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Literature Review Stability In Financial Sector Of Pakistan Economics Essay

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Published: Mon, 5 Dec 2016

The article tries to articulate the definition of financial stability and to discuss what kind of public policies should be adopted in pursuit of financial stability. They start by mentioning the important features of the definition of financial stability like it should be related to public’s welfare, it should be an observable state of affairs and it should not be so rigorously demanding that it stigmatizes virtually any change as evidence of instability.

He also mentioned that collapse of financial institutions is not the only reason for economic damage. A financially stable system is that it dampens the shocks caused by the financial crisis rather than amplifying it.

They also talk about whether asset price reflects the financial stability. According to them financial stability is a state of affairs in which an episode of financial instability is unlikely to occur, so that fear of financial instability is not a material factor in economic decisions taken by households or businesses. They future highlights the relation between Financial Stability and monetary policy.

He mentions that there is a trade-off between financial stability and other objectives of public policy. If government focuses on just achieving financial stability then this decision may harm economic growth in the country and vice versa. Hence the decision must be taken very wisely that neither financial system collapse nor economic growth is harmed. They then highlight some of the measures to prevent the crisis.

The main measures are the laws of the country, Official agencies and their rules and market conventions of the country. They determine how stable the financial system might get of any country. Later the authors mention some of the remedial measures that what should be the counter measures the tackle with the financial crisis such as providing liquidity as the lender of the last resort and solvency supports to individual financial institutions which are bankrupt or near to bankruptcy.

Authors conclude that these financial failures are due to the introduction of risk into commercial banking. There must be regulations on these financial institutions but excessive regulations can inhibit the development of risk management techniques and hence retard improvements in risk management standards.

They mention in their article that there is no consensus on how monetary policy and financial stability affects one another and whether there is synergy or a trade-off between them. It is not clear that monetary policy which has main objective of achieving price stability also fosters financial stability. They argue that high level of interest rates affects bank’s balance sheet negatively.

Another trade-off which author mentions is that of from very low inflation, or in other words deflation. This reduces banks profit margins and hence they will suffer. When explaining synergy, they show that predictable interest rates will ensure predictable returns and future prices which will help in financial soundness. They apply a binary model to a panel of yearly data for 79 countries over the years 1970-1999 to estimate the relationship between monetary policy design and financial instability.

The results show that central bank does play an important role in determining the likelihood of a banking crisis. Targeting the exchange rate is mildly significant in reducing the likelihood of a banking crisis. Also good economic growth of the country and liquidity in the bank’s balance sheet also reduces the probability of a banking crisis. Moreover the exchange rate targeting is also beneficial for the banks.

He first talks about the stress tests which are done under financial stability assessment programs (FSAP). This explains how much stress or burden a financial institution can bear. Later he talks about assessment of the effect of shocks on financial system. He explains that the lesser the effect of crisis on the economy, the greater the stability in the financial sector and the greater the effects of financial crisis on the economy, more vulnerable will be the financial sector.

Hence economic stability must be maintained in any case to keep the financial sector safe from the adverse effects of the global financial crisis. Some potential shocks which author mention are oil prices, demand abroad, productivity, a shift in risk aversion, a shift in exchange rate preferences etc.

They explain the role of monetary policy in explaining banking sector fragility and ultimately systemic banking crisis. Rough set model has been used in the research because it offers better predictive accuracy than the quadratic discriminant model. It analyses a large sample of countries in the period 1981-1999.

They came to know that degree of central bank independence is one of the key variables to explain financial crisis however these effects are not linear. They also mention in their article that there is no clear consensus on how monetary policy and financial stability are related; in particular it is not clear if there is synergy or trade-off between them.

A financial crisis is the sum of several individual crises together. The paper then determines the determinants of banking crisis like certain risks associated with the investments, credit risks, interest rate risk, currency risk, liquidity risk etc. When the value of their assets falls short of the value of their liabilities, banks become insolvent. These activities then lead to the banking crisis.

There is a general view that central banks smooth interest rate changes to enhance the stability of financial markets. But this might induce moral hazard and induce financial institutions to maintain riskier portfolios which may further inhibit active monetary policy. He also suggests that the macroeconomic stability which is caused by a result of aggressive monetary policy brings its own dangers like the moral hazards attached to it.

The paper also highlights some of the important definitions of financial stability from literature. Most of the cases financial stability is explained in an opposite way, i.e. by defining financial instability. Symptoms of financial instability which has been mentioned in the article are asset price volatility, distress in financial institutions and affected output performance.

These would determine how stable the financial system is. They concluded by both theoretical and empirical analyses that the futures market, and in particular the basis risk implied by the hedging strategies of financial institutions, is a key component of monetary policy aimed at achieving financial stability among other objectives.

A graphical decomposition in the research of the interest rate targets show that variables relating to macroeconomic stability have decreased in prominence whilst the financial stability variables have gradually come to the fore. The analysis in the article suggest that the standard textbook treatment of central bank’s objective function mostly based on price and output stabilization may be too restrictive description of central banking in practice.

