Measuring Financial Stress A Country Specific Stress Index for Finland
Summary
Financial stress indices are composite indices that condenses several market-specific stress indicators into a single measure of financial stress. They are useful for identifying dates of systemic financial crisis. Macroeconomic financial stress can be defined as interruptions in financial markets’ normal functioning @hakkio2009 or as episodes when the financial system is under strain and its ability to intermediate is impaired @balakrishnan2009. @hollo2012 uses systemic stress to describe an instability in the financial system as a whole, where stress is the amount of systemic risk already materialized. @debandt2000 define Financial systemic risk as the risk that financial instability becomes widespread and impairs the functioning of a financial system in such a way that economic growth and welfare suffer materially. Also, @illing2006 define the same term as a stress that results in altered economic behaviors (maybe a link to financial stress in psychology) that have adverse effects on the real economy.
@cardarelli2011 and @hakkio2009 state that financial stress is associated with broad categories of indicators:
- Increased uncertainty about fundamental values of assets or large shifts in asset prices
- Increased uncertainty about the behavior of other investors or abrupt increase in risk
- Expected return of an asset for an investor depends on the actions of other investors
- Decreased willingness to hold illiquid assets (flight to liquidity) or illiquidity of the financial system
- Decreased willingness to hold risky assets (flight to quality) or concerns about the health of the banking system
- Lenders and investors demand higher expected returns on risky investments ⇒ increased cost of borrowing for risky borrowers
- Increased asymmetry of information
- Especially between the lenders and borrowers as well as buyers and sellers of financial assets
- Refers to situations where the other party knows more about the true value of the asset
- In situations of financial stress: variation in the quality of borrowers or assets might increase ⇒ lenders’ confidence in the accuracy of their information about the borrowers might decrease
In this study, variance-equal weighting, static principal component analysis and portfolio-theoretic aggregation were used as aggregation methods. The indicators were categorized under money, bond, stock, foreign exchange markets and the banking sector.
Annotations
Previous theory and evidence
huotari2015 - p. 1
A financial stress index is a composite index that condenses several market specific stress indicators, such as market volatilities or risk spreads, into a single measure of financial stress.
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huotari2015 - p. 1
FSIs can also be used in identifying the dates of a systemic financial crisis.
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huotari2015 - p. 1
determining the crisis dates is trickier than one might think, as the crises vary both in terms of the severity and in how many markets they hit
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huotari2015 - p. 3
According to Hakkio and Keeton (2009), financial stress, in general terms, stands for interruptions in the normal functioning of the financial markets
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huotari2015 - p. 3
Balakrishnan et al. (2011). The authors define financial stress as episodes when the financial system is under strain and its ability to intermediate is impaired
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huotari2015 - p. 3
Cardarelli et al. (2011) state that financial stress is usually associated with the following: large shifts in asset prices, abrupt increase in risk or uncertainty, illiquidity of the financial system and concerns about the health of the banking system.
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huotari2015 - p. 3
Hollo et al. (2012) focus on the concepts of systemic stress and systemic risk. They define systemic stress as instability in the financial system as a whole.
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huotari2015 - p. 3
De Bandt and Hartmann (2000) define systemic risk as the risk that financial instability becomes widespread and impairs the functioning of a financial system in such a way that economic growth and welfare suffer materially.
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huotari2015 - p. 3
Illing and Liu (2006) state that systemic stress is stress that results in 4 economic behavior being altered sufficiently and has adverse effects on the real economy.
Note: INTERFACE WITH FINANCIAL STRESS ON PSYCHOLOGY Annotated on: 2025-06-03
huotari2015 - p. 4
definition of systemic stress by Hollo et al. (2012), where stress is the amount of systemic risk already materialized and systemic risk, as defined by De Bandt and Hartmann (2000), refers to wide-spread financial instability with potential causes for the real economy
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huotari2015 - p. 4
Hakkio and Keeton (2009) provide a comprehensive presentation on the key features of financial stress. The authors note that even though financial stress might be hard to measure, certain key phenomena tend to be associated with financial stress over time. The authors list five features of financial stress: i) increased uncertainty about fundamental values of assets, ii) increased uncertainty about the behavior of other investors, iii) increased asymmetry of information, iv) decreased willingness to hold risky assets (flight to quality) and v) decreased willingness to hold illiquid assets (flight to liquidity).
