can suffer from aches, pains, frequent fevers and infections. That a strong link between physical and mental health exists is known since ancient times.

Financial stability therefore ensures you don’t fall victim to money related stress and mental disorders. Money affords you healthy food and if necessary, medical care . Even financially strong people experience stress, but for different reasons. And this stress doesn’t necessarily cause mental illness.

3. Financial Stability & Family

Wealthy couples get along very well. That’s what we’re led to believe all along. And that’s sheer rubbish. A survey by a leading economic daily finds, less than 30 percent of couples trust their partners on money matters. Another 26 percent of the sample population or respondents say, their partners are secretive about personal finances. This in turn leads to quarrels in marriage.

Why? Because both partners fear about financial stability. The survey finds that overspending by a partner and neglecting investments is the main reason for this distrust. Without proper savings and investments, there can be no financial stability. And that will remain cause for marital discord.

4. Employment & Job Opportunities

An employer will hire you only when you appear to be financially stable. Because they don’t want your money problems to affect their business. Financially stable people are able to focus better on work and can prove highly productive. They don’t take their money related issues to work.

While poorer people are also hardworking and efficient, their financial woes sometimes stresses them beyond limit. Their money problems also attend office.  As a result, their productivity can be inconsistent. This is not a rule as such but such situations can arise.

5. Owning a Permanent Home

Owning a home has great significance in India. For most ordinary Indians, owning a home is a lifetime goal. And many achieve this objective through hard work and proper financial planning. Having own house has immense benefits : it’s an asset whose value increases over the years. And it provides shelter.

Financially unstable people have to live in rented premises, often very cheap and seedy accommodations, unless they have parental or ancestral home. They are dependent upon others for the basic human need- shelter. And they can lose shelter anytime if the house owner evicts them for any reason.

6. Old Age & Retirement

Yet another reason why financial stability is important in life is for old age and retirement. A financially stable person or couple is able to invest in schemes & plans for amass wealth of those golden years when regular income ceases. Hence, they can lead happier life as retirees.

In stark contrast, a financially unstable person would usually be dependent upon some kindly relative to provide food, shelter and clothing and often, medicines during old age. Unless some charity decides to onboard them, financially unstable people face the very gloomy prospect of destitution during old age.

In Conclusion

So at the end it implies that everyone gets opportunities to become financially stable. Yet, these people fail because they can’t manage finances, save or invest astutely.

Shiv Nanda is a financial analyst at MoneyTap who loves to write on various financial topics online. He also advises people on financial planning, investment choices and budgeting skills, and helps them make their financial lives better.

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Essays on financial stability

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Essays on Financial Stability

The four essays published here provide a useful overview for anyone interested in understanding the issues and policy environment surrounding financial system stability.

The first three essays consider different aspects of the question, What is financial stability/instability? The first essay, by John Chant, Special Adviser at the Bank in 2001–02, considers how financial instability differs from other kinds of instability, how it is different from the volatility normally associated with a well-functioning financial system, and how instability can be propagated within the financial system and to the real economy.

In the second essay, Alexandra Lai tackles some of the problems raised by Chant; in particular, the difficulty of understanding the nature of crises. She reviews a range of theoretical approaches that have been pursued in order to understand the potential instabilities in domestic financial systems.

In his essay, Mark Illing provides four case studies of episodes often thought of as periods of financial stress or crisis—the stock market crash of October 1987, the near-collapse of Long-Term Capital Management in 1998, the failures of the Canadian Commercial Bank and the Northland Bank in 1985, and the Bank of New York's 1985 computer problem.

The fourth essay, by Fred Daniel, provides a context for more general discussions of the role of policy in promoting financial stability, by providing an overview of the current institutional arrangements that condition financial behaviour in Canada and how the Bank of Canada interacts with other agencies who share responsibility for financial stability.

DOI: https://doi.org/10.34989/tr-95

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Financial Stability

The Federal Reserve monitors financial system risks and engages at home and abroad to help ensure the system supports a healthy economy for U.S. households, communities, and businesses.

