Analysis of Financial Stability: The Construction of a New Composite Financial Stability Index for Euro Area

This paper develops new tool for the analysis of the Euro Area financial system using a composite financial stability index (CFSI). The index was successful in capturing key periods of financial instability during the sample period and reflected a general improvement in financial stability. The econometric results come to support the presence of a positive trend in the CFSI during 1998-2006 and a recent reduction in volatility. To predict the level of stability and financial sector analysis, we used Monte Carlo simulation method that gives us further information about the future of European financial sector. Moreover, our study results surprised the impact of the financial crisis on the main macroeconomic indicators in the Euro Area. The analysis covers the period 1998-2012, quarterly data used were obtained from the ECB – Area Wide Model (AWM) Database, Federal Reserve of Saint Louis and OECD.