Measuring Financial Stability:

The Composition of an Aggregate Financial Stability Index for

Bangladesh
Md. Zulkar Nayn1
Mohammad Shahriar Siddiqui2
Abstract
Monitoring and ensuring financial stability, generally characterized by the absence of
excessive volatility, stress or crises in the financial system, has become an
overarching objective of the central banks around the world especially following the
recent global financial crisis. Although there has been no consensus on defining and
measuring financial stability, constructing a composite or aggregate measure of
financial system stability through some sort of index has started gaining recognition
as a part of early warning indicators for assessing the vulnerability of the financial
system as a whole. This paper represents a modest attempt to construct an aggregate
financial stability index (AFSI) for the financial system of Bangladesh. The study
finds that the AFSI for Bangladesh performed reasonably well in identifying stresses
in the financial system during FY 2008-9 and again at the end of 2010, when the
country's stock market crashed and the banking system faced a liquidity crunch.
However, the AFSI needs to be aided with other relevant data and qualitative
information for making a sound judgment.
Keywords: Financial Crisis, Banking Stability Index, Aggregate Financial Stability
Index, Early Warning Indicators, Financial Vulnerability Index, Regional Economic
Climate Index.
JEL Classification: F47, G15, G18, G21

Deputy General Manager, Financial Integrity and Customer Services Department, Bangladesh Bank
(e-mail: mdzulkar.nayn@bb.org.bd).
2
Deputy Director, Financial Stability Department, Bangladesh Bank (e-mail:
shahriar.siddiqui@bb.org.bd).

Measuring Financial Stability:

The Composition of an Aggregate Financial Stability Index for
Bangladesh
1. Introduction: The incidence of financial crises worldwide over the past two
decades has raised concerns about the stability of the financial system of an economy
and its interdependence with other sectors of the economy. Earlier the central banks
and banking supervisors put emphasis on the risk of solvency and liquidity of
individual banks rather than banking system as a whole. Over the years the focus has
shifted from micro-prudential to macro-prudential dimensions of financial stability generally characterized by the absence of excessive volatility, stress or crises in the
financial system. Especially following the global financial crises during 2008-09,
monitoring and ensuring financial system stability has become an overarching
objective of the central banks around the world. According to ECB (2007) financial
stability is a condition in which the financial system - comprising financial
intermediaries, markets and market infrastructure - is capable of withstanding shocks
and the unraveling of financial imbalances, thereby mitigating the likelihood of
disruptions in the financial intermediation process which are severe enough to
significantly impair the allocation of savings to profitable investment opportunities.
Although there has been no consensus on defining and measuring financial stability, a
number of central banks around the world have started assessing the risks to financial
stability through various indicators and indexes that are included in their periodic
financial stability reports (FSRs). Constructing a composite or aggregate measure of
financial system stability through some sort of index has started gaining recognition
as a part of early warning indicators for assessing the vulnerability of the financial
system. The International Monetary Fund (IMF) regularly publishes "Global Financial

Stability Report" reviewing strengths and weaknesses in the world financial system
based on a range of indicators and indexes.
Bangladesh Bank, like many other central banks around the world, has been
publishing a financial stability report incorporating some financial system indicators
and stress testing that could signal the strength and vulnerability of the financial
system. While individual variables and indicators are useful in analyzing the strengths
and weaknesses of a financial system, various studies have attempted to develop
composite indicators which could be convenient for the policy makers for triggering
any action based on the signals of vulnerability. Some central banks including South
Asian central banks such as the Reserve Bank of India and the Central Bank of Sri
Lanka also have been publishing periodic reports on financial stability that also
include an aggregate index, comprising some sub-indices, indicating a measure of
soundness of the banking and financial system.
While there is no widely accepted single measure or index for assessing financial
system soundness, central banks adopt different methodologies for constructing their
own financial stability indexes based on their financial and economic conditions,
availability of data and perceived risk of vulnerability. In this backdrop, it may be a
good idea to construct a composite/aggregate financial stability index for the financial
system of Bangladesh on experimental basis.
Thus the objectives of this study are as follows:
a. To construct an Aggregate Financial Stability Index (AFSI) for the financial system
of Bangladesh.
b. To assess the effectiveness of the index for signaling any vulnerability in the
system.

c. To identify other relevant information required for an overall assessment of the

financial sector stability.
2. Literature Review: The recognition of the need for FSI statistics among the
international community arose out of the financial crises of the 1990s. A review of
recent decades shows that many IMF member countries experienced financial crises
that often resulted in severe disruptions of economic activity. The significant costs of
these crises, both direct (such as the cost of recapitalizing the deposit takers) and
indirect (such as the loss of real economic activity), have highlighted the need to
develop a body ofpreferably high frequencystatistics that could help
policymakers in macro prudential analysis, that is, in identifying the strengths and
vulnerabilities in their countries financial systems. Such analysis could form the basis
for taking action to prevent crises from occurring.