The Panic - Run on the Fourth National Bank, No. 20 Nassau Street [New York City, 1873]. (Image LC-USZ6-952 via Library of Congress Prints and Photographs Division )

Last updated October 12, 2023

Essays in This Theme

Asian Financial Crisis - A financial crisis started in Thailand in July 1997 and spread across East Asia

Bank Holiday of 1933 - For an entire week in March 1933, all banking transactions were suspended

Banking Act of 1932 - The Banking Act of 1932 reformed the Federal Reserve’s role providing credit during economic downturns.

Banking Act of 1933 - Commonly called Glass-Steagall, the Act was widely debated before its enactment

Banking Panics of 1930-31 - The U.S. appeared to be poised for economic recovery when a series of bank panics began in fall 1930

Banking Panics of 1931-33 - Earlier regional banking panics turned into a nationwide financial crisis in fall 1931

Banking Panics of the Gilded Age - The late 19th century was beset by panics

Continental Illinois: A Bank that Was Too Big to Fail - The phrase “too big to fail” became commonly used for the first time after Continental’s crisis

Emergency Banking Act of 1933  - The 1933 law was aimed at restoring public confidence in the nation’s financial system

Emergency Lending to Nonbank Borrowers - The Emergency Relief and Construction Act of 1932 expanded the Fed's ability to make certain loans under "unusual and exigent circumstances."

Federal Reserve Credit Programs During the Meltdown - The Fed introduced various credit programs to deal with the 2007-09 financial crisis

Latin American Debt Crisis - During the 1980s, many Latin American countries were unable to service their foreign debt

Near Failure of Long-Term Capital Management - A group of banks and brokerage firms prevented the collapse of this hedge fund in 1998

The Panic of 1907 - The story of the crash that inspired monetary reform

Reconstruction Finance Corporation Act - During the years 1932 and 1933, the Reconstruction Finance Corporation effectively served as the discount lending arm of the Federal Reserve Board.

Savings and Loan Crisis - The 1980s was a period of distress for the financial sector, especially savings and loans

Stock Market Crash of 1929 - On October 28, 1929, the Dow declined nearly 13 percent

Stock Market Crash of 1987 - The Dow dropped 22.6 percent on Black Monday, October 19, 1987

Subprime Mortgage Crisis - The 2007-10 crisis stemmed in part from an expansion of mortgages to high-risk borrowers

Support for Specific Institutions - The failures of Bear Stearns and Lehman Brothers and the bailout of AIG occurred in 2008

Related Essays

• Supervision and Regulation
• The Fed's Functions

Related Links

• Board of Governors: Financial Stability
• San Francisco Fed: What is the Fed: Financial Stability

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Essays on financial stability: old and new risk sources

Ilaria, Gianstefani (2023) Essays on financial stability: old and new risk sources. Advisor: Crimaldi, Prof. Irene . Coadvisor: Renò, Prof. Roberto . pp. 182. [IMT PhD Thesis]

European Central Bank (ECB) defines financial stability1 as ”a condition in which the financial system – which comprises financial intermediaries, markets and market infrastructures – can withstand shocks and unravel financial imbalances. This mitigates the prospect of disruptions in the financial intermediation process that are severe enough to impact real economic activity adversely.” Practically speaking, stability is a balance among the agents participating in the financial environment: market par- ticipants weave relationships, creating dependencies and interconnec- tions. The risks and vulnerabilities affecting one agent can impact many others, generating a cascade effect that propagates and might throw the system out of balance. Hence it is essential to identify all the potential sources of risk in the spirit that if we can recognize the form and assess the severity, we can cope with specific risks and prevent the system from unbalancing.

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Benefits of Being Financially Stable

Being financially stable has tremendous benefits for our overall health and well-being, extending far beyond the ability to pay bills on time. Below we will define what is financial stability and talk about how it can affect your life.

