Financial stability is a property of a
A financial system is a system that allows the exchange of funds between financial market participants
There are two basic financial market participant categories, Investor vs. Speculator and Institutional vs. Retail
Retail is the proc ...
that dissipates financial imbalances that arise endogenously
A financial market is a market (economics), market in which people trade financial Security (finance), securities and derivative (finance), derivatives at low transaction costs. Some of the securities include stocks and Bond (finance), bonds, ra ...
s or as a result of significant adverse and unforeseeable circumstances. When
A stable is a building in which livestock
Livestock are the domesticated
Domestication is a sustained multi-generational relationship in which one group of organisms assumes a significant degree of influence over the reproduction and c ...
, the system absorbs economic shocks
primarily via self-corrective mechanisms, preventing the adverse events from disrupting the
real economyThe real economy concerns the production, purchase and flow of goods
Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economi ...
or spreading over to other financial systems. Financial stability is paramount for
Economic growth can be defined as the increase or improvement in the inflation-adjusted market value of the goods and services produced by an economics, economy over time. Statisticians conventionally measure such growth as the percent rate of i ...
, as most transactions in the real economy are made through the financial system.
Without financial stability,
A bank is a financial institution
Financial institutions, otherwise known as banking institutions, are corporation
A corporation is an organization—usually a group of people or a company—authorized by the State (polity), stat ...
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
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 ...
A bank run (also known as a 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 ( ...
Economics () is a social science
Social science is the branch
A branch ( or , ) or tree branch (sometimes referred to in botany
Botany, also called , plant biology or phytology, is the science of pl ...
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 ...
[The World Bank GFDR Report]
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
Default may refer to:
* Default (law), the failure to do something required by law
** Default (finance)
Finance is the study of fina ...
. 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 modelThe 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 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 differe ...
is treated as a
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
Security is freedom from, or resilience against, potential
Potential generally refers to a currently un ...
on its held
In financial accounting
Financial accounting is the field of accounting
Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
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 Investors Service, often referred to as Moody's, is the bond credit rating
To invest is to allocate money
Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the plentiful money bags handed to Kin ...
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
Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money availab ...
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.