Financial stability means that the financial system financial intermediaries, financial markets

and financial infrastructures is capable of ensuring efficient allocation of financial resources

and fulfilling its key macroeconomic functions even if financial imbalances and shocks occur in
the domestic and international environment.
Under conditions of financial stability, economic agents have confidence in the banking system
and ready access to financial services, such as payments, lending, deposits and hedging.
The intensity of the financial crisis has highlighted the need for a systemic approach to the
regulation and supervision of the financial sector. The crisis has taught us three important
lessons: () the degree of development of the financial system has a by far greater impact on
economic activity than thought earlier; (b) the costs of financial crisis are very high; (c) price
stability does not guarantee financial stability.
As part of the financial stability measures and activities, the National Bank undertakes regular
and comprehensive analyses of macroeconomic environment and functioning of key financial
institutions, markets and infrastructure; identifies risks that pose a threat to the stability of the
financial system; identifies trends that may increase the vulnerability of the financial system; and
launches debate on new regulatory initiatives and their potential effect on the financial system
and the real sector of the economy.
Recognising the need to increase the use of the dinar in the financial system in order to
strengthen the countrys financial stability, lessen the risk of currency changes to the most
vulnerable sectors of the economy, reinforce the efficiency of monetary policy, and by
extension, create preconditions for strong and durable economic growth
The National Bank and the Government agree to classify the activities related to the
implementation of dinarisation strategy into three groups, in accordance with the different
objectives of the process.
The first group comprises monetary and fiscal policy measures geared at strengthening the
macroeconomic environment by delivering low and stable inflation through a managed floating
exchange rate, alongside durable economic growth.
The second group comprises activities to promote the development of the market of dinar
securities and create conditions for the introduction of new dinar instruments.
The third group comprises activities to promote the development of foreign exchange hedging
instruments.
The National Bank will continue to support the process of dinarisation through reserve
requirements. The National Bank will also continue to support the process of dinarisation
through prudential and other measures.
In the event of a structural dinar liquidity shortage, the National Bank stands ready to use all monetary
policy instruments at its disposal to supply dinars at the key policy rate which ensures the achievement
of inflation target.

The Government will support dinarisation particularly by investing further effort in raising the share of
pure dinar debt in total public debt. Through stimulative tax policy, the Government will continue to
support saving in dinars.
The global financial crisis has shifted the focus of market participants and the public to the significance
of the stability of the financial system and possible costs that may arise if that stability is threatened.
This has encouraged a more rapid development of macroprudential policy at both national and
international level.

The main objectives of macroprudential policy are accomplished through the achievement of the
following intermediate macroprudential objectives:
1. Mitigating and preventing excessive credit growth and leverage;
2. Mitigating and preventing excessive maturity mismatch between funding sources and
placements of financial institutions;
As part of its efforts to safeguard and strengthen financial stability, the National Bankcompiles a set of
macroprudential indicators that help in the control and management of systemic risk in the financial
system of the country.

In addition to macroprudential indicators, the National Bank uses a number of interconnected

models that simulate the behaviour of banks, companies and households. These models are used
for assessing the vulnerability of not only individual institutions, but also of the financial sector
as a whole, and represent analytical support to macroprudential decision-making.
More on quantitative models and their results:

Stress-testing of the Serbian banking system

Financial Stability Indicators - Chart Pack Q3 2016

The primary objective of the NATIONAL BANK is to achieve and maintain price stability. Without
prejudice to its
primary objective, the NATIONAL BANK also contributes to the maintaining and strengthening of
financial stability. One of the NATIONAL BANKs instruments for accomplishing this goal is the
function of the regulator and supervisor of the major part of the Serbian financial sector, including banks.
the volume of NPLs has increased, lending activity has slowed and the deleveraging process has begun.

Monetary policy mainly works through its ability to affect current and expected
future interest rates; however, in certain circumstances, it also has the ability to
affect risk-taking by investors and financial institutions, and thereby is linked to
financial stability.2 I believe that, in general, the goals of monetary policy and
financial stability are complementary. For example, price stability helps
businesses, households, and financial institutions make better decisions, thereby
fostering the stability of the financial system. And a stable financial system allows
for more effective transmission of monetary policy throughout the economy. I
view this complementarity as similar to the complementarity between the two
monetary policy goals that the U.S. Congress has given to the Federal Open
Market Committee (FOMC), namely, price stability and maximum employment.
The FOMC has acknowledged that nonconventional monetary policy, including
large-scale asset purchases and the extended period of very low interest rates,
could pose potential risks to financial stability by affecting market functioning and
by spurring risk-taking in a search for yield. Empirical work is beginning to
document this effect. For example, Jimnez, Ongena, Peydr, and Saurina (2014)
use data on 23 million bank loans from the Spanish credit registry and find that a
lower overnight policy rate induces low-capitalized banks to lend more to ex ante
riskier firms and to require less collateral compared to high-capitalized banks,
direct evidence of monetary policys effect on risk-taking.
Sometimes inflation targeting and financial stability are complementary. For
example, if the economy is running above potential, creating inflationary
pressures, while financial vulnerabilities are also building, then both
considerations point to tighter monetary policy. In retrospect, this appears to
have been the case in many countries in the period leading up to the 200709
global financial crisis. The chart shows estimates by the International Monetary
Fund of output gaps and credit gaps during that period.

