The Financial Stress Index: Identification of Systemic Risk Conditions

Abstract

ArticleThe Abstract: This paper develops a financial stress measure for the United States, the Cleveland Financial Stress Index (CFSI). The index is based on publicly available data describing a six-market partition of the financial system comprising credit, funding, real estate, securitization, foreign exchange, and equity markets. This paper improves upon existing stress measures by objectively selecting between several index weighting methodologies across a variety of monitoring frequencies through comparison against a volatility-based benchmark series. The resulting measure facilitates the decomposition of stress to identify disruptions in specific markets and provides insight into historical stress regimes.

Does linkage fuel the fire? The transmission of financial stress across the markets

“…Specifically, using the "spillover index" approach of Diebold and Yilmaz (2012), we modify and extend the financial stress indices proposed by Oet et al (2011) to track both total and directional stress spillovers across the U.S. equity, debt, banking, and foreign exchange markets. Unlike other previous studies, the important linkages among these four major financial sectors in an interconnected world are directly taken into account by considering the average and time-varying connectedness of each individual market.…”

“…Building on a probit regression of 16 financial market indicators, Grimaldi (2010) from the European Central Bank (ECB) presents a similar weekly financial stress index for the euro area. In a study directly related to this paper, economists at the Federal Reserve Bank of Cleveland (Oet et al, 2011) integrate 11 market-based variables from four most important segments of the financial system (equity, debt, banking, and foreign exchange markets). A separate financial stress index is calculated for each of these four sectors before aggregating the individual subindices into a composite index (the Cleveland Financial Stress Index, CFSI) by applying the time-varying credit weighting method.…”

“…However, despite the widespread attention given to the development of financial stress index, the majority of studies have focused exclusively on constructing an "aggregate" index in assessing the overall level of stress in the global financial system. With an exception of Oet et al (2011), there has been little research on designing a financial stress indicator for each of the four important sectors in a well-functioning financial system (equity, debt, banking, and foreign exchange markets), and in particular we can identify only a limited number of studies on the potential interaction and transmissions of financial stresses across these major sectors. 5 This is somewhat surprising given that the growing concern that "financial stress is more systemic and thus more dangerous for the economy as a whole if financial instability spreads more widely across the whole financial system" (Holló et al, 2012, p.1).…”

“…5 This is somewhat surprising given that the growing concern that "financial stress is more systemic and thus more dangerous for the economy as a whole if financial instability spreads more widely across the whole financial system" (Holló et al, 2012, p.1). 6 In order to address some of these issues, this paper builds on the work of Oet et al (2011) and Diebold and Yilmaz (2012) and proposes an indicator of financial stress transmission, which we call "Financial Stress Spillover Index (FSSI)", to assess the condition of financial system and to identify periods of excessive spillover that may lead to financial instability.…”

“…Specifically, using the "spillover index" approach of Diebold and Yilmaz (2012), we modify and extend the financial stress indices proposed by Oet et al (2011) to track both the total and directional stress spillovers across the U.S. equity, debt, banking, and foreign exchange 5 Louzis and Vouldis (2011) and Holló et al (2012) are other studies in the extant literature that have attempted to incorporate the possible interaction of financial stresses between different market segments by aggregating individual stress indicators from the perspective of standard portfolio theory. However, they only considered the cross-correlations between individual stress indicators and, thus, did not directly address the nature and direction of stress transmissions or spillovers.…”