Measuring financial stability and comparing financial risk monitoring indicators

This paper examines the effectiveness of financial risk monitoring indicators when predicting financial cycles and assessing systemic vulnerabilities in the euro area. Using a time-varying parameter vector autoregression model, we analyse the dynamic impact of four key financial risk monitoring shocks across eleven euro area countries: aggregate financial stability index (AFSI) shocks, macroeconomic risk shocks, market risk shocks, and liquidity risk shocks. The results reveal significant heterogeneity in financial cycle responses, with core economies exhibiting faster recoveries and peripheral economies experiencing prolonged downturns as a result of structural fragilities. Compared to conventional financial risk monitoring indicators, the AFSI demonstrates superior predictive power when capturing financial cycle dynamics. These findings underscore the need for country-specific macroprudential policies within a coordinated European framework. Strengthening liquidity safety nets and refining risk-based capital buffers can enhance financial resilience. Our study contributes to the literature by offering a dynamic, policy-relevant approach to financial stability assessment in monetary unions.