So, the model measures the value of the firm’s assets (weighting for volatility) at the time that the debtholders will “exercise their put option” by expecting repayment. Put-call parity is used to price the value of the “put,” which is represented by the firm's credit risk. The Merton model (also called the asset value model) treats an institution’s equity as a call option on its held assets, taking into account the volatility of those assets. It is routinely used to ascertain a firm’s ability to meet its financial obligations and gauge the overall possibility of default. Other approaches to measuring institution-level stability are based on the Merton model. Also, the z-scores allow comparing the risk of default in different groups of institutions, which may differ in their ownership or objectives, but face the risk of insolvency. An advantage of the z-score is that it can be also used for institutions for which more sophisticated, market based data are not available. Also, the z-score looks at each financial institution separately, potentially overlooking the risk that a default in one financial institution may cause loss to other financial institutions in the system. If financial institutions are able to smooth out the reported data, the z-score may provide an overly positive assessment of the financial institutions’ stability. They are thus only as good as the underlying accounting and auditing framework. Perhaps the most important limitation is that the z-scores are based purely on accounting data. The z-score has several limitations as a measure of financial stability. Papers that used the z-score for analysis bank stability include Boyd and Runkle (1993) Beck, Demirgüç-Kunt, Levine (2007) Demirgüç-Kunt, Detragiache, and Tressel (2008) Laeven and Levine (2009) Čihák and Hesse (2010). A higher z-score therefore implies a lower probability of insolvency. The popularity of the z-score stems from the fact that it has a clear (negative) relationship to the probability of a financial institution’s insolvency, that is, the probability that the value of its assets becomes lower than the value of its debt. The z-score is defined as z ≡ (k+µ)/σ, where k is equity capital as percent of assets, µ is return as percent of assets, and σ is standard deviation of return on assets as a proxy for return volatility. It explicitly compares buffers (capitalization and returns) with risk (volatility of returns) to measure a bank’s solvency risk. It can severely shake confidence in the financial and economic system.Ī common measure of stability at the level of individual institutions is the z-score. Major instability can lead to bank runs, hyperinflation, or a stock market crash. During these periods, banks are reluctant to finance profitable projects, asset prices deviate excessively from their intrinsic values, and payments may not arrive on time. The true value of financial stability is best illustrated in its absence, in periods of financial instability. Financial stability is paramount for economic growth, as most transactions in the real economy are made through the financial system. In stability, the system will absorb the shocks primarily via self-corrective mechanisms, preventing adverse events from having a disruptive effect on the real economy or on other financial systems. A financial system is in a range of stability when it dissipates financial imbalances that arise endogenously or as a result of significant adverse and unforeseen events. It is also about resilience of financial systems to stress.Ī stable financial system is capable of efficiently allocating resources, assessing and managing financial risks, maintaining employment levels close to the economy’s natural rate, and eliminating relative price movements of real or financial assets that will affect monetary stability or employment levels. Most of them have in common that financial stability is about the absence of system-wide episodes in which the financial system fails to function (crises). There are numerous definitions of financial stability. Democratic Republic of Congo - Françaisīack to Key Terms Explained Financial stability.
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