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Timothy Bianco |

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Timothy Bianco

Tim is a former economic analyst in the Supervision and Regulation Department of the Federal Reserve Bank of Cleveland.

 

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11.01.2012

Economic Trends

Tracking Recent Levels of Financial Stress

Timothy Bianco

In early 2012, the Federal Reserve Bank of Cleveland began a monthly release of the Cleveland Financial Stress Index (CFSI). The CFSI was created tomonitor stability and identify emerging risks in a complex and dynamic financial system. The monthly release can be found here, and a further discussion of the index can be found here.

In recent months, the CFSI has decreased considerably as conditions in key financial markets have improved. The CFSI in July was 0.37 but has subsequently fallen to −0.92 as of October 15, 2012. The index is down 2.13 points over the previous 12 months and nearly 3.5 points since the index’s peak in October 2008.

The CFSI measures stress in four key financial markets (interbank, credit, equity, and foreign exchange). Together, these markets offer broad coverage of the financial system. Stress may originate in any of them, and though stresses in individual markets are not necessarily correlated, isolated stress in one may quickly spread to the broader financial market, with potentially devastating effects. Financial system supervisors are concerned with detecting systematic factors that could contribute to widespread stress.

For example, since late 1991 there have been two periods of significant financial instability, one occurring after the collapse of Long Term Capital Management (LTCM) in 1998 and one being the more recent financial crisis. During these periods, multiple markets were experiencing elevated, nearly simultaneous stress, presumably caused by common factors. This can be seen by decomposing the CFSI into the contribution each market makes to the total level of system stress (more detail on the index’s construction can be found here). To a lesser extent, more recent trends show that individual components of the CFSI were also increasing toward the end of 2011 and into the early part of 2012, though not to the same degree as during these two periods.

While stress was elevated through early 2012, the overall level of financial stress has abated significantly as the year has progressed. Stresses in all four markets have decreased, indicating that the potential for widespread stress has fallen relative to late 2011 and of course relative to the periods around the LTCM collapse and the recent financial crisis. The following table shows the decomposition of the CFSI over the previous months.The contribution from the equity market has most markedly decreased from August to October 2012, while strains in the credit market persist.

Decomposition of CFSI

 

October 15, 2012

September 17, 2012 August 20, 2012

Equity market contribution to CFSI

8.39

12.35

19.55

Interbank market contribution to CFSI

8.80

10.02

10.95

Credit market contribution to CFSI

17.29

17.43

18.19

Foreign exchange contribution to CFSI

1.88

1.49

0.81

Note: These contributions refer to levels of stress, where a value of 0 indicates the least possible stress and a value of 100 indicates the most possible stress. The sum of these contributions is the level of the CFSI, but this differs from the actual CFSI, which is computed as the standardized distance from the mean, or the z-score.
Source: Federal Reserve Bank of Cleveland.

The CFSI also employs a rating system to help financial system supervisors interpret the index, especially when stress is at moderate levels. The rating system differentiates CFSI levels into four ranges. The ranges are defined as “below-normal stress” (grade 1), “normal stress” (grade 2), “moderate stress” (grade 3), and “significant stress” (grade 4). Only twice in the CFSI’s history has stress moved into the “significant stress” grade—during the two periods mentioned above.

The CFSI climbed into grade 4 in late 2007, as the index peaked at 2.67 in late 2008, which coincided with the failure of Lehman Brothers. After significant actions were taken to help mitigate financial stress, the CFSI decreased to grade 1 and has since then fluctuated. The current reading of −0.92 is classified as a “below-normal stress” period.