Financial Stress: What Is It, How Can It Be Measured, and Why Does It Matter?
By Craig S. Hakkio and William R. Keeton
T he U.S. economy is currently experiencing a period of signifi-cant financial stress. This stress has contributed to the down-
turn in the economy by boosting the cost of credit and making businesses, households, and financial institutions highly cautious. T o alleviate the financial stress and counteract its effects on the economy, the Federal Reserve has reduced the federal funds rate target substan-tially and undertaken unprecedented actions to support the function-ing of financial markets. There will come a point, however, when the Federal Reserve needs to remove liquidity from the economy and un-wind special lending programs to ensure a return to sustainable growth with low inflation.
In past recoveries, the decision when to tighten policy was based mainly on the strength of business and consumer spending and the de-gree of upward pressure on prices and wages. An additional element in the current exit strategy will be determining if financial stress is no longer high enough to endanger economic recovery. As financial conditions be-gin to improve, the various measures of financial stress that the Federal Reserve monitors may give mixed signals. In this situation, policymak-
Craig S. Hakkio is senior vice president and special advisor on economic policy and William R. Keeton is an assistant vice president and economist at the Federal Reserve Bank of Kansas City. Research associates Ross Dillard, Paul Rotilie, and John Seliski helped prepare the article. This article is on the bank’s website at
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6 FEDERAL RESERVE BANK OF KANSAS CITY ers would greatly benefit from having a single, comprehensive index of financial stress. Such an index could also prove valuable further down the road, when the Federal Reserve might again need to decide whether financial stress was serious enough to warrant special attention.
This article presents a new index of financial stress—the Kansas City Financial Stress Index (KCFSI). The article explains how the com-ponents of the KCFSI capture key aspects of financial stress and shows that high values of the KCFSI have tended to coincide with known pe-riods of financial stress. The article also shows that the KCFSI provides valuable information about future economic growth.
The first section of the article discusses the key phenomena that economists generally associate with financial stress. The next section describes the set of financial variables selected to represent these fe
a-tures of financial stress and explains how the variables are combined in the KCFSI. The third section examines the behavior of the KCFSI during past episodes of financial stress and explains how the index can be used to determine the severity of financial stress. The fourth section examines the link between the KCFSI and economic activity, includ-ing the transmission of financial stress to economic activity through changes in bank lending standards.
I.  KEY FEATURES OF FINANCIAL STRESS
In most general terms, financial stress can be thought of as an inter-ruption to the normal functioning of financial markets. Agreeing on a more specific definition is not easy, because no two episodes of financial stress are exactly the same. Still, economists tend to associate certain key phenomena with financial stress. The relative importance of these phenomena may differ from one episode of financial stress to another. However, every episode seems to involve at least one of the phenomena, and often all of them.
Increased uncertainty about fundamental value of assets.One common sign of financial stress is increased uncertainty among lenders and investors about the fundamental values of financial assets. The fun-damental value of an asset is the present discounted value of the future cash flows, such as di
vidends and interest payments. Increased uncer-tainty about these fundamental values typically translates into greater volatility in the market prices of the assets.
ECONOMIC REVIEW • SECOND QUARTER 2009 7 In some cases, increased uncertainty about the fundamental values of assets reflects greater uncertainty about the outlook for the economy as a whole and for specific sectors. The prospective cash flows from stocks, bonds, and loans all depend on future economic conditions. As a result, heightened uncertainty about economic conditions can cause lenders and investors to become less sure of the present discounted val-ues of these cash flows. Uncertainty about the fundamental values of financial assets can also increase when financial innovations make it difficult for lenders and investors to even assign probabilities to differ-ent outcomes. This kind of uncertainty, in which risk is viewed as un-known and unmeasurable, is often referred to as Knightian uncertainty. According to some economists, such uncertainty tends to arise when losses are incurred for the first time on a new financial instrument or practice—for example, complex structured products such as collateral-ized debt obligations (CDOs) in the recent subprime crisis, or program trading in the Long-T erm Capital Management (LTCM) crisis of 1998. Lacking any historical experience on which to draw, investors may con-clude in such situations that they cannot even form a judgment about the probabilities of returns to the new products.1
react to stress的中文翻译
Increased uncertainty about the fundamental values of assets leads to greater volatility in asset prices by causing investors to react more strongly to new information (Pastor and Veronesi; Hautsch and Hess). Suppose, for example, that the maximum price an investor is willing to pay for a firm’s stock depends on his estimate of the firm’s long-run profitability. Suppose also that the investor revises this estimate when-ever he receives new information about the firm’s profit outlook. Then the greater the investor’s initial uncertainty about the firm’s long-run profitability, the more the investor will revise his estimate of the firm’s profitability in response to new information, and thus the more he will change his offer price in response to that information.2 Thus, increased uncertainty about the fundamental value of stocks will generally lead to increased volatility of the prices of those stocks.
