The OFR Introduces its Financial System Vulnerabilities Monitor and Financial Stress Index

The Dodd-Frank Act directs the OFR to monitor risks to the nation’s financial stability and develop tools for risk measurement and monitoring. To help fulfill that mandate, the OFR has developed two new tools: the Financial System Vulnerabilities Monitor (FSVM) and the Financial Stress Index (FSI).

The FSVM improves upon and replaces the OFR’s Financial Stability Monitor, which combined signals of vulnerabilities and stress. The FSVM focuses only on vulnerabilities for clearer and earlier signals of potential risks, while the FSI focuses on monitoring stress. The FSVM will be released quarterly rather than semiannually. The FSI will be updated daily.

The logic for two monitoring tools is simple: Just as monitoring health requires tracking both blood pressure and body temperature, monitoring financial stability requires tracking both vulnerabilities and stress.

Vulnerabilities are factors that can originate, amplify, or transmit disruptions in the financial system. For example, the reliance of Lehman Brothers and other broker-dealers on unstable funding was a vulnerability that allowed runs on those firms in 2008.

Stress is a disruption in the normal functioning of the financial system. Stress can be minor; for example, manifest in a brief period of uncertainty and price volatility in the equity market. Or it can be major, like that precipitated by the runs on Lehman and other broker-dealers in 2008.

A high level of stress indicates a disruption today. High or rising vulnerabilities indicate a high or rising risk of disruptions in the future. Vulnerabilities can lead to stress when shocks occur. Consequently, vulnerabilities and stress should be measured separately.

It thus comes as no surprise that, at any point in time, vulnerabilities and stress can move in opposite directions. For example, for the years leading up to the U.S. financial crisis, the FSVM shows many vulnerability indicators flashing orange or red. If the OFR and the FSVM had been in existence at the time, those signals would have represented warnings of potential financial instability because of excesses in U.S. housing valuations, household leverage, and financial firm leverage. The FSI shows that, at the same time, stress was very low. That reflected the easy financial conditions and confidence that allowed vulnerabilities to grow as borrowers, investors, and financial intermediaries took more risks.

The OFR Financial System Vulnerabilities Monitor

The FSVM is a heat map of 58 indicators of potential vulnerabilities. It gives early warning signals for further investigation, not conclusive evidence of vulnerabilities. We investigate these signals as part of our broader monitoring and assessment.

This monitor has six categories of indicators that reflect key types of risks that have contributed to financial instability in the past: (1) macroeconomic, (2) market, (3) credit, (4) solvency and leverage, (5) funding and liquidity, and (6) contagion.

The colors in the heat map mark the position of each indicator in its long-term range. For example, red signals that a potential vulnerability is high relative to its past. Orange signals that it is elevated. Movement toward red indicates that a potential vulnerability is building.

The latest monitor shows red or orange signals in a number of areas, including key asset valuations and risk premiums, some consumer and nonfinancial business debt ratios, and federal government debt and deficits. The OFR’s full assessment of these potential vulnerabilities and others will appear in our forthcoming 2017 Financial Stability Report.

The OFR Financial Stress Index

The FSI is a daily market-based snapshot of stress in global financial markets. It is constructed from 33 financial market indicators. The indicators are organized into five categories: (1) credit, (2) equity valuation, (3) funding, (4) safe assets, and (5) volatility.

The index measures systemwide stress. It is positive when stress levels are above average, and negative when stress levels are below average. Unlike financial stress indexes produced by others, the OFR’s FSI can be decomposed into contributions from each of the five categories. It also can be broken down by the region generating the stress.

The OFR’s FSI has other novel elements and methodology. It uses a dynamic process to account for changing relationships among the variables in the index. The daily frequency improves on the weekly or monthly frequency of other FSIs.

Today, the FSI shows that overall stress in the financial system is near its lowest level since the 2007-09 financial crisis. Extremely low volatility is the largest contributor to the low stress level. Low volatility may lead investors to take more risks. As discussed in the OFR’s recent Financial Markets Monitor, this behavior can make the financial system more vulnerable to shocks.

These Tools in Context: the OFR’s Monitoring and Assessment of Financial Stability

The FSVM and FSI are part of the OFR’s quantitative monitoring toolkit. They signal where the OFR needs to investigate potential stresses and vulnerabilities. We conduct those investigations using a broader set of data, qualitative information, and expert analysis. We then report our overall assessment of threats and systemwide risk in our Financial Stability Report and Annual Report.

Our process for monitoring, investigating, and reporting on changes in risks to financial stability includes:

• Quantitative Monitoring — Monitoring data on key features of the financial system and key indicators of vulnerability and stress.
• Qualitative Monitoring — Gathering intelligence and tracking news and outside analysis. This work complements and informs quantitative monitoring.
• Investigation and Assessment — Investigating potential threats identified in monitoring. Conducting a full assessment of financial system stability.

Richard Berner is the Director of the Office of Financial Research