Mental Health

Research has shown an undeniable link between poor financial health (specifically, increased amounts of debt) and mental health concerns.  Children in poverty  are also faced with many barriers while growing up.  Here are a few examples:

• Half of all adults who report that they are in “problem debt” also have experienced mental health issues.
• The likelihood of having a mental health problem is three times higher among people who have debt than among those who do not. Anxiety disorders, depression, and psychotic disorders were among the most common mental illnesses that those in debt have experienced.
• There was an even higher correlation between suicide and debt. Research has found that those who complete suicide are eight times more likely to be in debt than not.
• Furthermore, individuals who are in debt were far more likely to exhibit signs of a substance use disorder, such as problems with drinking or drug dependence.
• Short-term debt may place people at the highest risk of depression. One study found that short-term debt places individuals at the highest risk for depressive disorders. Furthermore, unmarried people, those who are nearing retirement age, and individuals who are less educated were particularly vulnerable to the harmful effects of stress associated with credit cards and overdue bills.
• 86% of the 5,500 people surveyed by the Money and Mental Healthy study who have experienced mental health problems reported that their current financial situation or change in financial stability had made their mental health problems worsen.

Fortunately, debt is a solvable issue, and a major benefit of financial stability is reducing these mental health concerns. However, if you are working through a mental health crisis, you may not be in a place to tackle financial hurdles just yet. Similarly, if there are significant money struggles, paying for mental health treatment may not always seem feasible. However, in order to achieve and maintain financial stability, you must make your mental health a priority and take care of yourself first. Seek out available resources in your community, talk with a friend, and begin to work towards mental wellbeing. Your financial wellness will follow.

Stress and Overall Health

Similarly, one of the most important benefits of being financially stable is that it can help reduce stress. Unfortunately, financial stress is a widespread experience. According to the American Psychological Association (APA), 72 percent of Americans are stressed about money at least occasionally and 22 percent feel extremely stressed about their finances. But it seems that parents, younger generations, and those living in lower-income households (making less than $50,000 per year) are particularly susceptible — they report higher levels of stress than Americans overall, especially when it comes to money, and those who have particularly high stress about money are more likely to say they engage in unhealthy behaviors to manage their stress.

While chronic stress of any kind contributes to a myriad of long-lasting physical health issues, anxiety about money in particular has its own set of disadvantages. According to Elizabeth Scott, MS, an author wellness coach who specializes in stress management and quality of life, references the following as the primary issues resulting from financial stress:

• As mentioned above, those who are experiencing financial stress are more likely to engage in unhealthy coping behaviors. These can include drinking, smoking, overeating, or other unhealthy mechanisms in response to their anxiety. Unfortunately, this leads to more stress, which is associated with even more health risks.
• Less money for self-care. Those who are struggling to make ends meet are far less likely to choose to pay for “extra” things like chiropractic care or preventative measures, or even basic healthcare or dentalcare, when meeting basic necessities is a priority. Unfortunately, when small health issues go unchecked, they can turn into larger problems – in turn leading to more stress in the long run.
• Less sleep. When individuals are under financial stress, they often experience trouble sleeping (or working long hours) which can add up to a sleep deficit over time. Not only does this cause chronic fatigue, but it impairs immune functioning and cognitive abilities, while also causing additional moodiness.
• Unhealthy emotions: Financial strain, and especially debt, can cause unhealthy emotions that can take a tremendous toll on your health. There is often anxiety, frustration, and a sense of hopelessness that comes along with increasing debt and the inability to even pay the accruing interest. This only causes additional stress and poor mental health and well-being overall.

Being financially stable can help reduce the devastating effects of chronic stress on our bodies and minds, and the cycle of stress that can occur when living paycheck to paycheck.

Stability in the Family

It may be a given that being financially stable allows you to pay household bills on time and readily meet the needs of your family, but did you know that it contributes to the strength of our relationships and family wellbeing as a whole? First and foremost, marriages and romantic relationships fare better without the added pressure of financial stress. In one survey, one third of couples reported finances to be the most stressful facet of their relationship, followed by intimacy at a very distant second (11 percent), children (9 percent) and in-laws (4 percent).

Overall, money was the source of marital tensions for 84% of respondents, and 13% reported fighting about money several times a month (with the disagreement about financial priorities topping the list of problems). Fortunately, financial stability and open communication can help create a healthier and happier relationship, which will overflow into the rest of the home.

