Definition
- Disruptions to the normal functioning of financial markets (@fava2024)
- Episodes when the financial system is under strain and its ability to intermediate is impaired (@balakrishnan2009, @singh2017)
- Episodes with large shifts in asset prices, unexpected rises in risk or uncertainty, a rise in the financial system’s illiquidity and apprehensions in the banking sector’s health (@rooj2025)
- A stress that is spread widely within the financial system and has potential adverse effects on the real economy (@huotari2015)
- Episodes of extreme values of a composite variable built from market-based indicators in real time and high frequency (@cardarelli2011)
- A state of the financial system in which a representative set of stress factors is extremely high and strongly co-dependent (@kremer2021, @chavleishvili2023, @chavleishvili2025)
- Condition in which a country’s financial system experiences significant pressure via high uncertainty, volatile liquidity and increased risk of default, disrupting market stability and overall economic structure, which lead to inflation, high interest rates and low exchange rates (@andriansyah2025)
- Simultaneous financial market turmoil across a wide range of assets, being a reflection of (i) uncertainty of market prices, (ii) sharp corrections in market prices, and (iii) degree of commonality across asset classes (@duprey2017)
- Amount of systemic risk — risk of impairment of financial system by instability — which has already materialized (@hollo2012)
- Emergence of event(s) that impair smooth functioning of the financial system’s ability to provide financial services (@ilesanmi2020)
Theoretical frameworks
- Financial Accelerator Theory:
- @cardarelli2011: explains how financial stress severity may depend on particular credit states beforehand
- @evgenidis2017: financial acceleration amplifies and propagates the transmission of financial stress shocks by reducing economic activity
- @hollo2012: when hit by a sufficiently large chock, an economy faces the risk of entering a vicious downward spiral with financial stress reinforcing it
- Modern Portfolio Theory:
- @chavleishvili2023: describes how to compute risk of a portfolio of assets from the return variances/covariances with equal portfolio shares
- @fava2024: useful to show financial stress is particularly high in times when financial instability radiates widely across the system
- @hollo2012: accounts for time-varying cross-correlations between subindices
- @kremer2021: computing the risk of an asset portfolio based on the return variances and covariances of assets with equal portfolio shares
- Rare Disasters Theory:
- @fava2024: able to state climate risk can predict stress for an entire financial system
- Real Option Theory:
- @mundra2021: uncertainty about financial outlook increases volatility in the market, such that firms adopt a wait-and-see approach
- Prospect Theory:
- @rooj2025: households may react more strongly to bad news than to good news, which suggests a reference-dependent preference
How it’s measured
Financial stress in economy is commonly measured through an index, called Financial Stress Index, or FSI for short. The FSI is a timeseries that aggregates information from a set of indicators that measure the severity and nature of stress as it occurs. The extent to which indicators deviate from some long-term trend should produce a meaningful historical comparison of stress severity. Many authors suggested different FSIs according to their goal and scope, since the indicators can change accordingly to countries and regions, as well as the methods of aggregation. Financial stress in economy is focused on detecting at least one of these:
- Increased asymmetry of information
- Increased uncertainty about fundamental values of assets
- Increased uncertainty about the behavior of other investors
- Decreased willingness to hold illiquid assets (flight to liquidity)
- Decreased willingness to hold risky assets (flight to quality)
- Increased concerns about the health of the banking system
Indicators
All the used indicators in the literature until now are measures of:
- Financial volatility: @huotari2015
- Credit spreads: @huotari2015, @nazlioglu2015
- Sovereign debt: @balakrishnan2009, @neves2022
- Debt market: @rooj2025
- Sovereign market: @chavleishvili2023, @chavleishvili2025
- Financial intermediaries: @fava2024, @kremer2021
- Bond market: @duprey2017, @fava2024, @hollo2012, @ilesanmi2020, @kremer2021, @mundra2021
- Funding spreads: @nazlioglu2015