A second example is one in which the economy is in recession, or operating below

potential, and the financial system is going through a phase of deleveraging and
low asset prices (Chart 1, see Case 2). In this case, easing monetary policy is the
right action for both inflation control and financial stability purposes. An example
is the United States after the 200709 crisis: easy monetary policy cushioned the
economy and also helped heal a broken financial system.
In both of these cases, there is no trade-off for monetary policy. There are other
situations, however, where there could be tension between the two objectives. One
is when the economy has been hit by a highly persistent adverse foreign demand
shocksuch as a recession in the economy of a major trading partnerwhile the
domestic financial system is unimpaired (Chart 1, see Case 3).
In this case, inflation targeting calls for policy easing to support economic activity
and return inflation sustainably to target. But that easing would also
disproportionately affect domestic sectors that are highly sensitive to interest rates
like housing and other consumer durable goods, encouraging the buildup of
financial vulnerabilities. This has been the situation in Canada for the past seven
years, as reflected in increasing levels of household indebtedness and elevated
house pricesalthough, as Ill discuss later, regulatory measures have been used to
mitigate the resulting financial system risks (Chart 2).
For example, regulators can lower loan-to-value ratios in response to indications
of rising household sector vulnerabilities. Another example is the countercyclical
capital buffer introduced as part of the Basel III reform of bank capital
requirements.
Such countercyclical measures are designed, in part, to weaken the feedback loop
between asset prices and credit growth that can lead to the kind of financial
excesses that set the stage for a crisis.
When the government imposes tighter requirements on mortgage insurance, for
example, it likely reduces demand for housing, which may, in turn, have a
negative effect on growth and inflation. Household indebtedness may also affect
the transmission mechanism of monetary policy, for instance, by influencing
households willingness to spend out of their disposable incomes. On the flip side,
if prolonged low interest rates encourage people to take on more debt, financial

stability concerns grow. So we need a better grasp of how monetary policy and
macroprudential measures interact.
Even if such spillovers are important, a clear assignment of policies could be
effective in achieving both objectives: monetary policy to target inflation,
macroprudential measures to target financial stability. Each could operate
independently, focusing only on its own objective.9 The resulting combination of
policiesa Nash equilibriumcould both achieve the inflation target and ensure
an acceptable degree of financial stability (Chart 3).
Under certain conditions, as long as monetary policy has a larger effect on
inflation than it does on financial stability risk and macroprudential policy has a
larger effect on financial stability risk than it does on inflation, there would be no
need, in theory, for the agencies responsible to coordinate their actions explicitly.
For the 12 central banks in the Asia-Pacific region that are members of the BIS,4 10 have explicit
financial stability objectives written in laws or statutes (Jeanneau (2014)). The adoption of
financial stability objectives, coupled with the well established goal of price stability for the
regions central banks (Filardo and Genberg (2010)), raises the question of how central banks
would deal with policy trade-offs that may arise from a conflict between the objectives of price
and financial stability.
However, greater challenges could arise if a central bank focused on stabilising short-run
inflation dynamics at times when inflation was low but credit growth was strong.
Their price stability objective is often stated as a medium-term goal, thus recognising the
importance of stabilising real economic activity in the short run (Svensson (1999)).
The monetary policy measures ie reserve requirements, credit growth limits and liquidity
requirements affect the amount of funds that are available for lending to the private sector.
The prudential tools ie maximum loan-to-value ratio, maximum debt-service-to-income ratio,
risk weights on housing loans and loan-loss provisioning on housing loans are used by the
authorities to target credit to housing.
Take the historically low interest rates and range of unconventional monetary policies around
the world in order to support modest recoveries and too low rates of inflation. This is an
environment where investors search for yield and financial imbalances can build up.
Sustained inflation, Schwartz argues, encourages speculative investment and borrowing on the
expectation that prices will continue to rise. When inflation abruptly declines as it did in the
early 1980s, however, borrower incomes may be insufficient to repay loans made on the
expectation of continuing price increases. The resulting rise in defaults reduces the equity of
lenders, possibly causing an increase in financial institution failures.

Schwartz argues, however, that if the aggregate price level is stable, or at least if its movements
are predictable, then resources will be employed more efficiently and financial distress,
regardless of its proximate cause, will be less severe.