The Latvian financial stress index as an important element of the financial system stability monitoring framework

Abstract

The objective of this paper4 is to develop a methodology for the Latvian financial stress index (FSI). To this effect, the particular methodologies widely used in international practice for composite indicators applied in financial stability monitoring and the experience of selected countries were examined. The authors analyse the nature of financial stress and the related symptoms and offer their interpretation of the financial stress concept. The paper provides the rationale behind the selection of the individual indicators (components) comprised in the FSI and evaluates various options for aggregating FSI components. The main conclusion presented in the paper is that the dynamics of the FSI developed on the basis of the methodology proposed by the authors of the paper is quite an accurate measure of changes in Latvian financial system stress levels. It signals periods of elevated stress as well as periods of an excessively vigorous and imbalanced development of the financial system. The Bank of Latvia has been using the FSI as one of the elements of Latvia’s financial system stability monitoring framework since 2010.