Gadanecz and Jayaram (2011) makes a review of the measures of financial stability
developed by researchers, central banks around the world and the International
Monetary Fund (IMF) and summarizes the measures commonly used in the literature;
their frequency, what they measure, as well as their signaling properties. They
identify some key indicators under six sectors of the economy for studying financial
system stability, where the sectors are the real sector, the corporate sector, the
household sector, the external sector, the financial sector and the financial markets.
Cheang and Choy (2011) shows some components of macro prudential analysis for
assessing financial system stability that include macroeconomic data (prices,
exchange rate etc), market-based data (stock prices, credit rating etc), financial system
data, structural information (i.e., relative size and ownership of corporation) and
qualitative information (i.e., compliance with standards).

Earlier studies on financial system distress are based on early warning indicator
methods for currency and balance of payment crises to banking crises. DemirgucKunt and Detragiache (1997) use a multivariate Logit model approach to identify
determinants of banking crises such as slow GDP growth and high inflation, sudden
capital outflow, low liquidity in the banking sector, a high share of credit to private
sector, past credit growth etc. Kaminsky and Reinhardt (1999) identify early warning
indicators of twin (banking and balance of payments) crises, such as credit growth and
equity prices. Goodheart et al (2006) state financial crisis monitoring can be
effectively done with an indicator of banking sector profitability as well as probability
of default.
Cardarelli, Elekdag and Lall (2008) construct the Financial Stress Index in the
aftermath of the global financial crises based on equal-variance weighted average of
seven variables associated with stock market returns, the volatility of stock returns ,
foreign exchange, liquidity, sovereign debt spreads, international reserves, and the
risk and profitability of the banking system. Each variable is standardized, i.e.
demeaned (using the arithmetic mean), and divided by its standard deviation.
Individual components are summed up using weighted average to yield the aggregate
financial stress index.
The Swiss National Bank constructs a composite stress index for the Swiss banking
system and regularly publishes the index in its annual Financial Stability Report. The
index measures the level of stress experienced by the banking sector at a given date
by combining several variables that represent possible symptoms of stress in the
banking sector, including banks profitability and capital base.

Following Illing and Liu (2003) and Van den End (2006) respectively the Bank of
Canada and the Netherlandsche Bank construct a measure of financial stability,
although not published in their FSRs. It is argued that a single aggregate measure is
better able to flag crises than partial measures commonly used in the literature. The
Financial Conditions Index of the Netherlandsche Bank makes significant
contribution towards understanding financial vulnerability.
The Bank of England presents its outlook for the financial system stability in
qualitative terms, supported by quantitative modeling of the key vulnerabilities and a
composite market liquidity index of the financial system. The Federal Reserve System
has an index of financial fragility.
Gerl and Hermnek (2006) propose in the Czech National Banks Financial Stability
Report an aggregate financial stability indicator based on the values of the IMFs core
financial soundness indicators. Similarly, the Central Bank of the Republic of Turkey
(2006) constructs a financial strength index using six sub-indices covering asset
quality, liquidity, foreign exchange risk, interest rate risk, profitability and capital
adequacy.
It is observed that the IMF's financial stress index for emerging economies (2009) is
quite robust in identifying the major financial stress episodes, including:
(i) 1997Q4: Asian Financial Crisis;
(ii) 1998Q2: Default on Russian external obligations and collapse of LTCM;
(iii) 2000: Dot-com crash;
(iv) 2008Q3: Global financial tsunami.
Reserve Bank of India regularly publishes Financial Stability Report, which includes
an aggregate index based on six sub-indices of financial soundness indicators. The

sub-indices include (i) Capital to Risk Weighted Assets Ratio, (ii) Leverage Ratio,
(iii) Overall Asset Quality, (iv) Profitability, (v) Liquidity and (vi) Efficiency.
Central Bank of Sri Lanka regularly publishes Financial Stability Report, which
includes an aggregate banking soundness index based on six sub-indices. The subindices include (i) Capital to Risk Weighted Assets Ratio, (ii) Non-performing Loan
Ratio, (iii) Profitability, (iv) Liquidity, (v) Efficiency and (vi) interest rate and foreign
exchange risk.
Cheang and Choy (2011) construct an aggregate indicator for the Macao banking
sector to indicate the state of its stability under the context of an early warning system
(EWS), which is constructed as a weighted average of a set of selected indicators
covering different aspects of financial stability.
Bank Indonesia has been using a Financial Stability Index or FSI since 2007 to
evaluate financial sector resilience. The maximum indicative limit of FSI is 2.00.
When the global crisis befell Indonesia FSI peaked at 2.43 in November 2008 and at
the height of the 1997/1998 crisis FSI soared to 3.23, indication financial
vulnerability.
In sum, it is argued that composite indicators of financial stability are better suited for
the definition of threshold or benchmark values to indicate the state of financial
system stability than individual variables (Gadanecz and Jayaram, 2011). And also,
whether a single aggregate measure of financial stability is constructed or not, FSRs
would need to analyze key variables in the real, banking and financial sectors as well
as variables in the external sector.
3. Methodology:
The Aggregate Financial Stability Index (AFSI) is constructed for the financial
system of Bangladesh following Cheang and Choy (2011). They constructed the

