Currently, regulatory and supervisory practices focus on management, profitability, liquidity and capital adequacy to detect fraud or mismanagement at the level of a financial institution. With the Great Recession and the regulatory reform that followed, the search for reliable means to capture risk of financial instability has become a central concern. In the United States, this concern has been institutionalized through the Financial Stability Oversight Council that has been put in charge of detecting threats to the financial stability of the nation. The search for means to detect signs of macroeconomic instability is not new. Schroeder (2009) and Tymoigne (2010) provides a review of the literature and note that, overall, there are two ways to tackle this problem depending on one’s understanding of the causes of financial crises.
The first approach argues that capitalist economies, mostly through market mechanisms, usually promote stability and can self-correct problems. Financial crises do occur but they are rare and mostly due to policy errors or random events. This approach conceptualizes financial fragility as a state and conflates financial fragility, financial instability and financial crisis. It focuses its effort on forecasting the timing and size of financial crises. Particular emphasis is put on rising default rates, declining real GDP, lower profitability and declining net worth as signs of financial problems. The second approach argues that capitalist economies are intrinsically unstable and that periods of economic stability (like the Great Moderation) are fertile grounds for the growth of economic instability.
This approach conceptualizes financial fragility as a process and aims at detecting changes in funding practices that increase the risk of financial instability. This approach emphasizes variables like debt-service ratio, refinancing volumes, liquidity, the growth of GDP relative to interest rate to capture signs of problems.