Constructing a financial riskiness index across countries

Abstract

The paper attempts to construct an index of financial riskiness across countries, and to find out whether this index is correlated with the stage of economic development, with political governance and with country size. The paper also addresses the question as to why the 2008 financial crisis was mostly associated with developed countries, which tend to have relatively high good governance scores, when compared to developing countries in general. The financial riskiness index (FRI) is made up of two components namely a Financial Imprudence Index (FII) weighted by a Financial Depth Index (FDPI). The paper finds that the FII tends to be negatively correlated with economic development, measured by GDP per capita while the FDPI was found to be positively correlated with GDP per capita. The same tendences were found to exist with good political governance. These two indices were not found to be correlated with country size. The results would seem to suggest that the reason why the 2008 financial crisis was mostly associated with developed countries, could be that although developed countries tend to be more prudent in their financial markets, when compared to developing countries, they also tend to have larger financial sectors in relative terms, and therefore financial imprudence, though not as widespread as is the case in developing countries, tends to have a higher effect in developed countries due to their relatively high dependence on the financial sector.