CISS — A Portfolio-Theoretic Framework for the Construction of Composite Financial Stress Indices

Abstract:     
This paper introduces a new indicator of current stress in the financial system as a whole named Composite Indicator of Systemic Stress (CISS). Its specific statistical design is shaped in accordance with standard definitions of systemic risk. The main innovative feature of the CISS is the application of portfolio theory to the aggregation of individual stress indicators into the composite index. Along the lines of how portfolio risk is computed from the risks of individual assets, we propose to compute the level of stress in the system as a whole by aggregating five market-specific subindices of stress - comprising a total of 15 individual stress indicators - on the basis of a time-varying measure of the cross-correlations between them. The CISS thus puts relatively more weight on situations in which stress prevails in several market segments at the same time, capturing the idea that financial stress is more systemic and hence more hazardous for the real economy if instability spreads more widely across the whole financial system. Applied to data for the euro area as a whole, we determine within a threshold VAR model an endogenous systemic crisis-level of the CISS at which financial stress tends to depress real economic activity materially.

Number of Pages in PDF File: 45

Keywords: Financial stress index, Systemic risk, Financial stability, Financial crisis, Macro-financial linkages, Threshold VAR, Portfolio theory

JEL Classification: G01, G10, G20, E44

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