![]() ![]() 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. Those beliefs may or may not be accurate assessments of true risk. The most important one is that because it is based primarily on market data, it reflects market participants’ beliefs about risk. There are limitations to keep in mind when interpreting the indicator. Data from 2000 to the present indicate that when the spread is less than 0.1 for more than two days it indicates stress, and if it stays below 0.5 for an extended amount of time, it indicates that the markets are signaling major stress about the banking system. 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. 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.įalling ADD or falling PDD indicates the market’s perception of rising average insolvency risk in the banking sector. The portfolio distance-to-default (PDD) is a similar measure that is based on options on a weighted portfolio of the same 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 average distance-to-default (ADD) reflects the market’s perception of the average risk of insolvency among a sample of approximately 100 US banks. 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. 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 SRI then compares the difference, or spread, between the two. The method of computing the SRI starts with calculating two measures of insolvency risk, one an average of default risk across individual banking institutions (average distance-to-default) and the other a measure of risk for a weighted portfolio of the same institutions (portfolio distance-to-default). To compute the indicator, we follow the method in Saldías (2013) and use data on US banks and financial intermediaries. Specifically, the indicator is designed to capture market perceptions of the risk of widespread insolvency in the banking system. The Cleveland Fed provides a systemic risk indicator to gauge the level of systemic risk in the US financial services industry.
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