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huotari2015 - p. 5
Increased uncertainty about the behavior of other investors also contributes to volatility in market prices. This is because the expected return of an asset for an investor depends as much on the actions of other investors as it does on the long-run or fundamental value of the asset.
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huotari2015 - p. 5
Increased asymmetry of information, especially between the lenders and borrowers as well as buyers and sellers of financial assets, refers to situations where the other party knows more about the true value of the asset.
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huotari2015 - p. 5
Hakkio and Keeton (2009) appoint two reasons why financial stress might increase the asymmetries of information: 1) the variation in the quality of borrowers or assets might increase and 2) lenders’ confidence in the accuracy of their information about the borrowers might decrease.
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huotari2015 - p. 5
Decreased willingness to hold risky assets, or flight to quality, causes lenders and investors to demand higher expected returns on risky investments. This will increase the cost of borrowing for risky borrowers.
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huotari2015 - p. 5
Flight to liquidity, or decreased willingness to hold illiquid assets, is a similar concept. During increased financial stress, investors typically become less willing to hold illiquid assets
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huotari2015 - p. 6
systemic financial stress is such that i) it is widely spread within the financial system and ii) has adverse effects on the real economy
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huotari2015 - p. 6
Hakkio and Keeton (2009) list three possible channels through which an increase in financial stress can lead to a decline in economic activity. These include: i) an increase in uncertainty about the prices of financial assets and the economic outlook in general, ii) increases in the cost to businesses and households of financing spending and iii) tightening of credit standards by banks.
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huotari2015 - p. 7
Along with variance-equal weighting, principal component analysis is one of the most common aggregation methods in previous FSI literature.
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huotari2015 - p. 8
The portfolio-theoretic aggregation method takes into account the time-varying cross correlations between the subindexes.
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huotari2015 - p. 8
The idea behind the portfolio aggregation is that stress prevailing at several markets simultaneously is more systemic and dangerous for the economy as a whole.
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huotari2015 - p. 10
The majority of the previous literature measures stress in five different segments: the money market, the bond market, the foreign exchange market, the equity market as well as in the banking sector.
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huotari2015 - p. 30
The most common evaluation criterion for financial stress indicators, however, is their ability to identify well-known past periods of financial stress (Hollo et al., 2012)
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New evidence from the article
huotari2015 - p. 32
Three commonly used aggregation methods, i.e. variance-equal weighting, principal component analysis as well as a portfolio theoretic aggregation method were considered in constructing the Finnish FSI
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huotari2015 - p. 32
The portfolio theoretic approach, on the other hand, seems to capture the systemic nature of the stress events better than the principal component method.
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Characteristics from the article
huotari2015 - p. 2
financial stress index for the Finnish financial system by combining 14 individual stress measures from five different markets: money, bond, stock, foreign exchange markets and the banking sector
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huotari2015 - p. 17
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Research gaps
huotari2015 - p. 3
The challenge in measuring financial stress as well as in defining financial crisis periods lies in the lack of an unambiguous definition for financial stress or a financial crisis.
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huotari2015 - p. 6
the relationship between financial stress and the real economy in general is complex and poorly understood
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Further reading
huotari2015 - p. 34
Hollo, D., Kremer, M., Lo Duca, M., 2012. CISS-a composite indicator of systemic stress in the financial system. Unpublished working paper. ECB Working Paper No. 1426.
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huotari2015 - p. 33
Balakrishnan, R., Danninger, S., Elekdag, S., & Tytell, I., 2011. The transmission of financial stress from advanced to emerging economies. Emerging Markets Finance and Trade, 47, 4068.
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huotari2015 - p. 33
Cardarelli, R., Elekdag, S., Lall, S., 2011. Financial stress and economic contractions. Journal of Financial Stability, 7(2), 78-97.
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huotari2015 - p. 34
Hakkio, C. S., Keeton, W. R., 2009. Financial stress: what is it, how can it be measured, and why does it matter? Economic Review 94.2 (2009): 5-50.
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