The Cleveland Fed provides a systemic risk indicator to gauge the level of systemic risk in the US financial services industry. Specifically, the indicator is designed to capture market perceptions of the risk of widespread insolvency in the banking system. The systemic risk indicator is based upon two measures of insolvency risk, one for individual banking institutions and the other for the nation’s banking system as a whole. When the insolvency risk of the banking system as a whole rises and converges to the average insolvency risk of individual banking institutions—the narrowing of the spread—it reflects market perceptions of an imminent systematic disruption of the banking system.
While the indicator can be expected to provide useful information about systemic risk in the banking system, it is one of a number of indicators that attempt to extract market signals from market prices. Because it is based primarily on market data, it reflects market participants’ beliefs about risk. Those beliefs may or may not be accurate assessments of true risk.