Modelling Financial Stability Index for Latvian Financial System

Abstract

Financial disturbances can be costly. In particular, systemic events in financial markets, such as banking crises, often affect the whole society in a deeply traumatising way. Consequently, it is important to anticipate risks of such adverse development so as to try to prevent that kind of disaster and ensure financial stability. Author of this paper analyses fragility of financial system of Latvia to the fluctuations in global economy and changes in direction of international capital flows by creating complex financial system stability index. Results have proven that dynamics of every developed sub-index show unique economic processes defining Latvian financial system’s stability. Secondly, sub-indices analysis allows to determine that Latvian financial vulnerability began to worsen in 2005, however, Latvian financial stability downward movement started in 2002, that in its turn shows the necessity for Latvian economic policy makers to get more actively involved in preventing growing risks of economy. Latvian financial system stability index established in this working paper and its accompanying methodology can be further used in follow-up research and Latvian financial stability index improvement.