Vol 6 (2009) - Issue 5

Article preview

Distress of Financial Conglomerates and the Jeopardy of the Financial System: Two Inseparable Matters?

1. Introduction

The liberalisation of the contemporary financial system and the diversity of global financial markets have produced vulnerable and threatening surroundings in the financial landscape. The emergence of international financial conglomerates, which are currently playing a dominant role in the financial scene, has produced additional risks to the stability of the financial infrastructure, especially in cases of failure. The aim of this article is to examine the problems arising from the potential collapse of an international financial conglomerate with respect to the stability of the financial system. There are several issues at stake, numerous challenges and risks that should be taken into serious consideration in this respect.

2. Financial stability: the goal

Initially, it would be instructive to attempt to define the contentious term ‘financial stability’. Although giving a clear-cut definition of financial stability is not an easy task since countless different interpretations have already been given, it can be largely agreed that financial stability is something positive, worth having, a ‘global public good’. We have witnessed numerous financial institutions’ efforts to analyse, pursue and achieve financial stability, pointing out that this is not only one of their main goals but even the key reason for their existence. Due to the extensive nature of the entire financial system and infrastructure, financial stability is a term that must be interpreted in a broad sense.

The chaotic organisation of the financial system and its numerous components that are inextricably intertwined can challenge its stability if disruption occurs in one of them by posing the threat of a systemic risk. If the financial system operates in a good and efficient way then there will be no great costs in economic activity and the ‘disruption’ will fade away quickly without causing irreplaceable damage. ‘A financially stable economy is one that does not degenerate into instability when it experiences a perturbation, namely an unexpected event or shock but on the contrary it dampens rather than amplifies shocks.’ Therefore, the reaction to unexpected disturbance of a financial system is one of the major criteria that determine its stability.

There are three essential characteristics for financial stability, which must exist in chorus in order for a financial system to be considered stable. In particular, a financial system is stable if it:

1) facilitates the efficient allocation of economic resources, geographically and over time, as well as other financial and other economic processes (such as savings and investment, lending and borrowing, liquidity creation and distribution, asset pricing and ultimately, wealth accumulation and output growth);
2) assesses, prices, allocates and manages financial risks; and
3) maintains its ability to perform these key functions even when faced with external shocks or a buildup of imbalances.

Hence, in quite a broad sense, a financial system is stable when it smooths the progress of the economy without being ‘disturbed’ by unanticipated financial imbalance.