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THE IMPACT OF SYSTEMIC FINANCIAL STRESS ON THE REAL ECONOMY: New evidence for Europe

Real economic stress lasts on average six months longer when it is associated with financial market stress. What''s more, the decline in GDP is on average three percentage points larger when it is associated with financial market stress.

These are among the findings of research by Thibaut Duprey, Benjamin Klaus and Tuomas Peltonen, to be presented at the Royal Economic Society''s annual conference in Brighton in March 2016.

Their study provides a new, model-based framework for a transparent and objective identification of systemic financial stress episodes. Applying this framework to 27 European Union (EU) countries, the authors identify 68 systemic financial stress episodes since 1964, which amounts to roughly 50% of all recessions.

By using this model, instead of relying on surveys of national experts (who may be biased), countries can get a better idea of when the economy is in trouble and what can be done to prevent future crises.

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It is widely agreed that the global financial crisis that started in 2007 was an episode of severe financial market stress, which spilled over to the real economy causing the Great Recession. But it is much more difficult to identify and classify other periods of, possibly systemic, financial market stress.

This study provides a new framework for a transparent and objective identification of systemic financial stress episodes beyond existing surveys of experts and apply it to the EU.

Methodology

The model-based framework consists of three steps:

• The financial cycle is captured by a simple country-specific financial stress index constructed for 27 EU countries starting as early as 1964 (Figure 1). Financial stress is defined as simultaneous financial market turmoil across a wide range of assets.

• Second, the non-linear model (Markov-switching) mechanically identifies periods where financial stress switches from low to high financial stress.

• Third, the researchers keep those financial stress events that coincide with a substantial and prolonged negative impact on the real economy (see red quadrant in Figure 2), namely GDP recessions with a drop in industrial production of at least six months.

Results

The researchers identify 68 systemic financial stress episodes for 27 EU countries. In Figure 3, systemic financial stress periods are in colours, while tranquil periods are in white. The intensity of real economic stress during each systemic financial stress period is represented by the colours and corresponds to the industrial production loss from peak to through.

The model-identified systemic financial stress events have three main features:

About 50% of recessionary events are classified as systemic, while the other half are not characterised by simultaneous financial market stress.

Real economic stress lasts on average six months longer when it is associated with financial market stress.

Decline in GDP is on average three percentage points larger when it is associated with financial market stress.

This chronology of crises is in line with the four major expert-based dataset available for Europe. For example, the approach captures between 100% and 89% of the banking crises identified by these experts.

Implications

A comprehensive and judgment-free analysis of the succession of tranquil and stress periods is crucial:

• First, the proposed approach limits the bias potentially arising when relying on expert judgment to identify financial crises.

• Second, the identification of good predictors of crises relies on the timing of past crises episodes.

• Third, the evaluation of the effectiveness of prudential policies aiming at preventing crises requires a sound and comparable definition of systemic crises across European countries.

''Dating Systemic Financial Stress Episodes in the EU Countries'' by Thibaut Duprey, Benjamin Klaus and Tuomas Peltonen (2015), ECB Working Paper No. 1873, (Appendix and Data).


Presenter at RES conference: Benjamin Klaus (European Central Bank) benjamin.klaus@ecb.int

Corresponding author: Thibaut Duprey (Bank of Canada) thibaut.duprey@gmail.com

 

Figure 1. Median and 10/90 percentile of the Financial Stress Index across EU-27 countries

Figure 2. Identifying systemic financial stress episodes

Figure 3. Chronology of systemic financial stress and real economic stress intensity across EU countries

Note: Periods for which no sufficient data was available are in light grey. The list of crises events is given in table B.5 of the article here, and the data is provided here.