St Louis Fed’s Financial Stress Index

Kevin L. Kliesen and Douglas C. Smith of St Louis Fed inform about a new tool they have developed to measure financial stability.

There are many ways to measure financial market stress. One is to look at an interest rate spread designed to measure default risk, such as the difference between yields on a “risky” asset (e.g., corporate bonds) and a “risk-free” asset (e.g., U.S. Treasury securities). However, financial stress can also arise in other dimensions. One type of risk prominent in the recent financial crisis was the inability of many financial institutions to secure funding to finance their short-term liabilities, such as repurchase agreements (repos). This type of risk is known as “liquidity risk.”

To overcome a potential problem of focusing solely on one indicator at the expense of others, some economists have combined several indicators designed to measure financial market stress into one summary variable, like an index number. A recent example of such an index is the Kansas City Financial Stress Index (KCFSI), measure constructed by the Federal Reserve Bank of Kansas City that uses 11 financial market variables. However, one potential limitation of the KCFSI is its use of monthly data. Significant developments in the financial markets often occur much more frequently (e.g., the difficulties associated with Bear Stearns and Lehman Brothers), so a more “realtime” index might be better. The trade-off for a higher frequency index, of course, is greater volatility, and thus, perhaps, noise.

For a more detailed description of the index see this. Those interested in fin stability measures should check out this survey I pointed earlier.

The authors then test the FSI on 3 key events – Russian Debt default in 1998, BNP Paribas suspending redemptions from hedge funds in 2007 and Lehman bankruptcy in 2008. They find the index showed alleviation of financial risks in the system in each of the three.

However, the authors add that the index is better seen as a coincident indicator and not a leading one.

in each instance, the STLFSI seemed to accurately capture the subsequent turmoil and financial stress. In one sense, the STLFSI and the KCFSI can be thought of as coincident indexes rather than as leading indexes—that is, they are designed to measure developments as they occur. In another sense, however, they have leading indicator properties because rising levels of financial stress, as recently seen, can portend economic turmoil and disruption.

A nice short read.

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2 Responses to “St Louis Fed’s Financial Stress Index”

  1. crisismaven Says:

    I wonder if it’s as good at predicting this: Of Mortgage Brokers, ARMs, Attrition and Marathons as the rocket scientists’ market timing tools were that got us into this mess in the first place

  2. St Louis Fed's Financial Stress Index « Mostly Economics Economic Finance news Says:

    […] More: St Louis Fed's Financial Stress Index « Mostly Economics […]

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