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Thanks for their helpful comments to Robert Flood, Robert Ford, Edward Harley, Glenn Hoggarth, Eva Gutierrez, Donald Mathieson, and Darren Pain. However, the opinions expressed should not necessarily be associated with them.
In addition to the quantitative analysis which is the focus of this paper, the Houben-Kakes-Schinasi paper also implies a need to address a hitherto neglected aspect of their comprehensive definition of financial stability, viz., the cost of allocation inefficiencies, across sectors and over time.
Referred to in that volume as “macroprudential indicators.”
For a discussion of the other elements that go into the IMF-World Bank financial sector assessments, see IMF and World Bank (2003).
A method of establishing peer groups, for the Eastern Caribbean Currency Union, appears in Sahely and Jacobs (2000).
These indicators include a risk appetite index (based on a correlation of rank of risk and rank of excess returns); a liquidity, credit and volatility index (published by J. P. Morgan), which combines yield differentials in U.S. treasuries, U.S. dollar swap spreads, and a variety of other financial prices; and an index published by Credit Suisse, which draws on similar range of market variables, in an econometric model (see IMF, 2002, Box 3.1).
For example, parameters might vary with the degree and nature of financial competition, access to international financial markets, and the quality of supervision and regulation.
When they are undertaken at the level of the individual institution, therefore, stress tests complement banks’ internal models of risk exposure, such as value-at risk (VaR) models, which are often used to measure risks from events that have high probability of occurrence (see Austrian National Bank, 1999).
Often a single shock will have effects via more than one channel (for example, an interest rate change may affect both credit and market risks), and these effects should also be aggregated.
Models of this kind are surveyed in Blaschke, Jones, Majnoni and Peria (2001). Alternative measures of the impact of exchange rate changes on credit quality have been suggested, for example, by Wilson, Saunders and Caprio (2000). The relationship between credit risk and economic cycles is explored in Lowe (2002).
The ratio of interest payments to earnings before interest, taxes, depreciation, and amortization (EBITDA).
The most commonly used are the risk-weighted capital assets ratio, the return on assets or equity, and the liquid assets ratio.
A hybrid nonparametric model, based on historical data, and applying exponential smoothing.