Financial Stress Indices and Financial Crises

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Previous theory and evidence

vermeulen2015 - p. 384

The general aim of a financial stress index (FSI) is Bto 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 summarize it in a single (usually continuous) statistic^ (Holló et al. 2012: 4).

Annotated on: 2025-05-27

vermeulen2015 - p. 384

an episode of financial stress is defined as a period when the financial system is under strain and its ability to intermediate is impaired. Financial stress tends to be associated with at least four fundamental characteristics: large shifts in asset prices, an abrupt increase in risk and/or uncertainty, liquidity droughts, and concerns about the health of the banking system.

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vermeulen2015 - p. 384

Financial stress indices are widely used by policymakers as an instrument for monitoring financial stability

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vermeulen2015 - p. 384

This tool would enable the public to observe drivers of stress in the financial system, and—by providing alerts—help to diffuse the information uncertainty and give the risk managers time to counteract

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vermeulen2015 - p. 385

episodes of financial turmoil characterized by banking distress are more likely to be associated with deeper and longer downturns than episodes of stress

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vermeulen2015 - p. 385

recessions associated with bankingrelated financial stress tend to last at least twice as long

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vermeulen2015 - p. 385

significant relationship between financial stress and some measures of economic activity

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vermeulen2015 - p. 386

the negative impact of financial stress on the real economy had a time lag of three months during the recent financial crisis and the euro-area sovereign debt crisis

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vermeulen2015 - p. 386

in the post-deregulation period the speed of systemic stress propagation slows, but the length of the recovery from systemic stress also slows

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vermeulen2015 - p. 386

within a linear framework, domestic credit growth is the best predictor of the stress index for Canada at all horizons

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vermeulen2015 - p. 386

asset prices tend to be better predictors of stress when they allow for nonlinearities

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vermeulen2015 - p. 386

Only credit growth turns out to have some predictive power for most countries. Several other variables have predictive power for some countries, but not for others

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vermeulen2015 - p. 387

Financial stress indices have certain limitations. First, they generally do not capture interconnectedness

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vermeulen2015 - p. 387

As financial stress indices focus on developments over time, they generally do not capture these important dimensions of financial stability

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vermeulen2015 - p. 401

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vermeulen2015 - p. 402

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vermeulen2015 - p. 403

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New evidence from the article

vermeulen2015 - p. 385

there is only a very weak relationship between the FSI and the onset of a crisis

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vermeulen2015 - p. 400

It turns out that our stress indices as well as the sub-indices are related to the occurrence of a crisis, although to a varying degree. In other words, the stress index is indeed a good thermometer. However, the relationship between our stress indices and the onset of a crisis is rather weak.

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Characteristics from the article

vermeulen2015 - p. 385

our financial stress index for 28 OECD countries, we use four criteria: the index should cover the entire financial system and indicators included should be available for many countries for a long period at a quarterly frequency, be comparable, and be related to financial crisis in line with theoretical expectations

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vermeulen2015 - p. 388

First, it should be available for many countries for a long period at a sufficiently high frequency

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vermeulen2015 - p. 388

That is why we decided to use quarterly data, which is also the highest frequency at which one can obtain historic tracking of financial crises

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vermeulen2015 - p. 388

the included variables should be comparable across countries

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vermeulen2015 - p. 388

FSI should cover as much of the financial system as possible, i.e., money, capital markets, the banking sector, and the foreign exchange market

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vermeulen2015 - p. 388

Our index also takes stock price volatility into account.

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vermeulen2015 - p. 388

The volatility of monthly changes in the nominal effective exchange rate is also included in our index

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vermeulen2015 - p. 388

This volatility reflects investors’ uncertainty about the fundamental value of the currency and about the investment behaviour of other agents

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vermeulen2015 - p. 389

We considered two indicators of stress in the bond market, namely the inverse yield curve, i.e., the short-term interest rate minus the long-term interest rate, and the domestic long-term interest rate minus the US long-term interest rate as a measure of sovereign risk

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vermeulen2015 - p. 389

The TED-spread reflects credit risk and liquidity risk. It also captures stress in the banking sector as the premium captures counterparty risk. However, in our sample it turned out that this money market spread frequently had the ‘wrong’ sign

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vermeulen2015 - p. 389

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vermeulen2015 - p. 390

All variables are standardized, i.e., we subtract the mean and divide by the standard deviation.

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vermeulen2015 - p. 390

Our overall index FSI is the non-weighted sum of the standardized variables included

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vermeulen2015 - p. 390

The correlation of the sub-indices is low, suggesting that they capture different dimensions of financial stress.

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vermeulen2015 - p. 391

in our sample of industrial countries banking crises occur most frequently, followed by currency crises and debt crises

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vermeulen2015 - p. 391

The figure suggests that our overall FSI and the occurrence of financial crises are somehow related. However, the relationship is not very strong.

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Research gaps

vermeulen2015 - p. 384

This is remarkable as the usage of FSIs as policy instrument to monitor financial stability or as dependent variable in early warning models presumes that FSIs are related to financial crises (Kliesen et al. 2012)

Annotated on: 2025-05-27

gauerle

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@vermeulen2015

Financial Stress Indices and Financial Crises

Summary

Annotations

Previous theory and evidence

New evidence from the article

Characteristics from the article

Research gaps

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