Usefulness of Financial Soundness Indicators for risk assessment: The case of EU member countries

The latest global financial crisis has highlighted the importance of monitoring the stability and soundness of the financial system. In 1999, the International Monetary Fund (IMF) undertook an initiative to develop and compile a set of macro-prudential indicators, the so called “Financial Soundness Indicators” (FSIs). This paper inspects the usefulness of these indicators to explain the financial soundness of EU member countries. Using ordered response models and credit ratings as a proxy for country risk, we examine the impact of capital adequacy, asset quality and earnings core FSIs on the financial risk of EU for the period 2008-2011. In addition, we explore the possible relationship between the financial development level of a country and its financial soundness. Our analysis provides evidence of the ability of some of these indicators to illustrate the health of the financial sector, as well as a significant positive relationship between financial development and financial soundness of a country.