Wednesday, January 6, 2010

Assessing financial sector stability

Apart from the "return of the master" - in the form of the big Keynesian revival - the other big major macroeconomic story of this crisis has been the debate about re-defining the role of monetary policy, especially in detecting and combatting financial market distress. More specifically, they have included the relevance of unconventional monetary policy responses to prevent the economy slipping further into crisis and the search for appropriate measures to assess systemic risk.

The latter has taken the form of attempts to identify measures of financial stability that accurately enable policy makers and regulators to detect early signs of trouble with the build-up of systemic risk. Mostly Economics points attention to a survey of parameters that measures financial stability by Blaise Gadanecz and Kaushik Jayaram. They list out the commonly used quantitative indicators that assess financial market conditions through various indicators of financial system vulnerabilities.

The authors identify the commonly used proxies for financial sector (or banking sector) stability as monetary aggregates, real interest rates, risk measures for the banking sector, banks’ capital and liquidity ratios, the quality of their loan book, stand alone credit ratings and the concentration/systemic focus of their lending activities. Financial market conditions are commonly described using equity indices, corporate spreads, liquidity premia, house prices and volatility. High levels of risk spreads can indicate a loss of investors’ risk appetite and possibly financing problems for the rest of the economy.

Among certain sections of academia, the recent events have increased the urgency to develop a single aggregate measure of the degree of financial fragility or stress. Such composite quantitative measures of financial system stability could enable policy makers and financial system participants to better monitor the degree of financial stability of the system; anticipate the sources and causes of financial stress to the system; and communicate more effectively the impact of such conditions. In other words, benchmark values of such composite parameters would serve as lead indicators of build up of financial market stress and imbalances.

The authors however suggest the use of partial composite measures such as a banking stability index or a market liquidity index and also propose some diversity in construction and use of these key indicators,

"For broader cross-country comparisons it would be useful to have an appropriate template and methodology for such indicators, although countries’ individual circumstances make such an exercise difficult (due, notably, to the varying relative importance of individual financial system components and to differing degrees of openness of the economies concerned). If one goes a step further and tries to compute a single aggregate measure of financial stability, the weightings of the different variables that constitute such an aggregate measure have to reflect this accordingly.

For instance, a maturity mismatch between short-term liabilities and long-term assets may have to be assigned a low weight, because maturity transformation is a common feature of the banking business and banks can successfully manage part of this risk using interest rate derivatives. Likewise, the fact that low volatility on a market can mean stable conditions as well as failings in the price discovery process should be considered when assigning a weight to market volatility.

Although some central banks have experimented with computing single aggregate measures of financial stability, no such measures can be used without knowledge and use of other – quantitative or qualitative – instruments. Moreover, although single aggregate measures reflect the financial system conditions well post facto, it is not yet clear how well they would perform in signalling the onset of financial stress."

Given the complex nature of modern day financial markets, with its multi-dimensional linkages with the remaining economy, I am inclined to the opinion that it may not be possible to have a single measure of financial stability that could achieve all the aforementioned objectives. For example, financial market stress due to over-leveraged (say due to low interest rates) institutions have different causes and underlying symptoms than that caused due to irrationally exuberant asset bubbles caused due to cross-border capital flows, and require different remedies. Further, the inter-twined nature of the relationship between monetary and financial stability (monetary conditions affect financial assets and vice versa) complicates the search for composite indicators to measure systemic risks in financial markets. Also, financial stability assessments will have to be done keeping in mind the "variables in the real, banking and financial sectors as well as variables in the external sector".

Empirical analysis using historical data can be useful in arriving at the permissible band for any of these aforementioned paramaters - individual, partial composite or composite measures. In view of the prominent underlying role of excessive debt taking in all major recent financial crisis, it can be safely argued that among all the individual parameters, the build-up of excessive leverage, especially short-term debts, remains the single most important parameter that deserves both rigorous monitoring and effective signalling (so that risk measures among all counterparties and regulators get dynamically recalibrated). Many of the other parameters are effectively symptoms of this underlying phenomenon.

Another important parameter to assess financial stability, especially for developing economies and at a time when cross-border capital flows are amongst the most volatile of financial market transactions, is the external sector. A large share of financial crisis among emerging economies in recent years owe its origins to build-up of exchange rate and current account deficit related stresses. Monitoring capital inflows, especially the short-term capital, and the possible build-up of maturity and currency mismatches can enable regulators to monitor such stresses.

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