CISS - A Composite Indicator of Systemic Stress in the Financial System
Thoughts
Connects with: @cardarelli2011 @hakkio2009 @illing2006
Annotations
hollo2012 - p. 4
The main general aim of financial stress indices (FSIs) such as the CISS is to measure the current state of instability, i.e. the current level of frictions, stresses and strains (or the absence thereof) in the financial system and to summarise it in a single (usually continuous) statistic.
hollo2012 - p. 5
The main distinguishing feature of the CISS vis-à-vis alternative FSIs is its focus on the systemic dimension of financial stress. This is achieved by a specific statistical design which is shaped according to standard definitions of systemic risk. The CISS comprises 15 mostly market-based financial stress measures equally split into five categories, namely the financial intermediaries sector, money markets, equity markets, bond markets and foreign exchange markets, arguably representing the most important segments of an economy’s financial system.
hollo2012 - p. 5
The portfolio-theoretic aggregation takes into account the time-varying cross-correlations between the subindices. As a result, the CISS puts relatively more weight on situations in which stress prevails in several market segments at the same time which, in turn, captures the idea that systemic risk/stress is high if financial instability is spread widely across the whole financial system.
hollo2012 - p. 8
Taken together, these mutual reaction patterns seem to confirm the idea that when hit by a sufficiently large shock an economy faces the risk of entering a vicious downward spiral with financial and economic stress reinforcing each other over time, a finding which could be explained theoretically by some financial accelerator mechanism (see, e.g., Bernanke, Gertler and Gilchrist 1999).
hollo2012 - p. 8
Systemic stress is interpreted as that amount of systemic risk which has already materialised. Systemic risk, in turn, can be defined as the risk that financial instability becomes so widespread that it impairs the functioning of a financial system to the point where economic growth and welfare suffer materially (de Bandt and Hartmann 2000, de Bandt, Hartmann and Peydro 2009, ECB 2009b).1
hollo2012 - p. 9
The literature suggests several key features of financial stress to be present under crisis conditions (e.g., Hakkio and Keeton 2009, Fostel and Geneakoplos 2008): an increase in uncertainty (e.g., concerning asset valuations and the behaviour of other investors); an increase in disagreement (differences of opinion) among investors; an increase in the asymmetry of information between borrowers and lenders (intensifying problems of adverse selection and moral hazard); and a reduced preference for holding risky assets (flight-to-quality) and/or illiquid assets (flight-to-liquidity) which may result from stronger risk or uncertainty aversion, for instance (Caballero and Krishnamurthy 2008). These different features of financial stress are often closely interrelated, with a tendency to reinforce each other as in the case of fire sales and liquidity spirals, a situation in which declining market and funding liquidity exacerbate each other (Brunnermeier 2009; Brunnermeier and Pedersen 2009; Krishnamurthy 2010).
hollo2012 - p. 11
The five subindices are supposed to represent the core of most financial systems: the sector of financial intermediaries, money markets, equity markets (only non-financial corporations), bond markets (government and non-financial corporations) and foreign exchange markets.