How can you measure financial stability in an economy?

1 Macroprudential indicators

One way to measure financial stability is to use macroprudential indicators, which are statistics that capture the aggregate risk and resilience of the financial system. These indicators can be divided into four categories: macroeconomic, financial, institutional, and market. Macroeconomic indicators include growth, inflation, fiscal balance, external balance, and exchange rate. Financial indicators include credit, leverage, liquidity, profitability, and asset quality. Institutional indicators include capital adequacy, supervision, regulation, and governance. Market indicators include volatility, spreads, prices, and contagion. By monitoring these indicators, you can identify potential vulnerabilities and imbalances in the financial system.

2 Stress testing

Another way to measure financial stability is to use stress testing, which is a simulation technique that evaluates the impact of adverse scenarios on the financial system. Stress testing can be applied to individual institutions, sectors, or the whole system, depending on the scope and purpose of the analysis. Stress testing can help you assess the solvency, liquidity, and contagion risks of the financial system under different shocks and assumptions. By comparing the results of stress testing with the baseline scenario, you can measure the degree of financial stability and the buffer capacity of the financial system.

3 Composite indices

A third way to measure financial stability is to use composite indices, which are numerical values that combine different indicators or factors into a single measure. Composite indices can be constructed using various methods, such as principal component analysis, factor analysis, or weighted averages. Composite indices can help you summarize and compare the level of financial stability across countries, regions, or time periods. However, composite indices also have some limitations, such as data availability, selection bias, and aggregation problems.

4 Financial conditions index

A specific example of a composite index is the financial conditions index (FCI), which is a measure of the overall state of the financial system and its impact on the real economy. The FCI can be calculated using various variables, such as interest rates, credit spreads, asset prices, exchange rates, and market volatility. The FCI can help you assess the degree of financial stress or ease in the financial system and its implications for economic activity and inflation. A high FCI indicates tight financial conditions that may hamper growth and stability, while a low FCI indicates loose financial conditions that may stimulate growth and stability.

5 Financial cycle

A final way to measure financial stability is to use the concept of the financial cycle, which is a long-term pattern of fluctuations in the financial system that can amplify or dampen the business cycle. The financial cycle can be identified using various indicators, such as credit-to-GDP ratio, house price-to-income ratio, or debt service ratio. The financial cycle can help you understand the dynamics and interactions between the financial system and the real economy and their implications for financial stability and macroeconomic policies. A rising financial cycle indicates an expansionary phase that may increase financial stability risks, while a falling financial cycle indicates a contractionary phase that may reduce financial stability risks.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?