Developing a Composite Financial Health Index for Banking Stability: A PCA-Based Approach in an Oil-Dependent Economy

Hussein Kamel  Hussein; Ezatollah Abbasian; Islam  Fakher

Authors

Hussein Kamel Hussein Ph.D. student in Finance– Banking, Aras International Campus, University of Tehran, Jolfa, Iran, and Head of a Supervisory Commission in the Federal Board of Supreme Audit, Iraq Author https://orcid.org/0009-0000-9492-1422
Ezatollah Abbasian Professor of Financial Economics, Department of Financial Engineering, Faculty of Management, University of Tehran, Tehran, Iran Author https://orcid.org/0000-0001-8364-6461
Islam Fakher Associate Professor, Department of Financial Management, Shahid Chamran University of Ahvaz, Ahvaz, Iran Author https://orcid.org/0000-0002-5240-2795

Keywords:

Financial Health Index, PCA, Banking Stability, Composite Indicator, Emerging Economies

Abstract

This study aimed to develop and validate a Principal Component Analysis (PCA)-based Composite Financial Health Index (CFHI) for Iraqi commercial banks and to examine its association with oil price volatility, economic growth, and inflation during 2010–2024. A quantitative longitudinal design was employed using a balanced panel of 18 Iraqi commercial banks observed over 15 years, yielding 270 bank-year observations. The core CFHI was constructed from capital adequacy ratio, non-performing loans, return on assets, liquidity ratio, and portfolio concentration. Variables were winsorized, directionally harmonized, standardized using z-scores, and subjected to PCA. Sampling adequacy was assessed using the Kaiser–Meyer–Olkin statistic and Bartlett’s test of sphericity. Components were retained based on eigenvalues greater than one, cumulative explained variance, and scree-plot inspection. Component scores were weighted according to explained variance to construct the CFHI. Fixed-effects panel regression was then used to assess the effects of oil price volatility, GDP growth, and inflation on financial health. Validity and robustness were examined through correlations, alternative PCA specifications, sensitivity tests, and predictive analysis. PCA adequacy was confirmed by a KMO value of 0.742 and a significant Bartlett’s test, (chi²(10)=512.684, p<0.001). Two components were retained and explained 71.18% of total variance. CFHI was positively associated with capital adequacy (r=0.674, p<0.001), profitability (r=0.698, p<0.001), and liquidity (r=0.533, p<0.001), and negatively associated with non-performing loans (r=-0.721, p<0.001) and portfolio concentration (r=-0.586, p<0.001). Fixed-effects estimates showed that oil price volatility negatively affected CFHI (beta=-0.031, p<0.001), GDP growth had a positive effect (beta=0.047, p<0.001), and inflation had a negative effect (beta=-0.058, p=0.006). A one-standard-deviation increase in CFHI reduced subsequent distress odds by 46% (OR=0.54, 95% CI: 0.39–0.75). The PCA-based CFHI provides a statistically robust and economically interpretable measure of multidimensional banking stability in Iraq and demonstrates that bank financial health is materially influenced by oil-market volatility and broader macroeconomic conditions.

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