The first generation of reforms is completed and there is a need to lay down proposals for next generation reforms. The purpose of second generation reforms is to further deepen the financial sector and integrate it into the economy.

He first discusses some of the lessons learnt previously out of the financial sector. The major point is that the financial sector functions effectively and efficiently only if the macroeconomic situation is favourable and stable. He argues that the financial sector stability is linked to the macroeconomic condition in the country and financial sector stability and performance relies on it. He also focuses on the use of technology and the use of Human resource competencies for achieving the required results of the reforms.

He further highlights some of the results accomplished by the sector. The financial markets in Pakistan are liberal and are quite competitive and efficient, but still shallow. He also argues that no matter the financial infrastructure has been strengthened but the legal system is still too time consuming and costly.

Also financial soundness indicators show an upward moving trend but there are vulnerabilities that need to be fixed. He suggests the need of corporate restructuring i.e. pruning costs, reducing debt and increasing efficiency. This will have short term benefits. Change in infrastructure financing is also needed so as to foster public-private partnership.

Risk management is also needed in the sector but we see that its progress is not good up till now. He also argues to promote more Islamic banks into the country. This would help in bringing those people who are resistive to come in because of their faith and beliefs.

Over the years financial crisis and health of economy has shown some close linkages.

He then highlights that how monetary stability and financial stability is seen to be closely related terms. The author defines financial stability as the absence of stresses that have the potential to cause a measurable economic harm beyond a strictly limited group of customers and counter parties.

Similarly the stability in financial markets means the absence of price movements that cause wider economic damage. Prices of assets do change when something happens to cause a reassessment of the future stream of income associated with the asset, or the price at which this income should be discounted. He also mentions in his article that there is no clear-cut definition of financial instability.

Instability can have damaging consequences from the fiscal costs of bailing out troubled institutions to the real GNP losses associated with banking and currency crisis. He also suggests that Financial stability is a public good that its ‘consumers’ do not deprive others of the possibility of also benefiting from it, so public authorities should supply it in an appropriate quantity.

He further identifies some approaches to ensure financial stability which are reliance on market forces, safety nets and regulations. In a nutshell financial stability provides favourable environment for efficient resource allocation and rapid economic growth. It is not clear that the stability can be maintained by the activist approach on part of the authorities or it can be best achieved by the reliance on market forces.

He explains that the present global financial crisis emerged from developed countries and spread to the rest of the world. According to him, the lowering of the interest rates in the US to overcome the recession led to the liberal lending for mortgage and building. The housing bubble finally burst in 2007 inspiring the subprime crisis.

The author then mentions some of the global trends leading to the crisis such as high commodity prices, trade, inflation and unemployment. The collapse of the US sub-prime mortgage market had ripple effects around the world. The problem was so severe that some of the world’s largest financial institutions collapsed.

This led countries and governments to pursue for bailout packages for the institutions which were bankrupt or near bankruptcy. Proponents of these bailout packages argue that it was necessary to prevent further damage to the financial sector and the trust on them. Opponents view that these bailout packages would not help because this crisis actually emerged because of excess credit and debt, giving bailout packages will further exacerbate the problems with the economy.

He then explains that how these developing countries can reduce the effects of such crisis on them like policies, expenditures and public spending and further efforts to increase the efficiency of the banking sector. He explains that before Pakistan was exposed to global financial crisis; it had many more problems going on such as High fiscal and current account deficits, rapid inflation, low reserves, a weak currency and a fragile economy.

The global financial crisis was itself not a big problem, but these previously built situations made the country vulnerable. The global financial crisis had a feedback impact on the financial sector of Pakistan through the real sector of the economy.

Some of the policy measures which author mentioned to address the challenges of financial crisis are significant cuts in the expenditures and prioritize them, tight monetary policy, income support programs for the poor, intensifying public-private partnership and by reinforcing the sound governance in the country. He states that the effects of global financial crisis are not going to end soon.

He states that Pakistan’s economy has been battered by two back-to-back shocks. At one side the global oil prices were too high and on the other side the commodity prices were increasing which was affecting the economy badly. Some channels through which the global financial crisis can potentially have an impact on the economy are trade in goods and services, capital flows, remittances and equity values.

The major channel is the Pakistan’s exports to the developed world which was reduces after the Global financial crisis. Later author explain certain macroeconomic policy response majorly which was carried out under the IMF program which forced Pakistan to carry with tight monetary and fiscal policies to restore macroeconomic stability.

The government also tried to reduce public expenditure and reformed tax administration. Macroeconomic stability is fundamental to fostering economic growth as stable macroeconomic environment encourages private investment and hence economic growth.

According to the 2007-2008 Financial stability review from the State bank of Pakistan, The Banking sector of Pakistan has remained remarkably strong and resilient, despite facing pressures emanating from weakening macroeconomic environment since late 2007.

In a nutshell, the major culprits behind Pakistan’s macroeconomic imbalance were a sharp spike in the international price of crude oil and an unprecedented jump in commodity prices. The global financial crisis had only a minor direct impact on Pakistan, but Pakistan economy remains in dire straits.


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