Systemic Risk Indicator
- Description: We provide a measure of systemic risk in the US financial services industry, which captures the risk of widespread stress in the banking system.
- When is systemic risk high? Systemic risk is measured as the difference, or spread, between the average distance-to-default (ADD) and the portfolio distance-to-default (PDD). Since the year 2000, a spread that is lower than 0.1 for more than two days indicates major financial stress, when average insolvency risk is rising and major banks are stressed by a common factor.
- What ADD tells you: ADD captures average insolvency risks for a sample of approximately 100 representative banking institutions. Falling ADD indicates that the market’s perception of average insolvency risk is rising.
- What PDD tells you: PDD captures insolvency risk for a weighted portfolio of the same 100 banking institutions. Falling PDD is another indication that average insolvency risk is rising.
DescriptionThe 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. To compute the indicator, we follow the method in Saldías (2013) and use data on US banks and financial intermediaries. The chart and data are updated weekly.
The method of computing the SRI starts with calculating two measures of insolvency risk, one an average of default risk across individual banking institutions (average distance-to-default) and the other a measure of risk for a weighted portfolio of the same institutions (portfolio distance-to-default). The SRI then compares the difference, or spread, between the two. 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 imminent systematic disruption of the banking system.
How to Interpret the Data
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.
- Craig, Ben R. 2020. “How Well Does the Cleveland Fed’s Systemic Risk Indicator Predict Stress?” Federal Reserve Bank of Cleveland, Economic Commentary, 2020-28.
- Saldías, M. 2013. “Systemic Risk Analysis Using Forward-Looking Distance-to-Default Series,” Journal of Financial Stability, 9, 498-517.
- Model Documentation. This document provides a technical description of the model and data used to compute the systemic risk indicator.
- Revision Document and Historical Data. The model that generates the data for the Systemic Risk Indicator was updated in February 2017, and historical data were updated retroactively. This document explains the revision. Non-updated historical data are available in this document.
Cleveland Financial Stress Index (CFSI)
In May of 2016, we discovered errors in the calculation of the CFSI and began a detailed review of the index and its underlying model. Subsequently, we discontinued the CFSI and developed the systemic risk indicator to gauge the level of systemic risk in the US financial services industry.