Constructing an aggregate financial stability index for Botswana

This paper evaluates the likely benefits of adopting an aggregate financial stability index (AFSI) as an additional mechanism for monitoring the financial system in Botswana. Since the turn of the new century that brought a sequence of financial episodes, financial stability remains a topical issue among researchers and policymakers. To guard against financial instability, authorities continually look for mechanisms to effectively detect stress in the financial system. This paper builds on recent literature to develop an AFSI for Botswana constructed from sub-indices that reflect financial development, financial vulnerability, financial soundness, and external environment developments. To determine the existence, or absence, of effects from key macroeconomic variables on the AFSI, the autoregressive distributed lag (ARDL) model is used. The study found that the synthetic AFSI constructed is robust and able to track the impact of different macroeconomic events on the stability of the financial sector in Botswana. As such, gains can be expected from the use of an AFSI. In this regard, policy makers will be able to unambiguously interpret the prevailing level of financial stress and respond accordingly.