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Why a stable financial system is a prerequisite

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Sanderson Abel

In every economy, it is fundamental to have a sound, stable and healthy financial system to support the efficient allocation of resources and distribution of risks across the economy.Financial instability and its effects on the economy can be very costly because of the associated contagion or spillover effects to other parts of the economy.

Financial instability may lead to a financial crisis with adverse consequences for the economy.
Financial sector stability can be defined in various ways:

Financial sector stability means that the financial system has the capability to allocate funds efficiently and absorb shocks as they arise, thus preventing disruption of real sector activities and the financial system.

Financial sector stability is a condition represented by a strong financial system capable of withstanding economic shocks, one that is able to ensure intermediary function, settlement of payments and diversification of risk.

Financial sector stability is a condition in which the economic mechanisms of price formation, funds allocation and risk management operate properly in support of economic growth.

In sum, a stable financial system is one in which financial intermediaries, markets and market infrastructure facilitate the smooth flow of funds between savers and investors and, by doing so, help promote growth in economic activity.
Conversely, financial instability is a material disruption to this intermediation process with potentially damaging implications for the real economy.

When financial instability occurs, it disturbs market functioning and can also impair bank balance sheets. The result can be disruption to the financial intermediation function with resulting constraints on the availability of credit for households and businesses. This, in turn, can lead to further reductions in aggregate demand that put additional stress on the weakened financial system.

Obviously, this is not a favourable dynamic.
Some of the mechanisms of ensuring financial stability are:
The central bank must be well capitalised to ensure financial stability as it can be used as the last line of defence when a crisis arises.

The central bank performs a pivotal role in ensuring the smooth and efficient functioning of markets and infrastructure such as the payment system in a country and mitigating systematic risks by providing the liquidity needed to oil the wheels of the financial system.
It is quite encouraging that the Government has come clear that it is working towards the recapitalisation of the central bank and also looking for resources to ensure that the central bank plays in the interbank market.

The Minister of Finance is reported to have alluded to the fact that capitalisation of the central bank would require around US$200 million while US$400 million would be required for the central bank to actively play a role in the interbank market.

Fiscal space allowing, the central bank should be capitalised.
Another method to ensure financial sector stability is to have in place a system in which there are well-developed crisis management arrangements for handling distressed financial institutions in such a way that public confidence in the financial system will not be undermined.

Hence the concept of deposit protection is important in the country to ensure confidence and stability in the financial sector as it ensures that depositors are reimbursed in a case where any bank fails in the country.

The importance of this is that the most vulnerable members of the society and usually the financially illiterate who cannot read the market are cushioned from the effects of the bank failure.

Smooth financial intermediation is a function of the financial sector stability, hence the need to ensure all factors that hinder this are resolved and done away with.

One aspect that has been working against efficient financial intermediation in the country is the rising amount of non-performing loans. The growing problem of NPLs has a negative and a cascading impact on the economy of the country and if left to grow, they will consequently lead to financial instability, hence the need for the country to develop mechanisms that will deal with this problem.

One mechanism that can be applied and have been successful elsewhere is the setting up of a Special Purpose Vehicle which will acquire all NPLs from banks and financial institutions and manage them with a view to recovering and liquidating loans in default.
The SPV would buy these NPLs at a discount from the financial sector and then pursue them.

Successful implementation of such mechanisms is dependent on the Government developing strong legislation to allow the set-up of the vehicle and the modalities of its operations.

Another way to ensure financial stability is to ensure defaulters in the banking system are penalised through failure to access further financing.

To accomplish this, there is need to set up the National Credit Reference Bureau to provide lenders with a platform to check the indebtedness of potential borrowers thus preventing over borrowing.

One worrisome thing that has developed in the country is that some of the citizens have become over borrowed, leading to the failure to repay resources advanced to them while others have generally developed a tendency of wilfully defaulting on their obligations toward the banks, credit retail shops and micro-finance institutions and everywhere where credit is provided.

The Credit Reference Bureaus underpinned with strong legal framework would go a long way in resolving this problem.
To sum it, it is imperative to have a stable financial system so that the system itself does not become a source of economic shocks but remains characterised by predictability, integrity and has sufficient controls in place to mitigate operational risks.

Sanderson Abel is an economist. He writes in his capacity as senior economist for the Bankers’ Association of Zimbabwe. He can be contacted on abel@baz.org.zw or on 04-744686, 0772463008

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