Aggregate Financial Index for Macao based on three sub-indices namely, i) Financial
Stability Index (FSI), ii) Financial Vulnerability Index (FVI), and iii) Regional
Economic Climate Index (RECI).However, some modifications have been made in
constructing the AFSI for Bangladesh based on availability of data and some other
practical considerations.
The AFSI also adopts the broad framework of the core set of FSIs recommended by
the IMF (2006) for monitoring and assessing the soundness and stability of the
financial sector in its member countries. The core set is a small set of indicators that
are widely agreed to be important and operationally useful for periodic monitoring the
soundness and vulnerabilities of the banking sector, while there are some additional
set of FSIs encouraged by the IMF.

Table 1: List of Individual Indicators for

Bangladesh Aggregate Financial Stability Index
Category

Indicator

Data Source

Banking Soundness Index

Capital adequacy

Capital Adequacy Ratio (CAR)

BS1

BBQ

Asset quality

Ratio of NPL to Total Loans

BS2

BBQ

Liquidity

Credit to Deposit Ratio

BS3

ET

Weighted Interest Rate Spread

BS4

ET

Return on Assets (ROA)

BS5

DOS

Return on Equity (ROE)

BS6

DOS

Net Interest Margin (NIM)

BS7

DOS

Current account balance-to-GDP

ratio

FV1

ET

Ratio of M2 to foreign exchange

reserves

FV2

ET

Real Effective Exchange Rate

(REER) (Base 2000-2001=100)

FV3

MPD

M2 Multiplier

FV4

BBQ

Ratio of domestic credit to GDP

FV5

ET

General Stock Price Index

movement (Dhaka Stock
Exchange)

FV6

BBQ

Fiscal balance-to-GDP ratio

FV7

BBQ

CPI inflation

FV8

BBQ

Global Petroleum Price Index

FV9

BBQ

CPI Inflation of India

RE1

BBQ

GDP growth of India

RE2

TE

Profitability

Financial Vulnerability Index

External sector

Financial sector

Real sector

Regional Economic Climate Index

Data Sources: BBQ= Bangladesh Bank Quarterly, ET =Economic Trends, Bangladesh Bank,
DOS =Department of Off-Site Supervision, MPD=Monetary Policy Department, TE=Trading
Economics (http://www.tradingeconomics.com/gdp-growth-rates-list-by-country).

3.1 Banking Soundness Index

The first category is renamed as banking soundness index (BSI) instead of financial
soundness index (FSI), as the indicators are based on banking sector data. This
category focuses on four major aspects of the banking sector, namely capital
adequacy, asset quality, liquidity and profitability. Each aspect is represented by at
least one indicator: the ratio of regulatory capital to risk-weighted assets i.e., CAR is
selected as the indicators of capital adequacy. The ratio of NPL to total loans is used
to measure asset quality, while the ratio of liquid assets to total assets and the loan-todeposit ratio measure liquidity.
(i) Capital adequacy ratio (BS1):
It indicates the cushion which a bank has at its disposal against potential risks. It
measures banks' strength to absorb unexpected loss and provides an indication of the
banks financial leverage the extents to which banks assets are financed by
sources other than the banks own capital.
(ii) Ratio of NPL to total loans (BS2):
The ratio is intended to identify problems with asset quality in the loan portfolio and
the degree of credit risk. An increasing ratio may signal deterioration in the quality of
the credit portfolio though this is typically a backward-looking indicator in that NPLs
are identified when problems emerge. Aggregate Financial Stability Index for an
Early Warning System
(iii) Credit-to-deposit ratio (BS3):
It indicates the percentage of deposit funding that is tied up in loan portfolio and
assesses vulnerability to loss of access to customer deposits. For a ratio over one, it
implies that banks depend on borrowing to finance lending.
(iv) Weighted interest rate spread (BS4)

It represents the difference between weighted lending and deposit interest rates. The
higher the interest rate spread, the higher would be the market liquidity.
(v) Return on assets (ROA) (BS5):
The ratio measures banks profitability or efficiency in using their assets and reflects
the cushion which a bank has at its disposal against potential risks.
(vi) Return on assets (ROE) (BS6):
The ratio measures banks profitability or efficiency in using their equity and reflects
the cushion which a bank has at its disposal against potential risks.
(vii) Net interest rate margin (NIM) (BS7):
The ratio measures the difference between interest expenses and interest income per
unit of total bank assets.