For example, most adults report that they overheard their parents arguing about money when they were children. Not only does this create tension in the home, but it inadvertently affects children as well. For families who are living with chronic financial stress, that anxiety about making ends meet often spills over onto children.

Additionally, while not every financially unstable household meets the federal criteria for poverty, many do – and research has shown the tremendous impact of poverty on children. In fact, about 15 million children (approximately 21% of all children) in the United States live in families with incomes below the federal poverty threshold. It is important to keep in mind that children are more vulnerable to negative consequences of poverty than adults.

Unfortunately, children who directly or indirectly experience risk factors associated with poverty have higher odds of experiencing health problems as adults such as heart disease, hypertension, stroke, obesity, certain cancers, and even a shorter life expectancy.

Poor children are also disproportionately more likely to attend schools in districts with fewer resources, less funding from local tax dollars, less parental involvement due to longer, lower wage working hours, and facilities that are inadequate. Furthermore, families living in poverty may not have access to adequate resources to meet even the most basic needs of their children, let alone their wants. Being financially stable reduces these and other risks associated with poverty and financial stress.

Also, kids who grow up in a household that is financially stable will look for ways to be financially stable themselves! Not only is it important to teach children about money, but parents themselves can serve as role models. Showing children the importance of financial stability, as well as the benefits, will help lay a foundation for their future financial health and success in adulthood.

Becoming Financially Stable

While financial stability brings a host of great benefits, it requires hard work, motivation, and intentionality (and sometimes backtracking!) to get there. No matter where you are in your financial journey, here are some tips to increase your financial health in the new year:

• Create a budget. You can search online for templates, or create one that suits your preferences and lifestyle. When making a budget, it is important to remember to set realistic goals, seperate your needs from your wants, identify and allocate your income and expenses, and modify for seasonal expenses (such as birthdays, other holidays, back-to-school shopping, oil changes, annual vehicle registration, or prolonged days off from work). Overall, a budget should be used to make a plan and stick to it. When creating your budget, show your kids how to do it themselves. This is a great lesson to  teach your children how to be financial independent  adults later on in life.
• Use cash when possible. Using a payment method on your phone such as PayPal or Apple Pay, credit cards, or even debit cards all point to what some financial consultants call “auto-pilot spending.” If you’re running on auto-pilot, you’re much more likely to overspend. Using cash allows you to “feel” the money physically leaving your hands, which decreases compulsive spending. Similarly, don’t go grocery shopping when you’re hungry and avoid online browsing when you’re tired or not concentrating well. These behaviors too often result in impulsive and sometimes costly spending.
• Make a plan to reduce and eventually eliminate all debt. There are some great online resources that can help, ranging from example payment plans to debt tracking sheets. Start by tackling your smallest debt first, and work up to the larger amounts! See where you can allocate more money during the week and move it towards your savings. Even a small amount will help in the long run. A little extra money each week can work significantly in your favor in regards to the interest you’re paying.
• In addition to addressing old debt, avoid accruing any new debt. Most forms of consumer debt are easily obtained but have both outright and hidden fees, as well as extremely high interest rates. It may be tempting, but it’s important to stay focused on your financial priorities.
• Start saving – even if it’s just a little! Having even a small savings can help in times when new debt seems like the only option, and you will be less likely to take out quick loans or swipe a credit card. Pay yourself first in the form of putting small amounts of money away. It will also help reduce stress because you will know that you have a small buffer in the case of a true emergency.
• Have a safety net in place. In addition to a savings account, it is important to have a plan for life changes or crises. For example, do you have available sick leave at work or disability coverage? What about life insurance? If something were to happen and you were unable to work or lost your job, what would be your next steps? Planning for the unforeseeable future can help both you and your loved ones have peace of mind.
• Talk to your kids about money! Financial stability (and instability) is intergenerational. Instilling values regarding saving, spending, and investing money in your children will help them be successful later in life. It’s never too early or too late to start!
• Similarly, make sure that you and your partner are on the same page about household finances. Will you share one bank account, or two? Who will pay for what? What does each person value the most? It is important to have conversations about money when everything is calm and collected, not in the heat of an argument. Additionally, it is important to make sure that each person in the relationship has an allocated amount of “free money” in the budget. Whether this is $25 or $200, the amount is irrelevant – the goal is to ensure that no one feels trapped. Furthermore, having a little leeway with “extras” will help remind you that money is truly an asset and not a burden, while also avoid bigger relational arguments and disputes later on.

