Developing a Financial Stability Index for Macroeconomic Monitoring and Forecasting

The frequency of financial crises around the world in the last twenty years have raised concerns about the economic stability of the financial systems in various countries as well as about its interdependence with other sectors. Despite the lack of a unified methodology for determining and measuring financial stability, a lot of central banks in different countries have started to measure the financial stability risks using various indicators that are included in their periodic financial stability reports. The development of an aggregated index is highly desirable to monitor the levels of economic stability over time and to reduce the likelihood of financial instability by identifying its sources. This study tries to combine the index of Economic Resilience and the range of core Financial Soundness Indicators (FSIs) into one approach to develop an aggregated index that reflects the state of the economy in different countries. The index of economic resilience is collected by International Institute for Management Development (IMD) in their annual stability reviews, while FSIs are published by the International Monetary Fund (IMF). Quantitative measures are used to give numerical estimates for the quality of constructed index. The novelty of this study lies in the fact that the aggregated index of economic resilience is constructed for different countries over the same time period. In addition, quantitative measures are introduced in order to choose the model with the best predictive power. The practical significance of the study is that data set used allows to apply developed models to calculate the level of financial stability in a wider sample of countries. This could potentially allow to develop the index of Economic Resilience for the countries that are not included in the IMD's annual reports.