3.2 Financial Vulnerability Index

The financial vulnerability index (FVI) mainly focuses on three key areas reflecting
macroeconomic conditions including the current account, the capital and financial
account, and the real sector. Each aspect is represented by at least one indicator.
(i) Current account balance-to-GDP ratio (FV1):
It gives an indication of vulnerability on the external sector of the economy if the
deficit widens.
(ii) Ratio of M2 to foreign exchange reserves (FV2):
The growth of money supply over international reserves provides an indication of
reserve adequacy. The ratio measures the ability to withhold external shocks and
ensure the convertibility of the local currency.
(iii) Real Effective Exchange Rate (REER) (FV3):
Although not included in the original work of Cheang and Choy (2011), it is added as
an indicator for constructing AFSI. The REER index is an indication of export
competitiveness of an economy. If it appreciates, the competitiveness of the export
sector increases. Six-monthly point-to-point REER of Bangladesh Taka (BDT) is
taken.
(iv) M2 multiplier (FV4):
The M2 multiplier is defined as the ratio of M2 to monetary base. Monetary base is
defined as notes and coins issued and banks deposits with the Bangladesh Bank. It
measures how much an increase of base money leads to the expansion of money
supply through the banking system.
(vi) Ratio of domestic credit to GDP (FV5):
Rapid loan growth is often accompanied by declining loan standards and precedes
banking crisis.

(vi) General stock price index movement (FV6):

Although not included in the original work of Cheang and Choy (2011), it is added as
an indicator for constructing AFSI. A stock market index is an indication of investors'
confidence in an economy as well as potential vulnerability of the economy, when it
goes out of line from the fundamentals. Six-monthly point-to-point General stock
price index (Dhaka Stock Exchange) movement calculated from changes in the value
of the index.
(vii) Fiscal balance to GDP ratio (FV7):
Ratio of deficit financing to GDP ratio is taken as an indication of financial system
stress.
(viii) CPI Inflation (FV8):
CPI gives an indication of overheating of the economy from a mismatch between
aggregate demand and supply situation of an economy. Six-monthly point-to-point
CPI inflation of Bangladesh is taken as a proxy.
(ix) Global petroleum price index (FV9):
Although not included in the original work of Cheang and Choy (2011), it is added as
an indicator for constructing AFSI. As we know when the price of petroleum goes up,
Bangladesh economy experience pressure in the foreign exchange market to meet
additional demand for foreign exchange.
3.3 Regional Economic Climate Index
The regional economic climate index (RECI) is primarily composed of inflation and
economic growth of Bangladesh's neighboring economy of India.
(i) CPI inflation of India (RE1):
Although not included in the original work of Cheang and Choy (2011), it is added as
an indicator for constructing AFSI. Because, Bangladesh economy is dependent to
some extent on import of essentials from India. So higher inflation in India means
higher demand for foreign exchange and imported inflation in the domestic economy.
Six-monthly point-to-point CPI inflation of India is taken.
(ii) GDP growth rate of India (RE2):
Semi-annual GDP growth rate of India calculated by simple arithmetic average of
quarterly GDP growth statistics of India. .

4. Construction of AFSI for Bangladesh:

4.1 Normalization/transformation of variables:
All selected individual indicators are available in six-monthly frequency. In order to
combine the individual indicators described above into one single synthetic index,
they need to be put on a common basis or scale. All individual indicators were
normalized before aggregation so that they have the same variance. In other words,
we apply the equal-variance weighting method to compute the aggregate index.
Statistical normalization converts indicators to a common scale with an average of
zero and standard deviation of one. The zero average avoids introducing aggregation
distortions stemming from differences in indicators means. The scaling factor is the
standard deviation of the indicator. Thus, an indicator with extreme value will
intrinsically have a greater effect on the composite indicator. This might be desirable
if the intention is to reward exceptional behavior, i.e. if an extremely good result on a
few indicators is thought to be better than a lot of average scores. By this approach,
the range between the minimum and the maximum should be varied among the
normalized indicators.
The formula of statistical normalization is:

Zt =

(X t - u)
s

(1)

Where, X t represents the value of indicator X during period t; u and s is the mean
and standard deviation respectively recorded by indicator X in the analyzed period;
Z t is the indicators normalized value.
The mean is subtracted from each variable before it is divided by its standard
deviation. Z has normal distribution with zero mean and unit variance, and is also
called standard normal distribution, N (0,1). However, the range of the standard

normal distribution is not between zero and one. Indeed, it is about the range from
minus three to plus three. All individual indicators are converted so that a positive
value implies that an indicator is above its historical average, which is calculated
since 2004, and a negative value is below its historical average indicating unfavorable
development for stability.
4.2 The Aggregate Index
The normalized indicators are then combined into a single index. We assign the same
weight to all individual indicators in order to calculate the composite indices of BSI
and FVI. The indices thus give equal importance to each individual indicator. It is the
most popular weighting method used in relevant research.
The normalized variables are aggregated into an aggregate index using the arithmetic
mean, according to the following formulas:
7

BSI

BS
1

(2)

7
9

FVI

FV
1

(3)

9
2

RECI

RE
1

(4)

There are some studies that assign different weights to individual indicators, for
example, according to past experience of crises. However, it is arguable that indicator
that is important in one crisis may not be important in another.