Remember, financial security takes time and cannot happen overnight (even in the case of winning the lottery). Taking baby steps toward your financial health will not only increase your physical and mental wellness, but reduce stress and increase your family’s stability overall. Taking ahold of your financial stability is also a great lesson you can show  you children when teaching them the value of money . We hope that this new year is a time of achieving your financial goals!

For more information on child development, please contact  Children’s Bureau  today.

https://www.moneyandmentalhealth.org/money-and-mental-health-facts/

https://www.ncbi.nlm.nih.gov/pubmed/24121465

https://link.springer.com/journal/10834

https://www.sambla.dk/laan-penge/

https://www.moneyandmentalhealth.org/wp-content/uploads/2016/06/Money-on-your-mind-full-report.pdf

https://www.apa.org/news/press/releases/stress/2014/financial-stress.aspx

https://www.apa.org/news/press/releases/stress/2014/stress-report.pdf

https://www.investblue.com.au

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Getting Started With Savings

The earlier you begin trying to save, the easier you’ll make things for your future self.

By Tara Siegel Bernard

Financial Boot Camp for 20-Somethings: Day 5 of 5

It’s time to get your money in order.

When you’re in your 20s, retirement seems so abstract, it might as well be thousands of years away.

Maybe it feels something like that to you right now. Why save for something so many decades in the future, when every last dollar is accounted for in the here and now? Saving for anything at all, in fact, may feel impossible.

But what if you just laid the groundwork so that it became easier to save a little something? That’s what we’re going to work on today.

Getting started early for retirement is smart for the same reasons you may want to put it off: Time is on your side. If you set aside what you can now, the magic of compounding numbers — when you begin to earn interest on interest — can do more of the heavy lifting over time.

In other words, saving early may result in having to save less over the long haul, which will take some pressure off as you’re juggling other demands that inevitably arise. Maybe those demands will be children and all the money they manage to siphon up , or perhaps you’ll need some time off to care for an aging parent .

And (mostly) nobody wants to work forever — the earlier you start saving, the sooner you can stop working and dedicate more time to what’s meaningful to you.

The easiest way to save — for everything, really — is automating. When you have money automatically and regularly shuttled to its destination, you don’t have to remember to do anything. That goes for purely pleasurable financial goals as well, like saving for a big trip.

It’s empowering, and will bring you closer to the things that make you both happier and more financially secure. It will take some time and patience — but your future self will thank you.

Before you get started, you need to figure out how much you have to work with.

Deal with debt. Before you begin saving, make sure you have a plan to knock out any high-cost debt, like debt on credit cards, where interest rates (around 22 percent) far exceed the money you might earn when investing your savings in the stock market over time (7 to 8 percent).

Get organized. Get a copy of your pay stub or check your direct deposit to get a sense of your take-home pay. (Freelancers should calculate their average monthly income.) Then write down all of your expenses — rent, all insurance not already deducted from your paycheck, utilities, groceries, transportation costs, car payments, mobile phone, student loans and any other debts.

How much is left over? Something? Congratulations! You have some room to save. Cutting it close? Is there anything you can pare back a bit to make space for some savings?

Build a Buffer. Creating a financial cushion — in the form of an emergency savings fund — can help you avoid turning to credit cards if you suddenly lose your job or hit a financial pothole, like covering a $1,000 car repair.

Financial planners suggest keeping three to six months of your expenses in emergency savings (stowed in a high-yield online savings account, which offer the best rates). That may seem like a lofty goal when you’re living on a starting salary that barely covers your bills. So start small , even if it’s saving $50 a month — $83 a month will get you to $1,000 in a year — and add more if and when you can afford it. Set up an automated plan that sweeps that amount from your checking account to your savings account. Then, don’t touch that money.

