Banking Soundness Index for Turkey: The Principal Component Analysis Approach

Abstract

This study aims to generate a banking soundness index by utilizing endogenous variables specific to banks in order to measure the banking sector’s financial soundness. The core set of the financial stability index of the International Monetary Fund (IMF) is taken as the basis and the calculations of the proposed index are made with the quarterly data over the period 2007:Q2-2020:Q3. The variables in the sub-indicators are standardized using the min-max normalization technique. The principal component analysis method is employed on the standardized data. According to the results of the principal component analysis, variables are categorized into two main components. A strong relationship exists between profitability and liquidity ratios in the first principal component. In the second principal component, it is observed that market risk and certain capital adequacy ratios are associated with each other. The index reached its highest level in 2007:Q2. It is observed to reach its lowest levels in 2015:Q3 and 2020:Q1. It is seen that the calculated banking soundness index complies with the evaluations about the banking sector included in the financial stability reports published by the Central Bank of the Republic of Turkey (CBRT).