An Enhanced Approach to Measuring Financial Stress
Advisory: This article is based in whole or in part on the CFSI (Cleveland Financial Stress Indicator), an indicator that was discontinued by the Federal Reserve Bank of Cleveland in 2016 due to the discovery of errors in the indicator’s construction. These errors overestimated stress in the real estate and securitization markets. As a result, readers should be cautious and interpret any analysis based on CFSI data with those errors in mind.
Financial regulators have been working for some time on ways to identify and mitigate financial crises. One line of work has been in developing financial stress indexes that would alert regulators to instability building in the financial system.
The Cleveland Financial Stress Index (CFSI) is one such index. The CFSI monitors stress in the overall financial system by tracking conditions in different types of financial markets. Two new markets have just been incorporated into the index, making it more sensitive to potential instability. The CFSI now tracks six types of markets: funding markets, credit markets, equity markets, foreign exchange markets, and the two new markets, real estate markets and securitization markets. Real estate and securitization markets were key contributors to the depth and duration of the 2008 financial crisis, and incorporating them into the stress index enhances the ability of the CFSI to detect emerging instability as it occurs.
Because early detection is critical, the CFSI will now be updated daily. When stress occurs in multiple markets, overall financial stress can be amplified. Daily updates will give regulators and financial analysts the ability to track the reaction of markets to specific economic events and monitor stresses as they are building. (More detail on the index's construction can be found here).
In recent months, the CFSI has remained low, as key financial conditions continued to improve. After falling to a recent low of -0.57 on March 14, 2013, the index's latest reading stands at 0.03. The current reading of 0.03 places the level of stress in Grade 2, a "normal stress" period. The index is down 0.86 units over the previous 12 months and nearly 3.03 points since its peak in December 2008.
Stress in each of the component submarkets can also be analyzed by decomposing the CFSI into the contribution each market makes to the total level of system stress. The individual components of the CFSI were elevated at the beginning of 2012 - though not to the same degree as during the financial crisis - but as the year progressed, stress in many of these markets decreased, indicating that the potential for widespread stress had fallen. So far in 2013, the CFSI's securitization market component has been contributing the most to the overall level of stress, while the foreign exchange and funding markets have been contributing little.