In this study the Aggregate Financial Stability Index (AFSI) is obtained by the
weighted average of the three sub-indices following Cheang and Choy (2011).

7
FV
BS
1

0.4 1

AFSI= 0.6
9

= 0.6BSI +0.4 (FVI+RECI)

REC
1

(5)

(6)

5. Result and Interpretation: The index is compiled using statistical normalization

which expresses indicators in terms of standard deviation from mean. Therefore, a
level above zero implies that the stability is higher than average and vice versa for a
level lower than zero. Our objective is trying to understand the causes of ups and
downs in the indices in relation to performance of the financial system during the
period.
Although, Bangladesh economy had not experienced the kind of financial crises that
the developed countries experienced recently and the South Asian countries in late
1990s, it went through some sort of financial stress and vulnerability. Following table
shows some major internal and external events and their impact on the financial
system of Bangladesh for evaluating the performance of the AFSI during the period
under consideration.

Table 2: Major Internal and External Events and performance in the

Financial System of Bangladesh during Dec 2004 to Dec 2011
Time Period

Internal and External Events

Impact on Financial System

January-June,2005

Marked deterioration of external -Pressure on the exchange rate of

current account deficit as well as Taka
BOP condition (Current Account
deficit of USD 326 million during

-Central Bank intervention to the

tune of USD 311 million.

rd

3 quarter of 2005).
January-June 2007

-Persistence of high oil prices and - Slower growth in credit to the

increase in other international government as well as private
commodity prices;

sector.

-High inflationary expectation.

-Uncertainty

over

political

transition in the country.

-Devastating cyclone and tidal
surge.
July 2008-June 2009

-Sluggish world economic growth -Bangladesh

Economy

only

in response to global financial mildly impacted by the ongoing

crisis that began in late 2007.
-The pace of export growth
slowed

significantly,

global slowdown (BB Annual

report 2008-9).

although -BB pursued supportive monetary

remittances from workers abroad policy

seeking

to

maintain

showed a strong and steady adequate credit flow.

growth (BB Annual Report).
-Downward trend of DSE general
price index largely persisted, with
some volatility, since July 2008.
July-December 2009

The rising trend of DSE General Large liquidity overhangs in the

Index continued since July 2009 banking sector.
with some volatility.
Bubble like condition in the

Time Period

Internal and External Events

country's

real

estate

Impact on Financial System

market

continued.
July-December 2010

-Overheating situation of the -Banking

sector

indicators

stock market gives signal of risks performed

reasonably

well,

in the financial system and finally although liquidity situation in

the bubble burst in December, banking sector came under strain
due to record high private sector

2010.
Monetary

measures

focused

credit growth.

mainly on reducing credit growth

in the unproductive sector.
Continued increase in inflation
poses a big challenge for the
government. BB raised CRR and
SLR, both by 50 basis points
which stood at 6.0 and 19.0
percent respectively.
January-June, 2011

-Share price index went through - The interbank money market

deep correction which continued faced liquidity stress throughout
upto June 2011. Banking sector.
-Heavy debt burdens and weak
growth prospect in a number of
advanced economies pose a risk

the 2011 that started from share

price debacle at the end of 2010,
while borrowing from the central
bank increased significantly.

to the economy of Bangladesh.

July-December 2011

the -Domestic credit growth slowed

-Demand

pressure

in

interbank

foreign

exchange and helped stabilize the exchange

continued and BB intervened in rate of Taka at a new equilibrium

the market. BB took a cautiously (Taka 81.85 per USD at end
accommodative monetary policy.

December 2011 against Taka

70.75 per USD at end December,
2010.

Table 3: Major Events and performance of Banking Industry in Bangladesh

(During Dec 2004 to Dec 2011)
Year(s)/Period

Events

Impact on Banking System

July-December,
2007

Three State-owned commercial banks

(SCBs) transfer their combined
cumulative loss of Taka 87.9 billion by
creating
goodwill
(valuation
adjustments account) at the time of
corporatization. (BB Annual Report
2007-08)
Minimum CAR set at 10.0 percent of
their RWA or Taka 2.0 billion,
whichever is higher. However, it
allowed dateline of 30 June 2009.
Banks have written-off an amount of
Taka 22.5 billion during 01/07/2008 to
30/06/2009. (BB Annual Report 200809)

The aggregate capital adequacy

ratio (CAR) of SCBs (7.9 percent)
as well as system (9.6 percent)
improved after transferring the
cumulative loss. ROA stood at 0.9
percent while ROE at 13.8 percent.

