Financial Instability, Supervision and Central Banks

Overview
Recent financial crises have greatly contributed to the renewed interest in studying financial instability. It is now well understood that the cost of financial instability can be very high. Empirical studies have reported that across countries the average fiscal costs of banking resolution can be as high as 50 percent of GDP. Studies also suggest that deadweight economic costs of banking and currency crises occurring together, measured by cumulative output losses, can amount to as much as 30 percent of GDP.

One difficulty in analyzing financial instability, in addition to finding a widely accepted and applicable definition of it, lies in the fact that most of the crises manifest themselves in a seemingly unique manner and frequently require different policies to manage and resolve. The fact that many theoretical models and empirical analyses of financial crises build on a coordination failure and informational frictions reflects and often contributes to this difficulty.