| Summary: | This thesis investigates the sources of financial system fragility in a small open economy with a traditional banking system, with a focus on Bosnia and Herzegovina. Conducting research on Western Balkan countries is challenging given the shortness of time series, unrepresentative samples, numerous structural breaks, poor quality data and the historical absence of the phenomenon that is the focus of investigation. For this reason, the common assumption that the findings associated with other regions or countries are applicable to the Western Balkans is rejected. Instead, two measures of systemic risk are constructed to assess a country’s financial system fragility that reflects the specific characteristics of a country such as Bosnia and Herzegovina. The liquidity index measures how vulnerable the financial system is to a currency crisis represented by the abandonment of the currency board arrangement. The solvency index is an indicator of banking system fragility at a point in time. Changes over time in both these measures of systemic risk are related to changes in a set of macroeconomic and banking sector specific variables. This thesis contributes to a better understanding of financial system fragility in Bosnia and Herzegovina and similar countries in several ways. It is found that both country and period specifics must be accounted for. Accordingly, each country should develop its own tailored measure of systemic risk, since some of the widely used set of indicators, such as the level of foreign reserves, may distort the perception of risk. A disaggregated approach to systemic analysis is favoured: it is more efficient to interpret two measures of systemic risk jointly rather than to merge them into a single indicator. However, there are substantial gains in modelling the risks of banking and currency crises as a system. It is demonstrated that even in a country with a simple financial system and dominant banking sector a single model cannot explain the evolution of systemic risk over the cycle. The nature of the risk factors, their relations with the perceived level of fragility, as well as the relationship between the measures of systemic risk were found to differ in pre-shock from the post-shock periods. Finally, it is shown that even simple financial systems are inherently unstable, with destabilizing relationships between the risks of banking and currency crises and developments in the real economy. It is concluded that developing a set of country-specific risk measures that indicate the evolution of the risk of banking or currency crises is an imperative.
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