The US Office of Financial Research (OFR) has launched two new tools aimed at monitoring and measuring the risks and stress levels of financial markets.
The first tool, the Financial System Vulnerabilities Monitor (FSVM), is replacing the OFR’s existing Financial Stability Monitor, which combined signs of vulnerabilities and stress.
By contrast, the FSVM focuses exclusively on monitoring vulnerabilities in the financial markets to signal potential risks, while the new Financial Stress Index (FSI) focuses on monitoring the stress levels of the financial markets.
“The logic for two monitoring tools is simple: Just as monitoring health requires both blood pressure and body temperature, monitoring financial stability requires tracking both vulnerabilities and stress,” says Richard Berner, director of the OFR in a blog published today.
The FSVM is a heat map of 58 indicators of potential vulnerabilities. It is designed to provide an early warning signal for further investigation rather than offering conclusive evidence of vulnerabilities.
The heat map is divided up into six areas of risk that have contributed to financial stability in the past: macroeconomics, markets, credit, solvency and leverage, funding and liquidity, and contagion.
The colours of the heat map mark the position of each indicator, with red indicating that a potential vulnerability is high relative to the past, orange that it is elevated, yellow showing that it is average and green showing that it is low.
The FSVM will be updated on a quarterly basis.
The FSI is a market-based snapshot that is updated each morning and is constructed from 33 financial market indicators, which are then organised into five categories: credit, equity valuation, funding, safe assets and volatility.
The index is designed to measure system-wide stress, and can be broken down to show the specific regions that are generating the stress.
“It distills information from multiple indicator categories and regions, offering insight into the drivers of stress. It helps the OFR monitor, compare and understand financial stress events. The index offers improvements on other FSIs, including its decomposition into indicator categories and regions, and a dynamic construction that allows for changes in variable composition and cross-asset relationships,” says Phillip Monin, a research mathematician at the OFR, in a paper published today regarding the FSI methodology.
The reason why the OFR decided to separate out the vulnerabilities and stress indicators is that the two can move in opposite directions and, by having them combined, it often diluted the signals being produced.
For example, looking at historical data the FSVM shows that in the period preceding the financial crisis, many of the vulnerability indicators would have been flashing orange or red, whereas the FSI shows that the stress on the financial market was very low. As the financial crisis developed, and certainly towards the end of the crisis, this dynamic switched as potential vulnerabilities decreased by stress within the financial system greatly increased.
“While the FSVM is intended to provide advanced warning of potential problems, the FSI measures the severity and nature of stress as it occurs. Vulnerabilities can build during periods of low stress. For example, historically high asset valuations can be viewed as a financial stability vulnerability because they suggest that investors have complacent attitudes toward risk. During a time of high asset valuations, stress is likely to be low. However, a sudden and large decline in asset valuations can indicate stress resulting from a shock in investor preferences or risk appetite. Stress and vulnerabilities should therefore be separately measured,” Morin explains in his paper.