Financial Soundness Indicators and the Characteristics of Financial Cycles
Better â€œfinancial soundnessâ€ of banks could help mitigate the volatility of financial cycles by reducing banksâ€™ risk exposure. But trying to improve financial soundness in the midst of a downturn can do the oppositeâ€”further aggravating the contraction of credit. Consistent with this notion, the paper found that better initial scores in certain financial soundness indicators (FSIs) are associated with milder and shorter downturns; and improving FSIs during a downturn worsens the shrinkage of credit and amplifies the cycle. In this context, our results suggest that policy makers should be mindful about the timing of regulating changes in banksâ€™ FSIs.
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