January-June, 2008

July-December,
2008

January-June, 2009

July-December,
2009

BB prescribed interest rate ceiling of

13 percent per annum on bank lending
for most purposes other than consumer
credit and loans to small enterprises.
(BB Quarterly Jan-Mar and Apr-Jun,
2009)
BB relaxed the conditions for loan
rescheduling to help sectors affected by
export decline (waver of down payment
requirements) up to September 30,
2009.

January-June, 2010

Introduced Basel II capital adequacy

framework as regulatory compliance.
Higher falling rate of deposit than that
of lending rate. (BB Quarterly Jan-Mar
and Apr-Jun, 2010)

July-December,
2010

Basel II capital adequacy framework

continued with regulatory higher
benchmark than that of previous period.
Rupali Bank Limited (one of the SCBs)
transfers its cumulative loss of Taka
12.08 billion by creating goodwill in
August 2010 with the decision of
Ministry of Finance.
SEC revamped with new leadership.
BB
directed
banks
to
retain

JanuaryJune,
2011

CAR stood at 9.49 percent. ROA

went up to 1.24 percent while
ROE increased to 21.26 percent.
(Dept. of Offsite Supervision, BB)
CAR stood at 10.1 percent and
gross NPL decreased to 10.8
percent. ROA remained almost
same and ROE falls to 15.8
percent.
The interest rate spread (IRS)
reduced. CAR stood marginally
above the regulatory requirement.
Gross NPL declined and ROA and
ROE increased.
Gross NPL ratio decreased to 9.21
percent in end December 2009.
ROA noticeably increased to 1.37
percent while ROE increased to
21.7 percent. (BB Quarterly JulSep and Oct-Dec, 2009)
CAR decreased to 7.91 percent
and gross NPL decreased to 8.67
percent. ROA went up to 1.58
percent while ROE increased to
22.94 percent. ISR increased to
5.28 percent.
CAR improved to 9.31 percent and
in gross NPL decreased to 7.27
percent. ROA went down to 1.11
percent while ROE also declined
to 20.97 percent. IRS marginally
decreased to 5.12 percent. (BB
Quarterly Jul-Sep and Oct-Dec,
2010)
The overheated capital markets
undergoing sharp price correction

Year(s)/Period

July-December,
2011

Events

Impact on Banking System

undistributed their 2010 profits from

capital market activities. Interest rate
caps on bank lending withdrawn.
Liquidity
and
asset-liability
management in banks came into BBs
intensive supervisory attention. BBs
financial inclusion drive emphasized to
channelize credit to productive
pursuits.
BB raised the minimum requirements
of capital of a bank to the level of BDT
4.0 billion from August 2011 instead of
BDT 2.0 billion. (BB circular [BRPD
circular letter no. 11/2008])

in December-January was in
process
of
recovery
and
stabilization in Q3 FY11. Gross
NPL ratio slightly declined and
both ROA and ROE turned down.
IRS stood at 5.14 percent. (BB
Quarterly Jan-Mar and Apr-Jun,
2011)

2007 to 2011

Internal restructuring of SCBs to

strengthen
their
loan
recovery
mechanism and initiation of recovery
drive and write-off measures.

2010-2011

Banks are advised to limit spread

within lower single digit. (BB circular
[BRPD circular letter no. 01/2012]).
However, the same instruction was first
given in 2010 in a Bankers meeting at
BB.

The CAR stood at 11.35 percent

and gross NPL decreased to 6.12
percent. ROA stood high at 1.54
percent while ROE recorded
higher at 17.02 percent against
15.45 percent in June 2011. (BB
Quarterly Jul-Sep and Oct-Dec,
2011)
The gross NPL ratio shows an
encouraging trend since its decline
from 13.2 percent in 2007 to 7.3
percent in 2010. (BB Annual
Report 2010-11)
IRS reported 5.12 percent at the
end June 2011 and reached to 5.43
percent at the end December 2011.
(BB Annual Report 2011-12)

The aggregate financial stability index (AFSI) as well as the sub-indices for the
financial system of Bangladesh were prepared for the period from December 2004 to
December 2011, which is shown in a graph (Chart-1).

Chart 1: The Aggregate Financial Stability Index and Its Sub-indices,

2004-2011
(Statistical Normalization)

Source: AuthorsCalculation
Note:
RegimeofcalculationofCARchangedfrom2010[BaselItoBaselII].
Minimumcapital(inamount)forbanksincreased(BDT2billionin2007andBDT4billionin2011)
BaseYearofREERchanged(199495=100to20002001=100)

It is observed from the above chart that initially during January-June, 2005 the
aggregate index (AFSI) was far below the average level (zero line) indicating some
stress in the financial system. We can see from the Table-2 above that there was a
marked deterioration in our current account and the value Bangladesh Taka was under
pressure during this period. It is observed that from December, 2005 to June, 2008 the
aggregate index as well as all three sub-indices was around the average level,
indicating relative stability of the financial system of Bangladesh during this period.
Thereafter, from the middle of 2008, the AFSI along with all three sub-indices fell
gradually up to June 2009, which may be attributable to slow down in the global
economic growth following global financial meltdown. From the middle of 2009 the
AFSI and sub-indices began to rise sharply up to December, 2010, when the country's
stock market index recorded a historic peak before being crashed. From the end of
2010, the indices began to fall up to June 2011, when the banking system experienced

severe liquidity pressure in domestic money market and foreign exchange market. It is
observed that the AFSI as well as sub-indices went well with the performance of our
financial system.

