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Is it Hot in Cleveland?

In 2007, the federal reserve bank of Cleveland began conceptualizing a "financial stress index" that would provide monthly readings on systemic pressures.

It was ready for testing by 2009-too late to warn anyone about the most recent financial crisis, but not a bad time to work on refinements to a tool intended to gauge the health of the markets.

The internal monitoring wrapped up this spring. Now, on the third Monday of every month, the Cleveland Fed offers its two cents on stress in the financial system, which was deemed "normal" in the last release before press time.

The Cleveland Fed Stress Index takes into account 11 variables within the credit, equity, currency and interbank markets. Weightings for each of the four sectors vary according to their relative sizes, which can change over time.

"There's always going to be some level of stress in the financial system," says Stephen Ong, vice president in the Cleveland Fed's banking supervision and regulation department. "But what's important is to understand the degree of stress that exists at any given time."

The index mainly comprises the type of data that can be expressed as spreads, such as the difference in yields on corporate and U.S. Treasury debt at various points along the yield curve. A widening spread between the yields of a top-rated corporate bond and of the 10-year U.S. Treasury, for instance, may indicate that businesses are having more difficulty financing their debt. That, in turn, can mean broader stresses in the markets.

The equity component of the index is designed to monitor stock market volatility. A key indicator there is a ratio of the current value of the Standard & Poor's 500 financial sector index relative to its high over the previous year. That's a data point that not only provides insight into how much equity values have risen or fallen during the period, but captures expectations about future conditions in the financial services industry.

In currency markets, the stress index monitors volatility by tracking the trade-weighted U.S. dollar exchange index, which measures the dollar's value relative to a broad set of currencies worldwide. Within the interbank sector, analysts are keeping a close watch on four key indicators in banking. They include the yield difference between the 10-year average A-rated bond and the 10-year Treasury note, as well as the interbank liquidity spread between three-month LIBOR and the three-month Treasury note.

There are four grades of stress within the Cleveland index. A reading of one indicates below-normal stress within the markets, while a reading of four would point to significant stress. Based on the Cleveland Fed's retroactive application of the index, the market impact of the 1998 collapse of Long Term Capital Management would have registered a reading of two, while the events of 2008 would have kept the stress measurement at a grade of four, all year long.

Other Fed district banks have developed systemic stress measurements.The Kansas City Fed was the first, with a monthly financial stress index that launched in 2009. The St. Louis Fed followed suit in 2010. That's a lot of data, but there's arguably high demand for it.

"You have to look at the interconnection of the institutions and the systemic risks as the focal point of the new world of regulation and supervision," says Fed watcher David Jones, president and CEO of DMJ Advisors, an economics consulting firm based in Denver.

The Dodd-Frank Act established the Office of Financial Research, which is charged with providing data and economic analysis to the Financial Stability Oversight Council, another Dodd-Frank creation intended to identify and control excessive risks in the financial system.

In its first annual report, the FSOC indicated it already sees some potential risks to stability. The list includes money-market funds. "We cannot predict the precise threats that may face the financial system," Treasury Secretary Timothy Geithner, who leads the 10-member FSOC, noted in the council's report. "The best way to prepare for this uncertainty is to continue to build the shock absorbers and safeguards that improve the resilience of the financial system."

And, of course, to monitor it all. Christopher Low, chief economist at FTN Financial in New York, says indices like the Cleveland Fed's are helpful in that regard. But a stress index is "not a replacement tool," he says. "Officials still have to watch everything."




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