[1] The foundation of financial stability is the creation of a system that is able to absorb all of the positive and negative events that happen to the economy at any given time.
In a similar vein, businesses must take out loans in order to expand, construct factories, recruit new workers, and make payroll.
[1] The Altman's z‐score is extensively used in empirical research as a measure of firm-level stability for its high correlation with the probability of default.
Ultimately, the model measures the value of the firm's assets (weighted for volatility) at the time that the debtholders exercises their “put option” by expecting repayment.
In subsequent research, Merton's model has been modified to capture a wider array of financial activity using credit default swap data.
However, studies focusing on probabilities of default tend to overlook the ripper effect caused by the failing of a large institution.
SES considers individual leverage level and measures the externalities created from the banking sector when these institutions fail.
The enhanced model is called SRISK, which evaluates the expected capital shortfall for a firm in a crisis scenario.
One implication of the SES indicator is that a firm is considered “systemically risky” if it faces a high probability of capital shortage when the financial sector is weak.
[6] Another gauge of financial stability is the distribution of systemic loss, which attempts to fill some of the gaps of the aforementioned measures.