Increased uncertainty about behavior of other investors.Anoth-er form of uncertainty that often increases during financial crises and contributes to asset price volatility is uncertainty about the behavior of other investors. For an asset that may need to be sold before ma-turity, the expected return to an investor can depend as much on the actions of other investors as on the long-run or hold-to-maturity value
8 FEDERAL RESERVE BANK OF KANSAS CITY of the asset. Keynes made this point by comparing the stock market to a beauty contest in which a prize was rewarded for picking the face that the largest
number of other people picked. In such situations, Keynes noted, the incentive of the individual is to anticipate “what average opinion expects average opinion to be.” This kind of recursive behavior becomes more prevalent when lenders and investors become more un-certain about the fundamental values of assets. Thus, it tends to arise in the same situations as Knightian uncertainty—when investors discover that their assumptions about a new financial product or practice were incorrect and have little historical experience on which to base their new opinions.3
Like uncertainty about fundamentals, uncertainty about the be-havior of other investors tends to show up in increased volatility of asset prices. When investors base their decisions on guesses about other investors’ decisions, prices of financial assets become less tied to funda-mental values. Therefore, prices also become more volatile.
Increased asymmetry of information.A third common sign of financial stress is an increased asymmetry of information between lend-ers and borrowers or buyers and sellers of financial assets. Asymmetry of information is said to exist when borrowers know more about their true financial condition than lenders, or when sellers know more about the true quality of the assets they hold than buyers. Information gaps of this kind can lead to problems of adverse selection or moral hazard, boosting the average cost of borrowing for firms and households and reducing the average price of assets on secondary markets. S
uppose, for example, that investors know the average risk of a group of firms issu-ing bonds but cannot distinguish the high-quality firms in the group from the low-quality firms. Investors will then require a rate of interest on the bonds appropriate for a firm of average risk. But at such a rate, the higher-quality firms may prefer not to borrow and instead rely on internal funds. If so, an adverse selection problem will arise: The mix of firms selling bonds will worsen, leading investors to demand a still higher rate of return.4
Such asymmetries of information might worsen during a period of financial stress for two reasons. First, the variation in the true quality of borrowers or financial assets might increase (Mishkin; Gorton). Sup-pose, for example, that everyone expects the collateral on a particular
ECONOMIC REVIEW • SECOND QUARTER 2009 9 type of loan to increase in value. Then lenders will view all loans of that type as safe, regardless of the borrower’s future income or profits. But now suppose everyone expects the value of the collateral to decline—for example, because a real estate bubble has burst. Then loans to low-income borrowers will have greater risk than loans to high-income bor-rowers, because low-income borrowers will be less able to repay their loans if the value of the collateral falls below the amount due on the loan. Thus, if lenders have difficulty determining borrowers’ income, an asymmetry of information will arise—borrowers will differ in their true risk, and e
ach borrower will have a better idea of that risk than lenders.5 The second way information asymmetries can worsen in a fi-nancial crisis is through lenders losing confidence in the accuracy of their information about borrowers (Gorton). Suppose, for example, that the issuer of a bond knows its true risk of default, but that investors must rely on credit ratings by a third party to determine that risk. If investors sud-denly come to doubt the objectivity of those ratings, they will become more uncertain as to which bonds are likely to repay and which are likely to default. Once again, an asymmetry of information will arise, with is-suers of the bonds knowing more about their true risk than investors.6 Decreased willingness to hold risky assets (flight to quality). One common sign of financial stress is a sharply decreased willingness to hold risky financial assets. Such a change in preferences will cause lend-ers and investors to demand higher expected returns on risky assets and lower returns on safe assets. These shifts in preferences away from risky assets and toward safe assets are often referred to as “flights to quality.” The result is to widen the spread between the rates of return on the two types of assets and increase the cost of borrowing for relatively risky borrowers (Caballero and Kurlat).
What could cause lenders and investors to become much less will-ing to hold risky assets? Some theories of financial crises emphasize the tendency for lenders and investors to underestimate risk during booms and overestimate risk during subsequent busts (Kindleberger; Minsky; Berger and Udell;
Guttentag and Herring). According to this view, lenders and investors tend to become complacent during peri-ods of prolonged economic stability and forget their previous losses. During such periods, investors are especially prone to ignore “fat-tail” risks—the non-negligible probability of extreme losses. However, be-

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