A pathological accumulation of systemic risk can, if it materialises, severely disrupt the normal functioning of the entire financial system. However, mitigating such risks is a challenging task since both financial stability and systemic risk remain abstract economic concepts which are difficult to define in practical and precise terms.
According to the definition of the European Central Bank, financial stability is a condition in which the financial system – comprised of financial intermediaries, markets and market infrastructures – is “capable of withstanding shocks and the unravelling of financial imbalances.”
Monitoring the financial system with the aim of eliminating vulnerabilities and safeguarding financial stability helps reduce the likelihood of disruptions in the financial intermediary process that may be severe enough to significantly impair the allocation of savings to profitable investment opportunities that support economic growth.
According to the definition in the regulations establishing the European Systemic Risk Board (ESRB), systemic risk refers to a risk of disruption in the financial system with the potential to have serious negative consequences for the internal market and the real economy. All types of financial intermediaries, markets and infrastructure may be potentially systemically important to some extent.
Maintaining financial stability
Protecting the financial system and safeguarding financial stability require the identification of major sources of risk and vulnerabilities such as deficiencies in the allocation of savings and investment or improper assessments of financial risks. Indeed, such weaknesses can be the forerunners of the emergence of future disruptions that could compromise the stability of the financial system and have negative side-effects on the real economy.