Financial stability refers to a well-functioning, liquid, solvent and sound financial system that efficiently facilitates payments, pools funds and allocates resources to the most productive sectors of the economy and their most valuable uses. Furthermore, the financial system must be resilient to both endogenous and exogenous shocks, e.g., poor lending policies and terms of trade shocks, respectively. Conversely, financial instability is characterised by inefficiencies in the payment and settlement systems and infrastructure.
A well-functioning and stable financial system is critical to sustainable economic growth. The global economic crisis of 2007 – 2009 emanated from the failure of the financial system, resulting in low global economic growth and high unemployment. Disruption in the global financial system had the effect of limiting access to credit for borrowers/investors, thus compromising the smooth functioning of the real economy.
Three elements of financial stability are worth reemphasising, namely, smooth operations of the financial system; centrality of the financial intermediation process in growth prospects; and the need for effective supervision to enhance the credibility of financial institutions. These elements are discussed below.
Smooth Operations of the Financial System
In a broad sense, financial stability refers to the smooth functioning of the financial system, including monetary stability. In this context, monetary stability refers to the maintenance of the value of money which is important for sustainable real economic growth. Problems which arise in the monetary system, such as high inflation, tend to disrupt financial and economic transactions. The financial system, in turn, includes banks, insurance companies, pension funds, microfinance institutions and financial markets. Furthermore, the financial system encompasses financial infrastructure, technical systems, regulations and routines used to facilitate payments and the exchange of securities.
Centrality of the Financial Intermediation Process
Financial institutions, in particular banks, play a critical role in the economy, by pooling funds from savers and lending them to creditworthy individuals and firms in business. This process, called financial intermediation, is important for the welfare of economic agents, and stimulates development of the real economy. Banks and other financial institutions, such as insurance companies, must possess the necessary expertise enabling them to identify creditworthy investment opportunities. Furthermore, stock markets are involved in the financial intermediation process through facilitating investment, buying of companies and commodities, as well as financing of firms through selling of shares. Since disruptions to the intermediation process interfere with the funding and liquidity of businesses, these may impact negatively on the growth of the economy.
For a long time, the supervisory and regulatory framework in Botswana has been geared towards enhancing the safety and soundness of banks, given their importance in the intermediation process, by ensuring that banks follow good governance practices, adopt sound management systems and practices, and avoid excessive risk taking. However, with increasing sophistication in a range of products available, and the increasing role of financial markets and other institutions, such as micro-lending institutions, insurance companies and pension funds in the financial intermediation process, it became necessary to set up another supervisory body in 2008 alongside the BoB, namely, NBFIRA. Hence, enhancing credibility of, and confidence in, financial institutions encompasses both banks and non-bank financial institutions.