5. Limitations of the Study:

The study was undertaken on experimental basis with a view to understanding and
capturing the performance of Bangladesh economy and financial system on an
aggregate basis from a single index, which was based on earlier empirical researches
in other countries. The variables and indicators were chosen partly on the basis of
theoretical assumptions and partly on the basis of practical considerations. Some of
the limitations of the study can be summarized as follows:
a) The variables and indicators included in constructing the aggregate index (AFSI)
and three other sub-indices are not comprehensive. Moreover, some indicators are
chosen based on practical considerations without any empirical study. On the other
hand, some core indicators suggested by the IMF like net open position in foreign
exchange to capital are missing for non-availability of adequate data.

In this

backdrop, some indicators may be added and some may be dropped with a view to
getting a more reliable index.
b) The range of data is taken for a relatively short span of time - from 2004 to 2011,
because some of the banking data were not available before 2004.This small sample
size may not give a good statistical measure. However, the situation will continuously
improve when the data series accumulate over time and likely to include quarterly
data.
c) Some of the data were not available on quarterly basis. So the study was
undertaken based on half-yearly data, whereas other similar studies were undertaken
based on quarterly data. Although, GDP growth data for Bangladesh are not available

on half-yearly basis, previous year's available data were used for calculating some
ratios in relation to GDP.
d) The study is based on backward looking data. The study would be more valuable if
some forward looking projection could be made.
e) The index does not include indicators of non-bank financial institutions,
considering their importance in financial stability.
f) The constructed aggregate index is a decision making tool only and does not
include all the relevant information that a policy maker needs. Other related data and
qualitative information are needed for sound judgment. For example, the quality of
risk management and corporate governance in banks, quality of supervision of banks
and financial institutions, risk of fraud and forgeries, payment system risk, credit
concentration risk, regulatory weaknesses and political instability, risk emanating
from off-balance sheet items and contagion risks are also important for making a
sound and informed judgment.

6. Conclusion:
Monitoring and ensuring financial stability, generally characterized by the absence of
excessive volatility, stress or crises in the financial system, has become an
overarching objective of the central banks around the world especially following the
recent global financial crisis. Although there has been no consensus on defining and
measuring financial stability, constructing a composite or aggregate measure of
financial system stability through some sort of index has started gaining recognition
as a part of early warning indicators for assessing the vulnerability of the financial
system as a whole. This paper represents a modest attempt to construct an aggregate
financial stability index (AFSI) for the financial system of Bangladesh. The study
finds that the AFSI for Bangladesh performed reasonably well in identifying stresses

in the financial system during FY 2008-9 and again at the end of 2010, when the
country's stock market crashed and the banking system faced a liquidity crunch.
However, the AFSI needs to be aided with other relevant data and qualitative
information for making a sound judgment.

References
Cardarelli, R., S. Elekdag, and S. Lall (2008), Financial Stress and Economic
Downturns, World Economic Outlook, October 2008 Issue, International Monetary
Fund, Chapter 4, 129-158.
Cheang, N., and I. Choy (2011), Aggregate Financial Stability Index for an Early
Warning System, Macao Monetary Research Bulletin, Issue No. 21, 27-54.
Dermirguc-Kunt, A., and E. Detragiache (1997), The determinants of banking crises:
evidence from developing and developed countries, IMF Working Paper WP/97/106.
ECB [European Central Bank] (2007), Progress towards a framework for financial
stability assessment, speech by Jos-Manuel Gonzlez-Pramo, Member of the
Executive Board of the ECB, OECD World Forum on Statistics, Knowledge and
Policy, Istanbul, 28 June.
End van den, J.W. (2006), Indicator and Boundaries of Financial Stability, DNB (De
Nedherlesche Bank) Working Paper Series 97, March.
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Gadanecz, B., and K. Jayaram (2011), Measures of financial stability-a review, IFC
Bulletin No 31, 365-380.
Gerl, A., and J. Hermnek (2006), Financial Stability Indicators: Advantages and
Disadvantages of their Use in the Assessment of Financial System Stability,
Financial Stability Report 2006, Czech National Bank (CNB), 69-79.
Goodhart, C., O. Aspachs, M. Segoviano, D. Tsomocos and L. Zicchino (2006),
Searching for a metric for financial stability, LSE Financial Markets Group Special
Paper Series, Special Paper no 167, May.

