Using Policy Intervention to Identify Financial Stress

Abstract

This paper describes the construction of a financial stress index (FSI). Our index incorporates the level, volatility and comovement of a variety of financial series, rather than a single dimension of the data. To determine which time periods are ones of notable financial stress and thus the relevant ones for determining the role of the level, volatility and comovement of our financial series, we use actions taken by policymakers. In addition to describing the construction of our FSI, we discuss issues relevant to the general construction of stress indexes such as how an FSI differs from a financial conditions index, the challenges of combining different financial series into a single measure and the role historical experience plays in index construction.

Disentangling Diverse Measures: A Survey of Financial Stress Indexes

“…Butters (2011, 2012) Financial instability. Carlson, Lewis, and Nelson (2012) Markets that are not "functioning or behaving in a typical fashion" (p. 3); "impaired functioning might take the form of increased difficulty in executing transactions or an inability of intermediaries to fund their market-making operations at usual tenors. Fragility might take the form of exceptionally heightened sensitivity to new information or shocks" (p. 12).…”

“…An FCI can also be used to predict changes in economic business cycles. As such, an FSI can be considered a snapshot of the level of fragility in the financial market and an FCI a mapping of financial conditions onto macroeconomic conditions (Carlson, Lewis, and Nelson, 2012;CLNFCI). In this sense, FSIs have "no natural observable counterpart in the real world" (Louzis and Vouldis, 2011, p. 3) and can only be measured relative to themselves, while FCIs assume a relationship between the financial sector and an element of the macroeconomy.…”

What Macroeconomic Conditions Lead Financial Crises?

“…This example illustrates how financial crises and external borrowing have generally been related.The period around 2000: The model with asset prices and the current account also signals elevated risks in the United States beginning in 1998 and in many other countries around the same time. While a crisis was not identified in this database for that period, it coincides with the Long-term Capital Management incident -which led to policy action and is hence identified as a distress event inCarlson et al (2014). In addition, the collapse of the dot-com bubble and subsequent recession came soon after the model signaled possible problems.…”

Financial Stress Index: A Lens for Supervising the Financial System

“…Among the recent research contributions to financial stress are studies by Hakkio and Keeton (2009), Hatzius et al (2010), Kliesen and Smith (2010), Oet et al (2011a), Brave andButters (2011), Holló, Kremer, andLo Duca (2012), and Carlson, Lewis, and Nelson (2012). Principally, an FSI design conception follows the users' functional objectives.…”