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1 October 2014 CFA Institute Journal Review

Financial Stability Indicators and Public Debt Developments (Digest Summary)

  1. Heather K. Traficanti

To investigate the links between financial stability and fiscal policy, the author uses a macroprudential analysis with such macroprudential indicators as stress tests and qualitative analysis of the legal, regulatory, and institutional frameworks of the financial system. Financial soundness (or stability) indicators are at the heart of the analysis. Weak bank profitability, low asset quality, and a weak capital base increase the fragility of the banking system and raise the probability of future fiscal troubles.

What’s Inside?

The author analyzes the effect of selected financial soundness (or stability) indicators (FSIs) on the probability of future debt deterioration, after controlling for several macroeconomic variables. Although the article focuses exclusively on the fiscal costs of a banking crisis, for which the link of causation typically goes from the banking sector to the government sector, there are additional strands of literature that are related to the policy questions that the author studies. Furthermore, he investigates the way FSIs that are used for macroprudential analysis are associated with and can provide signals about aggregate banking losses that can lead to a buildup in public debt (if the losses are assumed by the government sector). Building on this evidence, he relates the evolution of FSIs to the accumulation of debt.

How Is This Research Useful to Practitioners?

The recent economic and financial market crises have caused governments around the world to take decisive action in terms of sustaining economic activity and preventing a meltdown of the financial sector. The author’s findings indicate that early signs of instability can be used to initiate such steps as creating additional fiscal buffers, particularly during good times, and setting up appropriate supervisory and regulatory actions to avert a possible destabilization of the banking sector and subsequent fiscal troubles.

The European Commission investigated the fiscal costs of the 2008–09 financial crisis and found that advanced economies have higher recovery rates. Simultaneous crises in banking and the exchange rate lead to lower recovery rates, whereas a stronger fiscal balance at the onset of a crisis leads to higher recovery rates. Previous research found that crisis response strategies that commit more fiscal resources (e.g., blanket guarantees, bank recapitalization with public funds, bank nationalization, or asset management companies) do not reduce the economic costs of the crisis, and in some cases, they lead to worse post-crisis performance. The findings also indicated that parliamentary political systems tend to adopt bank rescue measures that heavily affect the respective budgets.

In terms of capital adequacy ratios, the author finds that including the ratio of bank regulatory capital to risk-weighted assets improves the ability to predict future debt deterioration episodes because the average marginal effects of the remaining control variables that are statistically significant (real GDP and adjusted debt ratio) are about the same with or without the FSIs. Furthermore, an increase in bank profitability (a higher return on assets and on equity) improves the ability of the banking system to withstand external shocks and removes the possibility of government intervention.

How Did the Author Conduct This Research?

The FSI data are from successive IMF Global Financial Stability Reports. Because of their wide coverage, FSIs are able to capture a range of factors that may pose risks to the financial system as a whole.

The following core FSIs are used: capital adequacy (measured by the ratios of capital to assets and regulatory capital to risk-weighted assets), asset quality (measured by the ratios of nonperforming loans to total loans and loan loss provisions to nonperforming loans), and profitability (measured by return on assets and return on equity). Capital adequacy, asset quality, and profitability are all important indicators of bank performance and fragility. The FSI data start in 1997, which reflects the fact that many countries began collecting FSI data in the context of the IMF’s Financial Sector Assessment Program, which began in 1999. Despite the short time period of the dataset (1997–2010), the sample size of 20 countries is sufficient to allow for consistent estimators by taking into account the asymptotic properties of the countries.

The dependent variable the author uses considers three cases: (1) The debt ratio deteriorates by 8% or more of GDP in a single year (sharp debt deterioration), (2) the debt ratio deteriorates by 10% or more of GDP in a single year (dramatic debt deterioration), and (3) the debt ratio deteriorates by more than 5% of GDP in a single year while the nominal long-term interest rate increases compared with the previous year (debt deterioration with sovereign debt financing problems). These three dependent variables generate 32, 21, and 13 country-year observations, respectively.

Abstractor’s Viewpoint

Using data for 20 OECD countries over the period of 1997–2010, the author investigates whether financial stability indicators can predict or be associated with an increase in the debt-to-GDP ratio in the near future. Although the research is technical in nature, all the steps and processes are clearly defined and illustrated in tables and figures. Using this knowledge on a standalone basis, practitioners in government and economics could more accurately predict the future financial stability and public debt developments for countries being analyzed.

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