Saving for Retirement

Many people with student loan debt often wonder if they should focus on paying down those loans before saving for retirement. The short answer: Probably not. (If you’re really struggling to pay your federal student loans, check out the income-driven repayment plans I mentioned yesterday. )

But there’s a strong case to be made to both invest and pay down your loans simultaneously , if you can.

The illustration below practically screams why. Can you see how much you’re likely to give up by focusing solely on paying off loans for 10 years?

If you have access to a 401(k) or a similar workplace retirement savings plan, you’re in luck — only 69 percent of private-sector workers do.

You may have already heard that some plans come with a nice little perk: free money. Employers may provide matching contributions when you save; for example, they might match every dollar you contribute up to 4 percent of your salary.

That means you’re effectively contributing 8 percent of your income, which is pretty close to the 10 percent that experts recommend (they often recommend saving more, up to 20 percent, but 10 percent is a great start — consider ratcheting it up one percentage point each year as you get raises).

What if you don’t have a workplace retirement savings plan?

Roth individual retirement accounts (or Roth I.R.A.s ) are often the right choice for younger people (though they are subject to income and contribution limits ). That’s because you’re depositing money that has already been taxed, and you’re probably in a lower tax bracket now than you will be later in life, when you’re likely to be earning more.

Compare that with the traditional I.R.A ., which provides you with a tax deduction now, but you pay income taxes when the money is withdrawn. That means your Roth I.R.A. balance is what you’ll have to spend, whereas traditional I.R.A. balances will be reduced by the amount of tax you will owe later.

How should you invest your money? The short answer: A diversified mix of index funds . These are inexpensive mutual funds that track broad spheres of the stock and bond markets (exchange-traded funds, which are like mutual funds but trade in an exchange, are a similar option). For more details on your investment options, check out this guide .

More immediate spending goals

Besides retirement, you surely have other savings goals. Maybe you’re saving for a car, a wedding party or a special trip. Since these goals have a shorter time horizon than retirement, or something you’ll need to access within three years or less, you’ll want to take less risk with this money. The easiest strategy is to automatically transfer money into a high-yield online savings account, say, monthly. With short-term goals, the amount you save is far more important than your return.

But if you need the money in three to 10 years — call that a medium-term goal — you may have more options, depending on how flexible you can be with your timing.

It may be tempting to invest your savings in the stock market, for example, in hopes of generating a higher investment return. But that comes with more risk. As one financial planner wisely put it: You have to consider how it might feel to lose half of your stock investment in any given year, which can take some time, even years, to recover. Do you have the time (or the stomach) for that?

You can take a hybrid approach and invest in a mutual fund that has a mix of 60 percent bonds and 40 percent stocks, for example, or there may be bond investments to explore that provide more stability (though they carry risks of their own ). But tread carefully.

Even if you don’t have large amounts to save now, setting up the infrastructure to save is the hardest part — and as your earnings increase, it will be much easier to save and invest more.

Action items:

Do you have a high-yield online savings account ? Some banks, including Ally and Capital One, let you set up different savings buckets for specific goals, which you can label (emergency funds, vacation, down payment). DepositAccounts.com has a helpful guide to help you sort through options.

If you have a workplace retirement plan and haven’t thoroughly inspected the investment options , set a reminder in your phone’s calendar to check. What index fund options do they have on offer? Also familiarize yourself with any target-date fund offerings. (These are a ready-made mix of investments that you can select and then forget about and are a blend of stock and bond mutual funds that gradually and automatically become more conservative as you approach the year you expect to retire. If you were born in 2000, the 2065 or 2070 funds may be the right fit for your situation.)

If you don’t have access to a workplace retirement plan, familiarize yourself with roboadvisers , or companies that lean heavily on technology to manage your investments but also often have human financial advisers. These are nice options for people with simple needs, or who have a savings and investment plan they want to establish and run on autopilot. Morningstar ranked its top picks here.

Have a question about money?

Ask us here .

Did you miss Day 1? Catch up here. Day 2 is here , Day 3 is here , and Day 4 is here .

Tara Siegel Bernard writes about personal finance, from saving for college to paying for retirement and everything in between. More about Tara Siegel Bernard

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Credit card debt is rising, and shopping for a card with a lower interest rate can help you save money. Here are some things to know .

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