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Financial stability is a property of a
financial system A financial system is a system that allows the exchange of funds between financial market participants such as lenders, investors, and borrowers. Financial systems operate at national and global levels. Financial institutions consist of complex, c ...
that dissipates financial imbalances that arise endogenously in the
financial market A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial ma ...
s or as a result of significant adverse and unforeseeable circumstances. When
stable A stable is a building in which livestock, especially horses, are kept. It most commonly means a building that is divided into separate stalls for individual animals and livestock. There are many different types of stables in use today; the ...
, the system absorbs economic shocks primarily via self-corrective mechanisms, preventing the adverse events from disrupting the real economy or spreading over to other financial systems. Financial stability is paramount for
economic growth Economic growth can be defined as the increase or improvement in the inflation-adjusted market value of the goods and services produced by an economy in a financial year. Statisticians conventionally measure such growth as the percent rate o ...
, as most transactions in the real economy are made through the financial system. Without financial stability,
bank A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital m ...
s are more reluctant to finance profitable projects, asset prices may deviate significantly from their intrinsic values, and the payment settlement schedule diverges from the norm. Hence, financial stability is essential for maintaining confidence in the economy. Possible consequences of excessive instability include
financial crisis A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and man ...
,
bank run A bank run or run on the bank occurs when many clients withdraw their money from a bank, because they believe the bank may cease to function in the near future. In other words, it is when, in a fractional-reserve banking system (where banks no ...
s,
hyperinflation In economics, hyperinflation is a very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This causes people to minimize their holdings in that currency as t ...
, and
stock market crash A stock market crash is a sudden dramatic decline of stock prices across a major cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic selling and underlying economic factors. They often foll ...
es.The World Bank GFDR Report


Empirical measures


Firm-level stability measures

The Altman's z‐score is extensively used in empirical research as a measure of firm-level stability for its high correlation with the
probability of default Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations. PD is used in a variety ...
. This measure contrasts buffers (capitalization and returns) with risk (volatility of returns), and has done well at predicting bankruptcies within two years. Despite development of alternative models to predict financial stability Altman's model remains the most widely used. An alternate model used to measure institution-level stability is the
Merton model The Merton model, developed by Robert C. Merton in 1974, is a widely used credit risk model. Analysts and investors utilize the Merton model to understand how capable a company is at meeting financial obligations, servicing its debt, and weighing ...
(also called the asset value model). It evaluates a firm's ability to meet its financial obligations and gauges the overall possibility of default. In this model, an institution's
equity Equity may refer to: Finance, accounting and ownership *Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the diff ...
is treated as a
call option In finance, a call option, often simply labeled a "call", is a contract between the buyer and the seller of the call option to exchange a security at a set price. The buyer of the call option has the right, but not the obligation, to buy ...
on its held
asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that c ...
s, taking into account the volatility of those assets. Put-call parity is used to price the value of the implied “put” option, which represents the firm's credit risk. Ultimately, the model measures the value of the firm's assets (weighted for volatility) at the time that the debtholders exercises their “put option” by expecting repayment. Implicitly, the model defines default as when the value of a firm's liabilities exceeds that of its assets calculate the probability of credit default. In different iterations of the model, the asset/liability level could be set at different threshold levels. In subsequent research, Merton's model has been modified to capture a wider array of financial activity using credit default swap data. For example,
Moody's Moody's Investors Service, often referred to as Moody's, is the bond credit rating business of Moody's Corporation, representing the company's traditional line of business and its historical name. Moody's Investors Service provides internationa ...
uses it in the KMV model both to calculate the probability of credit default and as part of their credit risk management system. The Distance to Default (DD) is another market-based measure of corporate default risk based on Merton's model. It measures both solvency risk and liquidity risk at the firm level.


Systemic stability measures

Unfortunately, there is not yet a singular, standardized model for assessing financial system stability and for examining policies. To measure systemic stability, a number of studies attempt to aggregate firm-level stability measures (z-score and distance to default) into a system-wide evaluation of stability, either by taking a simple average or weighing each measure by the institution's relative size. However, these aggregate measures fail to account for correlated risks among financial institutions. In other words, the model fails to consider the inter-connectedness between institutions, and that one institution's failure can lead to a contagion. The First-to-Default probability, or the probability of observing one default among a number of institutions, has been proposed as a measure of
systemic risk In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to the risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the ...
for a group of large financial institutions. This measure looks at risk-neutral default probabilities from credit default swap spreads. Unlike distance-to-default measures, the probability recognizes the interconnectedness among defaults of different institutions. However, studies focusing on probabilities of default tend to overlook the ripper effect caused by the failing of a large institution. Another assessment of financial system stability is Systemic Expected Shortfall (SES), which measures the contribution to systemic risk by individual institutions. SES considers individual leverage level and measures the externalities created from the banking sector when these institutions fail. The model is especially apt at identifying which institutions are systemically relevant and would impact the most on the economy when it fails. One drawback of the SES method is that it is difficult to determine when the systemically-important institutions are likely to fail. To enhance predictive power, the retrospective SES measure was extended and modified in later research. The enhanced model is called SRISK, which evaluates the expected capital shortfall for a firm in a crisis scenario. To calculate this SRISK, one should first determine the Long-Run Marginal Expected Shortfall (LRMES), which measures the relationship between a firm's equity returns and the market's return (estimated using asymmetric volatility, correlation, and copula). Then, the model estimates the drop in the firm's equity value if the aggregate market experiences a 40% or larger fall in a six-month period to determine how much capital is needed in order to achieve an 8% capital to asset value ratio. In other words, SRISK gives insights into the firm's percentage of total financial sector capital shortfall. A high SRISK % indicates the biggest losers when a crisis strikes. One implication of the SES indicator is that a firm is considered “systemically risky” if it faces a high probability of capital shortage when the financial sector is weak. Another gauge of financial stability is the distribution of systemic loss, which attempts to fill some of the gaps of the aforementioned measures. This measure incorporates three key elements: each individual institution's probability of default, the size of loss given a default, and the contagion resulting from defaults interconnected institutions.Eijffinger, 2009


References

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