Systemic Risk Indicator

The Systemic Risk Indicator (SRI) gauges systemic risk in the US banking system.

Anyone interested in the level of systemic risk in the US banking system will find the SRI useful, including financial analysts, finance professionals, banking professionals, financial regulators, and academics.

The chart and data are updated weekly.

For each of the financial institutions in the sample, we use total market capitalization, total liabilities, and daily at-the-money implied volatilities of call and put options on their stock. To compute the average distance-to-default, we use the portfolio weights provided by State Street Global Advisors. To compute the portfolio distance-to-default, we use daily at-the-money implied volatilities of call and put options on the KBE ETF. The risk-free interest rate is proxied by the 10-year constant maturity US Treasury yields.

The SRI focuses on the stability of the US banking system, which is an important part of the financial system.

Our current sample consists of the 64 financial firms in the State Street Global Advisors’ SPDR S&P Bank ETF, which is sometimes referred to as the KBE ETF. The same set of banks is used to compute both the average distance–to–default, which is calculated using options on the equity of each of these 64 banks, and the portfolio distance–to–default, which is calculated using options on the KBE ETF (an exchange–traded fund based on the S&P Banks Select Industry Index, a banking index investment fund). The current list of institutions is listed in table 1 of the model documentation.

The method of computing the SRI involves calculating two measures of insolvency risk, one for individual banking institutions (average distance–to–default) and the other for the banking system as a whole (portfolio distance–to–default), and then comparing the difference, or spread, between the two. The average distance–to–default (ADD) is constructed by first calculating the distance–to–default for each bank in the sample using data on its equity, liabilities, and options prices on its stock, which is then averaged across banks using the portfolio weights provided by State Street Global Advisors. The portfolio distance–to–default (PDD) is calculated using options on the KBE ETF (State Street Global Advisors’ SPDR S&P Bank ETF).

To gauge the level of systemic risk in the banking system, the average distance-to-default, the portfolio distance-to-default, and the spread between the two should be interpreted jointly. The average distance-to-default (ADD) reflects the market’s perception of the average risk of insolvency among a sample of approximately 100 US banks. It is calculated using options on the equity of individual banks in our sample and then averaging the perceived insolvency risk of these individual banks. The portfolio distance-to-default (PDD) is a similar measure that is based on options on a weighted portfolio of the same banks. It is calculated using options on an exchange-traded fund (ETF) that reflects the banking system in the aggregate: State Street Global Advisors’ SPDR S&P Bank ETF, commonly referred to as “KBE,” its ticker symbol.

Falling ADD or falling PDD indicates the market’s perception of rising average insolvency risk in the banking sector. Fragility in the banking system is indicated when falling PDD converges toward ADD (the narrowing of the spread), even when both PDD and ADD are well in positive territory.

The spread is the most useful measure. Data from 2000 to the present indicate that when the spread is less than 0.1 for more than two days it indicates stress, and if it stays below 0.5 for an extended amount of time, it indicates that the markets are signaling major stress about the banking system.

There are limitations to keep in mind when interpreting the indicator. The most important one is that 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. 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.

Our model is the same as in Saldias (2013); we apply the model to US financial institutions. Saldias (2013) used data on European banks.

We welcome your questions, comments, and suggestions for ways to make this website more useful and to enhance our list of FAQs. While we cannot respond to every query, we plan to make updates to the site and the FAQs, and your input would be much appreciated. Email us at CLEVSystemicRiskIndicator@clev.frb.org.

The distance–to–default is measured in standard deviation. It estimates the number of standard deviation movements a firm’s asset value has to fall in order to reach insolvency.