Illing, M., and Y. Liu (2003), An index of Financial Stress for Canada, Bank of
Canada Working Paper, No. 2003-14.
IMF [International Monetary Fund] (2006), Financial Soundness Indicators:
Compilation Guide, March.
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June, 473-500.

Appendics:
Chart 1: Capital Adequacy Ratio (CAR), Non-performing Loan (NPL) ratio and
Interest rate spread

Chart 2: Credit Deposit Ratio (CDR)

Chart 3: Return on Asset (ROA), Return on Equity (ROE), Net Interest Rate
Margin (NIM)

Chart 4: Real Effective Exchange Rate (REER) Index and Global Petroleum
Price Index

Chart 5: Current account balance, fiscal balance and domestic credit with GDP
ratio

Chart 6: M2 to Foreign Exchange Reserve and M2 Multiplier

Chart 7: General Price Index (DSE) movements and CPI Inflation

Chart 8: CPI Inflation and GDP growth of India

Table I: Variables under Banking Stability Index (in percentage)

Year
2004
2005
2006
2007
2008
2009
2010
2011

Month
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec

CAR
8.78
7.11
7.34
8.02
5.29
6.48
7.37
9.49
10.05
11.68
11.67
7.91
9.31
9.75
11.35

NPL
Ratio
17.63
15.79
13.55
16.59
13.15
13.96
13.23
13.02
10.79
10.5
9.21
8.67
7.27
7.14
6.12

Interest
Rate
Spread
5.27
5.31
5.00
5.38
5.61
5.92
5.98
5.34
5.00
4.86
5.14
5.27
5.23
5.15
5.46

CDR
100
98
101
96
97
96
100
102
103
99
101
99
103
103
104

ROA
0.6753
0.5375
0.6974
0.5779
0.7864
0.7587
0.8942
1.2433
1.1575
1.3883
1.3743
1.5794
1.7832
1.3134
1.5398

ROE
12.5665
12.3070
15.0055
16.4508
14.1307
11.9192
13.7808
21.2613
15.5960
18.2062
21.7172
23.4563
20.9682
15.4511
17.0200

NIM
1.9100
1.1200
2.2000
1.2100
1.9200
1.3200
1.9700
1.0600
2.1400
1.0400
2.0500
1.2400
2.3900
1.1900
2.4800

Table II a: Variables under Financial Vulnerability Index

Year
2004
2005
2006
2007
2008
2009
2010
2011

Month
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec

CAB-toGDP
0.0002
-0.0100
0.0061
0.0111
0.0132
0.0087
0.0094
0.0118
0.0062
0.0164
0.0297
0.0323
0.0163
0.0059
-0.0012

Fiscal
balance to
GDP
-1.10
-1.50
-1.00
-2.06
-1.82
-1.81
-2.88
-2.27
-1.92
-1.65
-0.38
-2.24
-0.67
-3.15
-3.42

Domestic
credit to
GDP ratio
0.4545
0.5527
0.6046
0.6244
0.6845
0.6789
0.7479
0.7729
0.8405
0.8482
0.9038
0.9428
1.0596
1.1259
1.2506

M2 to FX
reserves
7.4069
8.1152
8.8073
7.4602
7.5268
6.0549
6.1010
5.9052
6.8168
5.7468
4.5802
4.8633
5.0504
5.4447
6.0293

M2 Multiplier
1.3
5.13
4.92
4.79
4.36
4.76
4.5
4.7
4.54
4.27
4.7
4.5
4.7
4.5
4.8

Table II b: Variables under Financial Vulnerability Index

Year
2004
2005
2006
2007
2008
2009
2010
2011

Month
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec

REER
93.64
91.15
91.74
87.15
83.86
83.43
86.55
84.48
86.02
92.77
91.30
93.27
97.74
94.70
89.42

Petroleum
(US$/Barrel)
42.70
50.80
53.60
68.30
59.00
66.10
89.40
131.50
41.00
69.20
75.50
74.00
89.18
107.52
106.21

Change in
General Price
Index (DSE)
49.44
-13.09
-2.08
-20.14
20.16
33.54
40.38
-0.55
-6.84
7.69
50.67
35.68
34.72
-26.21
-14.05

CPI inflation
6.5
7.4
7.1
7.5
6.1
9.2
11.6
10
6
2.3
8.5
8.7
8.28
10.17
10.63

Table III: Variables (in percentage) under Regional Economic Environment

Index

Year
2004
2005
2006
2007
2008
2009
2010
2011

Month
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec
Jun
Dec

CPI inflation
India
3.7
4.1
5.6
6.3
6.9
5.7
5.5
7.8
9.7
9.3
15
13.7
9.47
8.62
6.49

GDP Growth
(India)
6.3
9.2
9.3
9.9
9.8
9.5
9.6
8.2
6.8
6.1
8.0
9.4
8.6
7.8
6.5