A Single Composite Financial Stress Indicator and Its Real Impact in the Euro Area

Abstract

In this paper, we construct a single composite financial stress indicator (FSI) which aims to predict developments in the real economy in the euro area. Our FSI contains financial variables that have a causal relationship with the real economy. Therefore, our FSI is able to serve as an early warning indicator for negative impacts of financial stress on the real economy.The causal relationship between our FSI and the real economy is tested and confirmed by the error-correction models. An empirical analysis reveals that our FSI has more predictive power than the bench-mark normally used for financial markets, especially stock markets, namely the Euro STOXX 50 volatility index for the recent banking crisis and the euro-area sovereign debt crisis. One of the main empirical results is that our FSI shows negative effects from financial markets on the real economy one to four months in advance. Nicht-technische Zusammenfassung AbstractIn this paper, we construct a single composite financial stress indicator (FSI) which aims to predict developments in the real economy in the euro area. Our FSI was shown to perform better than the Euro STOXX 50 volatility index for the recent banking crisis and the euro-area sovereign debt crisis and to be able to serve as an early warning indicator for negative impacts of financial stress on the real economy.

Financial Stress in the Czech Republic: Measurement and Effects on the Real Economy

“…Our selection of the underlying variables follows, to some extent, traditional indicators used in papers internationally, such as Illing and Liu (2006), Grimaldi (2010), Oet et al (2011), Islami andKurz-Kim (2013). Clearly, the variables are also chosen based on data availability.…”

Financial Stress Indices and Financial Crises

“…Financial stress indices have been constructed for one country (e.g., Illing and Liu 2006;Hakkio and Keeton 2009;Morales and Estrada 2010;Holló 2012) or for several countries (e.g., Holmfeldt et al 2009;Cardarelli et al 2011;Slingenberg and de Haan 2011;Holló et al 2012;Cevik et al 2013;Islami and Kurz-Kim 2013). In general, stress indices for a single country combine more indicators into one statistic than multicountry stress indices (see Table 6 in the Appendix for a comparison of several stress indices; for a more extensive comparison we refer to Kliesen et al 2012).…”

“…Their impulse response functions based on bivariate VARs show a significant relationship between financial stress and some measures of economic activity. Islami and Kurz-Kim (2013) construct Financial Stress Indices and Financial Crisesa FSI for the euro area and examine its predictive ability for the real economy during the recent banking crisis and the euro-area sovereign debt crisis. These authors conclude that their FSI outperforms the Euro STOXX 50 volatility index.…”

“…The volatility of monthly changes in the nominal effective exchange rate is also included in our index (see also Illing and Liu 2006;Cardarelli et al 2011;Islami and Kurz-Kim 2013). Like stock price volatility, this indicator is derived using a GARCH(1,1) specification for the monthly change of the real effective exchange rate.…”

Credit Risk Determinants in the Vulnerable Economies of Europe: Evidence from the Spanish Banking System

“…The strong belief that financial distress may contract economic growth, has inspired academics to investigate those factors that may trigger a banking crisis (Agnello et al 2011;Chaibi and Ftiti 2015;Islami and Kurz-Kim, 2014). According to Chaibi and Ftiti (2015), academics have considered various indicators for measuring uncertainty or stress in financial markets such as structural weaknesses in the financial systems and moral hazard.…”