Analysis of Financial Stability: The Construction of a New Composite Financial Stability Index for Euro Area

Abstract

This paper develops new tool for the analysis of the Euro Area financial system using acomposite financial stability index (CFSI). The index was successful in capturing key periods offinancial instability during the sample period and reflected a general improvement in financialstability. The econometric results come to support the presence of a positive trend in the CFSIduring 1998-2006 and a recent reduction in volatility. To predict the level of stability and financialsector analysis, we used Monte Carlo simulation method that gives us further information aboutthe future of European financial sector. Moreover, our study results surprised the impact of thefinancial crisis on the main macroeconomic indicators in the Euro Area. The analysis covers theperiod 1998-2012, quarterly data used were obtained from the ECB – Area Wide Model (AWM)Database, Federal Reserve of Saint Louis and OECD.

Keywords

• financial stability
• composite financial stability index
• stochastic modeling and simulation
• quantitative methods for assessing systemic financial stability