Beyond the Z‐score: A novel measure of bank stability for effective policymaking

Abstract

This article looks beyond Z‐score and proposes a novel methodological framework to build an all‐encompassing indicator of bank stability for individual banks using the optimisation‐based ‘benefit‐of‐the‐doubt (BoD)’ approach. Unlike other available approaches, this approach is totally data‐driven and generates endogenous weights to aggregate sub‐indicators of bank stability and dimensions. Further, the final outcomes are not limited to a scalar measure of bank stability. The unique optimal weights offer valuable policy‐relevant insights and highlight the most precarious areas of stability, which demand the immediate attention of the bank's management and the industry regulators for both micro‐and macro‐level policymaking. Using the data of Indian public sector banks operating in the year 2018, the study illustrates the proposed framework to obtain a holistic indicator of bank stability, defined on 14 ratio sub‐indicators and 5 broad dimensions (soundness, asset quality, profitability, management efficiency, and liquidity) of bank stability.