A Theoretical Appraisal of Elaborating a Stock Market Prudential Surveillance System Based on a Conceptual Model of Integration of the Financial Sectors and Market Risk Mitigation

Abstract

This theoretical research investigates the integration process between the two most prominent financial sectors the stock market and the credit market and attempts to engineer an alternative prudential toolkit shaped for stock market resilience from systemic risk and financial instability and that complements the basic Basel II and III framework shaped for the credit market. An analytical study will be conducted for the purpose of engineering a stock market prudential surveillance system with both micro and macro-prudential instruments, taking into account the integration constraints and unveiling thereby the threats ensuing from excessive covariance between stock returns. It finds evidence of theoretical arguments implying amplification and offsetting of threats by interaction between prudential instruments deployed simultaneously across sectors, for instance the credit sector and the stock market sector and finds solutions to collusion of interaction within the framework of elaborating instruments related to the prudential engineering. This research holds that Pareto improvement in the prevalence of market frictions introduced by prudential surveillance instruments leaves room for resilience from the onslaught of market risk entailed by sentiment driven speculation. Prudential surveillance fashioned like Basel II and III for the scope of mitigating stock market vulnerability to excessive volatility harbours some highly challengable presumptions regarding the methodology to be persued for the sake of shaping the best methodological approach to prudential engineering of instruments. The interaction process between the proposed prudential scheme and monetary policy highlights one additional challenging scope for central banking while shaping monetary policy stance. This complementary prudential framework reinvigorates the Basel II and III agreements which is specific to the credit sector and might reveal in shortage of instruments providing surveillance on the sources of systemic exposure whenever it is stemming from the stock market. This reinvigorating toolkit thereby reinforces the surveillance instruments aimed at mitigating financial instability in a more pervasive and comprehensive method.