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Financial Stability

Systemic risk

Financial stability function aims to limit systemic risk in the financial system. Systemic risk is a risk that affects the functioning of the entire financial system, not only of specific institutions. Systemic risk is commonly defined as the risk of disruption to financial services that is (1) caused by an impairment of all or parts of the financial system and (2) has the potential to have serious negative consequences for the real economy. The first element of this definition means that a certain part of financial services has become inaccessible or that the cost of those services has recorded a dramatic increase, regardless of whether the cause of the disruption lies in or outside of the financial system. The second element implies negative effects on the real sector, manifesting as a contraction of economic activity.  Both elements are necessary in order to qualify risk as systemic.

There are two dimensions to systemic risk – one stems from the linkages among financial institutions which make them sensitive to the spreading of risks affecting other members of the system – cross sectional dimension, while the other refers to the inherent procyclicality of the financial system – time dimension. The procyclicality means that during the upward phase of the cycle financial institutions tend to be more aggressive in risk-taking so that their leverage, liquidity, and prices of securities and real estate increase, leading even to the overvaluation of their assets, whereas in the downward phase, the trend reverses, triggering a build-up in market uncertainties, a fall in financial asset prices, deleveraging, liquidity squeeze…ending in a full-blown financial crisis.

Macroprudential instruments

Macroprudential instruments are regulatory measures taken by the relevant body in order to limit and control systemic risk in the financial system. Macroprudential instruments may be classified by the scale of systemic risk they target. In order to dampen the risk of procyclicality, the following measures may be applied:  higher capital requirements in the upward phase of the cycle, restrictions on profit distribution, public warning on the rising risk in the system, LTV and DTI ratios, bank levies, etc. On the other hand, to keep the risk of linkages in check, the relevant authorities could set special capital requirements for systemically important financial institutions, place bans on non-core activities, order split-up of a financial institution or sale of a business line so as to reduce the systemic importance of an institution, introduce special leverage ratios for systemically important financial institutions, etc.

Amendments and Supplements to the Law on the National Bank of Serbia (RS Official Gazette, No 44/2010) entrusted the central bank with the responsibility to safeguard and strengthen the stability of the financial system (Article 3). To enable the exercise of this role, the legislator introduced as one of the new statutory functions of the National Bank the determining and implementation of activities and measures aimed at safeguarding and strengthening the stability of the financial system, i.e. vested the National Bank with an explicit authority to use macroprudential instruments.  The decision-making on the use of these instruments has been entrusted to the highest executive body of the National Bank of Serbia – the Executive Board (Article 14, paragraph 1, item 11).

Systemically important financial institutions

Systemically important financial institutions (SIFIs) are those whose liquidation or bankruptcy may threaten the functioning of a part or all of the financial system. The risks affecting these institutions thus turn into systemic risks to the financial system. For this reason, SIFIs must be treated differently than other institutions.

There are three generally accepted criteria for identifying SIFIs:  1) size, 2) substitutability and 3) interconnectedness. Other criteria may also be added, such as complexity, the degree of financial dependence, etc. These criteria and the manner of assessing whether they are met represent the basis for the methodology for identifying SIFIs.

The Financial Stability Board (FSB) has determined the methodology for identifying globally systemically important financial institutions (G-SIFIs) and published a list of G-SIFIs. In a similar vein, SIFIs must be identified at national level.

The following needs to be done in order to resolve the issue SIFIs:

  • develop the methodology for identifying SIFIs;
  • determine the necessary capital or other requirements for SIFIs to strengthen their loss absorbing capacity; 
  • develop a special regime of systemic supervision of SIFIs;
  • develop an efficient resolution framework for SIFIs, which may as well involve winding down of their operations but without detrimental effects on the rest of the financial system.