Financial Stability Review – April 20254.1 Focus Topic: A Conceptual Framework for Assessing Financial Stability

Assessing financial stability requires systematic evaluation of the financial system’s resilience to economic and financial shocks. This Focus Topic sets out the RBA’s conceptual framework for assessing the complex interactions within the financial system. This systematic approach – which is informed by approaches used internationally¹ – facilitates the identification of vulnerabilities in the financial system, along with how they might transmit through the system and any offsetting features that improve system resilience (Figure 4.1.1). Capturing complex financial stability issues in a simple conceptual framework is challenging and no single approach is perfect. The RBA will continue to challenge, assess and adapt its framework to incorporate learnings, and to account for the evolving nature of financial stability issues.

A systematic approach to assessing vulnerabilities and determining appropriate actions can enhance the financial system’s resilience.

Mapping the build-up of vulnerabilities in the financial system is a key focus of the framework. Vulnerabilities in the financial system can cause the system to amplify shocks instead of absorbing them, which can lead to significant financial and non-financial costs to the economy. A financial system that has few vulnerabilities and is highly resilient could withstand even a substantial shock without disrupting provision of funding and other key financial services. Conversely, a financial system with greater vulnerabilities or lower resilience will be more sensitive to shocks, heightening the likelihood of major disruptions to the financial system and economy when risks materialise.

The focus on vulnerabilities helps policymakers promote financial stability regardless of the form or origin of risks. This is important as shocks are unpredictable and authorities may have limited ability to address specific risks. For example, as a small open economy, Australian policymakers do not have the tools to reduce the risk of an adverse shock originating overseas. Nevertheless, by closely monitoring vulnerabilities, they can better determine appropriate actions to enhance the financial system’s resilience to those risks.

The framework helps to more consistently map vulnerabilities and to explore emerging ones where policy responses are still under development (Figure 4.1.1). This is vital given that evolving economic and financial environments – from geopolitical shifts to the digitalisation of financial services – continue to reshape vulnerabilities, how shocks are transmitted through the financial system and the resilience of the financial system in such circumstances.

The framework is used to examine the net vulnerabilities in the financial system.

The framework aims to simplify the analysis of developments in the financial system into seven vulnerability categories:

• credit exposure
• asset price exposure
• operational exposure
• complexity
• leverage
• liquidity and funding
• other vulnerabilities.

The RBA takes a holistic approach to examine the net vulnerabilities in the system. For each identified vulnerability, the RBA considers how it could amplify the impact of a shock and how the shock could be transmitted across participants and sectors (e.g. via markets and exposures). The RBA then evaluates whether the system has built-in resilience to absorb or mitigate the threat. This allows for the identification of net vulnerabilities – that is, after taking into account the system’s resilience.

The framework also takes into account external factors that can influence net vulnerabilities and policy actions across sectors and time. External factors originate from the risk landscape and the environment in which the financial system operates. For example, this could include changing weather patterns, an aging population, digitalisation, or geopolitical factors. External factors provide the context in which this assessment takes place. Whether a characteristic of the financial system presents a net vulnerability depends on the context (e.g. the structure of the financial system and economy). External factors can also be used to develop scenarios that explore potential vulnerabilities. Once net vulnerabilities have been assessed, reference to external factors can help to shape and prioritise remedial actions. These actions, and the actions of financial system participants, influence the vulnerabilities themselves and can have feedback effects on the environment and risk landscape. This creates a cycle that informs and refines future policy recommendations.

Distinguishing between sector-specific or system-wide vulnerabilities is key in determining the right policy responses. This includes formulating appropriate actions, identifying which regulatory bodies should be involved, and spotting any regulatory gaps. These actions can range from targeted policy actions and improved monitoring to better communication from regulators and raising public awareness. Each member of the Council of Financial Regulators (CFR) – the Australian Prudential Regulation Authority, the Australian Securities and Investments Commission, the Australian Treasury and the RBA – has its own set of responsibilities and powers for financial stability. This means each institution plays a different role in shaping and implementing policy. The CFR agencies work closely together to share insights and analysis, and coordinate policy responses as appropriate.²

Identified vulnerabilities are subject to ongoing monitoring.

Vulnerabilities are monitored across sectors of the financial system using a variety of indicators. Together, these indicators inform our overall assessment of the extent of vulnerabilities in the financial system. We choose not to aggregate the measures into a single simplified index: this is because we need to maintain a granular view of each sector in the financial system and no single indicator provides a complete view of financial system stability. Single indicators are useful for summarising information, but at the cost of potentially masking threats to financial stability in specific parts of the financial system. The combination of single indicators and more detailed monitoring provides a holistic toolkit.

The framework supports a rigorous assessment of financial stability.

Whether the assessment starts with an identified vulnerability, an external factor or a new policy, the framework is designed to help trace its impact through the financial system. For example, if high debt levels are identified in a sector of the financial system, stepping through the components of the framework allows a systematic assessment of how it affects financial stability, including the risks that would expose borrowers (e.g. a sharp downturn in economic growth), the transmission to lenders or through markets (e.g. through higher default rates or larger credit spreads), the resilience of borrowers (e.g. cash buffers) and potential policy actions. Alternatively, an assessment could start with identifying a risk that is elevated and asking what vulnerabilities would amplify the effect if that risk were to materialise. The framework provides a conceptual map that facilitates systematic assessments, but it can be applied flexibly to approach assessments from different perspectives.

The conceptual framework seeks to distil a significant amount of information in a way that allows policymakers to focus on what really matters for financial stability. With the aid of four elements, the framework helps to simplify the complex workings of the financial system, guide both assessments and policymaking, and inform the RBA’s related communication:

• Systematic evaluation: It covers the main categories of potential risks and vulnerabilities so that the financial system is thoroughly and consistently reviewed.
• Balanced perspective: It ensures that all relevant risks and vulnerabilities are considered, not just the ones currently in the spotlight.
• Resilience strategies: It helps authorities identify strategies to address vulnerabilities and improve risk management by tracing vulnerabilities and their effects through the financial system.
• New risks: It helps organise and assess emerging risks and vulnerabilities, as well as external factors, making it easier to distinguish new issues from existing ones.

The benefits of having a clear framework to analyse new issues are highlighted in 4.2 Focus Topic: Looking at Digitalisation through a Financial Stability Lens. The framework helps rationalise complex interactions and distinguish between existing vulnerabilities – those that might be further exacerbated – and emerging ones.

The framework is subject to ongoing challenge and revision. In developing the framework, choices had to be made about how to distil the very complex process of performing a financial stability assessment into a simpler conceptual model, among many valid alternatives. In addition, characteristics of the financial system and its interactions change over time. Both of these points call for ongoing challenge and revisions to ensure that the framework continues to serve its purpose of facilitating high-quality assessments.

Endnotes

Relevant international frameworks include the Financial Stability Board’s Financial Stability Surveillance Framework, the Bank of England’s Framework for Assessing Risks in Market-based Finance and the framework set out in Adrian T, D Covitz and N Liang (2014), ‘Financial Stability Monitoring’, FEDS Notes, 4 August. 1

Details about the Council of Financial Regulators activities are available on its website. 2