Financial stress: what is it, how can it be measured, and why does it matter?
Thoughts
Financial stress occur through disruptions to the normal functioning of financial markets.
Uses Knightian Uncertainty Theory to ground that such uncertainty tends to arise when losses are incurred for the first time on a new financial instrument or practice.
Key indicators: financial volatility, bond market, interest rates, security market. Aggregation methods: static principal component analysis.
Determinants findings:
- Economic activity: financial stress episode (KCFSI) led to decreased CFNAI (b=-0.15)
- Credit standards: KCFSI successfully predicted changes in credit standards (b=7.95)
Connects with: @illing2006
Annotations
hakkio2009 - p. 6
In most general terms, financial stress can be thought of as an interruption to the normal functioning of financial markets. Agreeing on a more specific definition is not easy, because no two episodes of financial stress are exactly the same.
hakkio2009 - p. 6
Increased uncertainty about fundamental value of assets. One common sign of financial stress is increased uncertainty among lenders and investors about the fundamental values of financial assets. The fundamental value of an asset is the present discounted value of the future cash flows, such as dividends and interest payments.
hakkio2009 - p. 7
Uncertainty about the fundamental values of financial assets can also increase when financial innovations make it difficult for lenders and investors to even assign probabilities to different outcomes. This kind of uncertainty, in which risk is viewed as unknown and unmeasurable, is often referred to as Knightian uncertainty. According to some economists, such uncertainty tends to arise when losses are incurred for the first time on a new financial instrument or practice—for example, complex structured products such as collateralized debt obligations (CDOs) in the recent subprime crisis, or program trading in the Long-Term Capital Management (LTCM) crisis of 1998.
hakkio2009 - p. 7
Increased uncertainty about behavior of other investors. Another form of uncertainty that often increases during financial crises and contributes to asset price volatility is uncertainty about the behavior of other investors.
hakkio2009 - p. 8
Increased asymmetry of information. A third common sign of financial stress is an increased asymmetry of information between lenders and borrowers or buyers and sellers of financial assets. Asymmetry of information is said to exist when borrowers know more about their true financial condition than lenders, or when sellers know more about the true quality of the assets they hold than buyers.
hakkio2009 - p. 9
Decreased willingness to hold risky assets (flight to quality). One common sign of financial stress is a sharply decreased willingness to hold risky financial assets. Such a change in preferences will cause lenders and investors to demand higher expected returns on risky assets and lower returns on safe assets.
hakkio2009 - p. 10
Decreased willingness to hold illiquid assets (flight to liquidity). A final sign of financial stress is a sharply decreased willingness to hold illiquid assets. An illiquid asset is one that the owner cannot be confident of selling at a price close to its fundamental value if faced with a sudden and unexpected need for cash. In some cases, an asset is illiquid because the secondary market for the asset is thin, so that selling a substantial amount of the asset has a large effect on the price.
hakkio2009 - p. 30
As shown in the accompanying box, high values of the KCFSI have tended to either coincide with or precede tighter credit standards over the last 20 years. This evidence suggests that changes in credit standards provide an additional channel through which financial stress may affect economic activity.