Systemic Risk Indicator
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. 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 indicator 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. 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.
The following chart shows daily values of portfolio distance-to-default, average distance-to-default, spread, and the KBE bank stock index.
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 major 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) reflects the market’s perception of the systematic insolvency risk of the banking system as a whole. 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 indicates the market’s perception of rising average insolvency risk in the banking sector. Falling PDD indicates the market’s perception of rising insolvency risk in the banking system as a whole. 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.
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.