Financial Stability refers to when the financial system can maintain its fundamental functions and is also resilient to disruptions that threaten these functions. By extension, financial instability is a material disruption to the system’s functions, which has damaging consequences for the real economy.
The Financial System refers to institutions including commercial banks, insurance companies, capital markets and other financial agents, as well as the financial markets and the financial infrastructure of technical systems that is required to make payments and exchange securities. The system also includes the regulatory framework in the form of legislation, supervision and regulation, and other standards. The fundamental functions of the financial system are to intermediate funds between savers and investors, facilitate payments, and manage risk. Any disruptions that would interfere with the execution of these functions would result into large costs to the economy. For instance, if the payments system is disrupted, banks will not be able to effect payments to each other as well as to their customers. Another example is a credit crunch, where access to credit is limited, affecting financial institutions’ ability to fund their lending activities.