MEASUREMENT AND MANAGEMENT OF FINANCIAL SYSTEM STABILITY: A MORE COMPREHENSIVE AND POLICY ORIENTED APPROACH FOR DEVELOPING COUNTRIES

Abstract

This study develops and empirically validates a Composite Financial System Stability Index (FSSI) for a developing country like Nigeria, aimed at providing a more holistic and forward-looking framework for monitoring, analysing, and managing systemic financial risks. Motivated by the increasing complexity of the Nigerian financial system and its exposure to macroeconomic and external shocks, the study integrates key macroeconomic, banking, insurance, capital market, and other financial institution indicators into a single composite index covering the period 2006 to 2025. Using a combination of descriptive statistics, ARDL–Error Correction Models (ECM), principal component analysis, and backtesting techniques, the research examines how these indicators interact to influence financial stability over time.

The findings reveal that the FSSI effectively tracks financial stability dynamics, accurately identifying periods of vulnerability and recovery. Sectoral trends highlight that while the banking and insurance sectors have demonstrated resilience, the macroeconomic and capital market components have been more sensitive to shocks. The results further show that the FSSI can robustly estimate both short-run and long-run relationships between key macro-financial variables and system stability, with a fast speed of adjustment of approximately 82% per quarter. In addition, the study designs an Early Warning System (EWS) Dashboard built on the FSSI, offering a forward-looking surveillance tool capable of signalling emerging risks before they escalate into systemic crises.

Policy recommendations focus on institutionalising the FSSI framework within the Central Bank of Nigeria’s financial stability architecture, enhancing data quality and sectoral coverage, and strengthening macroprudential coordination among financial regulators. The study contributes to knowledge by providing an empirically grounded, context-specific framework for financial stability monitoring in Nigeria—bridging the gap between traditional macroeconomic analysis and modern macroprudential policy practice. It underscores the critical role of integrated, evidence-based tools in building a more resilient, adaptive, and stable financial system.