Developing a new multidimensional index of bank stability and its usage in the design of optimal policy interventions

Abstract

This study proposes an optimisation-based “benefit-of-the-doubt” (BoD) methodological framework for developing a new multidimensional index of bank stability. The proposed index has the ability to serve as a potent policy tool that overcomes the downsides of accounting- and market-based measures of bank stability. This data-driven approach generates endogenous weights for aggregating bank stability indicators and dimensions. Further, we integrate the BoD framework with a metafrontier approach, which we call a “meta-BoD framework”. The final outcomes of the suggested framework go beyond a scalar measure of bank stability and provide the unique weighting matrix that offers valuable policy-relevant insights about the most precarious areas of stability that require the attention of management and regulators for both micro- and macro-level policy interventions. In addition, it draws insightful information about the instability gaps across heterogenous bank groups. The study presents an illustrative example of the proposed framework to obtain a bank stability index using the dataset of 76 Indian banks operating between 2014 and 2018. The bank stability index is made up of 14 financial ratio indicators covering five dimensions of stability: asset quality, management efficiency, capital adequacy, profitability and liquidity. The findings offer the detailed information required for comprehending the evolution of bank stability and assessing instability gaps across bank groups.