- Interest rates: @huotari2015
- Equity valuations: @huotari2015
- Equity market: @chavleishvili2023, @chavleishvili2025, @duprey2017, @fava2024, @hollo2012, @ilesanmi2020, @kremer2021, @mundra2021. @nazlioglu2015, @rooj2025
- Stock market return: @balakrishnan2009, @neves2022
- Money market: @chavleishvili2023, @chavleishvili2025, @fava2024, @hollo2012, @ilesanmi2020, @kremer2021
- Securitization: @nazlioglu2015
- Real Estate: @nazlioglu2015
- Banking market: @balakrishnan2009, @cardarelli2011, @mundra2021, @neves2022, @rooj2025
- Security market: @cardarelli2011, @balakrishnan2009, @neves2022
- Foreign exchange market: @huotari2015, @balakrishnan2009, @chavleishvili2023, @chavleishvili2025, @duprey2017, @fava2024, @hollo2012, @ilesanmi2020, @kremer2021, @mundra2021, @nazlioglu2015, @neves2022, @rooj2025
Aggregation methods
The methods of aggregation of indicators vary by weighting scheme, which include:
- Static principal component analysis weights: @huotari2015, @evgenidis2017, @mundra2021, @nazlioglu2015, @rooj2025
- Portfolio theoretic weighting: @hollo2012, @huotari2015, @duprey2017, @fava2024, @mundra2021
- Variance-equal weighting: @huotari2015, @balakrishnan2009, @cardarelli2011, @mundra2021, @neves2022, @rooj2025
- Matrix association indexing: @chavleishvili2023, @chavleishvili2025, @kremer2021
- Credit aggregate-weighting
- Sample CDF transformation
- Exponentially weighted moving average: @mundra2021
- Dynamic conditional correlation: @mundra2021
Transmission factors
Financial linkages
- @balakrishnan2009 showed financial linkages jointly predict stress transmission to emerging countries in different times:
- Bank linkages (b=0.01), portfolio linkages (b=0.05) and direct investment linkages (b=0.04) between 1998-2003
- Bank linkages (b=0.03), portfolio linkages (b=0.03) and direct investment linkages (b=0.08) after 2007
Determinants
External financial stress
- @balakrishnan2009: high financial stress index in both advanced economies (b=0.40) and other emerging countries (b=1.52) was determinant to increased EM-FSI in an emerging country
Interest rates
- @balakrishnan2009: 3-month London interbank offered rate led to increased EM-FSI in the country (b=0.21)
- @cardarelli2011: the greater the real interest rates the greater the severity of results of financial stress through cumulative output loss (b=0.88)
Growth
- @balakrishnan2009: increased annual GDP growth rate globally was related to decreased EM-FSI (b=-0.95)
Financial openness
- @balakrishnan2009: financial openness in the past timeframe was related to increased financial stress (episode) (b=0.02)
Borrowing ratios
- @cardarelli2011 net borrowing ratios were associated with financial stress severity:
- Non-financial corporation net borrowing ratio predicted effect of financial stress through cumulative output loss (b=1.98)
- Household net borrowing led to increased financial stress severity when moderated by financial stress duration (b=0.593)
Climate change
- @fava2024: climate risks improved financial stress accuracy across multiple countries (RMSFE ratio >1)
Outcomes
Commodities
- @nazlioglu2015 showed FSI was associated with oil market:
- During in-crisis period, CFSI Granger-caused oil prices
- During post-crisis period, oil prices Granger-caused CFSI
Economic activity
- @ilesanmi2020: financial stress episode (FSI) has a negative, not-immediate, impact on IDP
- @kremer2021: financial stress episode (CISS) led to decreased (-1.1%) GDP growth in the 90% quantile
- @mundra2021: financial stress episodes in different methods of aggregation predicts fall in investment (from 1.05% to 0.76%)
- @neves2022: financial stress predicts severity of impact of economic downturns after negative credit and output gap shocks
- @chavleishvili2023: increased financial stress as per CISS led to decreased GDP in US economy
- @chavleishvili2025: increased financial stress as per CISS led to decreased GDP in both US and EU economies
Industrial production
- @hollo2012: financial stress episode (CISS) predicted industrial production for the euro area (φ=-0.07)
Household confidence
- @rooj2025 showed increased financial stress led to decreased confidence:
- About current situation (β=-0.02), moderated by:
- Income group: lower (β=-0.02), highest (β=-0.03)
- Education level: lower (β=-0.01), highest (β=-0.02)
- About future situation with complete moderation by:
- Income group: lowest (β=-0.01)
- Education level: lower (β=-0.02), higher (β=-0.01)
- About current situation (β=-0.02), moderated by: