Banking Stability for Financial Stability

Abstract

This paper while emphasizing the importance of the concept of financial stability in wake of recent global financial crisis in particular and other (banking and financial) crises in general attempts to highlight the significance of the soundness of banking sector in emerging economies where banking sector constitutes a lion’s share in the financial system. This study investigates banking stability by structuring a recursive micro panel Vector Auto Regressive (VAR) model and corroborates the significance of the interrelatedness of the bank-specific variables such as; Liquidity, Asset Quality, Capital Adequacy and Profitability. This paper while underscoring the prominence of financial stability in wake of recent global financial crisis in particular and other (banking and financial) crises in general argues that the soundness of banking sector in banking dominated financial system of emerging economies is of great significance in ensuring financial stability. Further, the paper offers an in-depth review of literature on financial stability in backdrop of the ongoing definition debate for financial stability. A significant contribution of this study is in establishing that liquidity in the banking dominated financial system is reciprocally related with asset quality, capital adequacy, and profitability of constituent banks by employing a robust panel data drawn from 56 leading banks for a period of 12 years. Another contribution of this study is that, employing the most appropriate key determinants of banking sector soundness, the paper models a simple and basic axiomatic form of banking stability index (BSI) in the context of an emerging economy banking sector.