This thesis analyses financial stability in eight members of the Executives’ Meeting of East Asia-Pacific Central Banks (EMEAP) economies. One of the factors that may increase financial imbalances (and hence it affects financial stability of an economy) is the accumulated outstanding debt of the economic agents. For example, the corporate sector’s outstanding debt can negatively affect activity of lenders and hence the capabilities of the economy. Since banks are important financial intermediaries in most financial systems, the financial status of banking sector is also important to analyse financial stability of a country. Macroeconomic conditions and financial system structure are some of the important factors that can affect financial conditions (financial soundness) of banks and hence the banking sector. Financial soundness of banks can secure the stability of the financial system. Chapter 2 shows that financial imbalances that arise from accumulated outstanding debt within the corporate sector have a negative effect on the technical capabilities (total factor productivity) of the economy. Therefore, monetary authority (central bank) should control over the debt level. To address this, chapter 2 focuses on the design of monetary policy rule for a small open economy in the context of a Dynamic Stochastic General Equilibrium (DSGE) model. This model is extended to show the effects of financial imbalances on the economy. Real exchange rate is another important factor that affects the firm’s real marginal cost, aggregate supply and aggregate demand as discussed in this chapter. The derived optimal monetary policy rule indicates that the monetary authority responds to financial imbalances through output gap when financial imbalances exist due to accumulated outstanding debt. Moreover, the optimal policy rule shows that the response of the monetary authority to exchange rate movements is indirect, through the domestic inflation and output gap. Chapter 3 describes the effect of the financial system structure on financial stability through investigating the financial soundness of the banking sector. Bank financial soundness is the measure of the stability of the financial system and is defined by return on assets, equity capital-asset ratio and return volatility. The first two items increase financial soundness, whereas return volatility decreases financial soundness of a bank. The structure of the financial system is described as market-based or bank-based. Given interrelations between financial sectors and between economies of the EMEAP countries, chapter 3 uses the global (infinite dimensional) vector autoregressive (VAR) model that has been proposed recently to estimate the generalised impulse responses of financial stability measure. Results show that the market-based financial system can increase financial stability through increasing financial soundness of the banking system. Chapter 4 uses nonperforming loans (NPLs) (as one of the main factors behind Asian financial crisis in 1997/8) to analyse financial soundness of banks. NPLs determine loans default rates that decreases banks’ financial soundness. Chapter 4 tests the resistance of the banking system of the EMEAP countries to large macroeconomic shocks (stresses) in a stress-test framework, computing frequency distributions of default rates in three main macroeconomic scenarios (baseline model, stressed real GDP growth and stressed real interest rate). Default rate indicates the possible loss of banks and hence it is an indicator of credit risk which weakens banks’ financial strength. The stress-test indicates that stressing real GDP growth with negative extreme shocks leads to an increase in frequency of higher default rates (in comparison with the baseline model), whereas positive shock to real interest rate may secure financial stability through increasing the frequency of lower default rates and decreasing frequency of higher default rate
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