Manfred Kremer

CISS - A Composite Indicator of Systemic Stress in the Financial System

This paper introduces a new indicator of contemporaneous stress in the financial system named Composite Indicator of Systemic Stress (CISS). Its specific statistical design is shaped according to standard definitions of systemic risk. The main methodological innovation of the CISS is the application of basic portfolio theory to the aggregation of five market-specific subindices created from a total of 15 individual financial stress measures. The aggregation accordingly takes into account the time-varying cross-correlations between the subindices. As a result, the CISS 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 thus more dangerous for the economy as a whole if financial instability spreads more widely across the whole financial system. Applied to euro area data, we determine within a threshold VAR model a systemic crisis-level of the CISS at which financial stress tends to depress real economic activity. Weekly updates of the CISS dataset at: sdw.ecb.europa.eu/browseSelection.do?node=9551138 JEL Classification: G01, G10, G20, E44

Melting Down: Systemic Financial Instability and the Macroeconomy

We integrate systemic financial instability in an empirical macroeconomic model for the euro area. We find that at times of widespread financial instability the macroeconomy functions fundamentally differently from tranquil times. We employ a richly specified Markov-Switching Vectorautoregression model to capture the dynamic relationships between a set of core macroeconomic variables and a novel indicator of systemic financial stress. Both the parameters that capture the transmission of shocks through the economy and the variances of the shocks change at times of high stress in the financial system. In particular, the negative output effects of sizeable increases in financial stress are much larger after such a regime change than during tranquil times. Macroprudential and monetary policy makers are well advised to take these nonlinearities into account.

What Do Asset Price Movements in Germany Tell Monetary Policy Makers

Asset prices can play a twofold role in monetary policy. First, they may be seen as important elements in the chain along which monetary policy stimuli are transmitted to the real economy. From this perspective, asset price movements cause changes in aggregate demand or the price level through substitution, income and wealth effects. If these structural relationships were stable and could be estimated reliably, asset prices could be used as indicators of, or even target variables for, monetary policy. Second, they may be seen as predictors of the future course of the economy, independently of their active role in the transmission process. This view does not depend on the causal influence of asset prices on the macroeconomic variables to be predicted. Instead, it takes due account of the fact that the price of rationally valued assets should reflect the expected path of the asset’s income components and the equilibrium returns used for discounting the future stream of income. If these expectations were influenced by the anticipated development of certain macroeconomic fundamental factors, and if, furthermore, market expectations were not systematically biased, asset prices could be used by the central bank as predictors of real activity and inflation. The monetary policy implications of both roles depend crucially on the informational efficiency of asset markets. Market inefficiencies would cause asset prices to deviate from their fundamental values, distorting their informational content and their indicator quality. Furthermore, if asset prices play an important role in the transmission process, mispricing may adversely affect economic activity and price stability. The main body of this paper is devoted to assessing the predictive power or the informational content, respectively, of dividend yields and the term structure spread to draw some preliminary conclusions about the efficiency of the stock and government bond markets in Germany. The theoretical framework is provided by the rational valuation approach. Applied to the bond market and the stock market, this approach leads to the expectations hypothesis and the dividend discount model, respectively, both on the assumption of rational expectations. The informational content is judged by metrics from univariate regression techniques using short and long-horizon measures for future inflation, stock returns, dividend growth, and interest rate changes as dependent variables and the spread or the dividend yield as regressors. The paper closes with some implications of the results for monetary policy.

Do Term Premia Affect the Predictive Power of the German Yield Curve for Future Economic Activity

This paper presents and further analyses estimated term premia for Germany as the largest euro area country. The term premia are estimated within an affine arbitrage-free term structure model with two latent factors. Survey data help anchor model-implied long-horizon expectations for interest rates which have a large bearing on estimated term premia at the long-end of the yield curve in particular. The results suggest that term premia embedded in long-term interest rates displayed some cyclical variations over time. Moreover, term premia experienced a trend decline over the sample considered (1973 to 2006), but in particular since the mid-1990s. Hence, it may principally be important to take term premia developments explicitly into account when assessing the information content of the yield curve for future economic conditions or market expectations of future short-term interest rates, for example. This paper analyses empirically whether and to which extent term premia affected the predictive power of the slope of the yield curve for economic activity in Germany.

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

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.