Electronic copy available at: http://ssrn.

com/abstract=1914862

1
SAFE:AnEarlyWarningSystemforSystemicBankingRisk
MikhailV.Oet
1
,RyanEiben
2
,TimothyBianco
3
,DieterGramlich
4
,StephenJ.Ong
5
,andJingWang
6
*
Originalversion:December2009
Thisversion:August242011
Abstract
Fromthefinancialsupervisorspointofview,anearlywarningsysteminvolvesanexanteapproachtoregulation,
targetingtopredictandpreventcrises.AnefficientEWSallowstimelyexantepolicyactionandcanreducetheneedfor
expostregulation.Thispaperbuildsonexistingmicroprudentialandmacroprudentialearlywarningsystems(EWSs)to
proposeahybridclassofmodelsforsystemicriskincorporatingthestructuralcharacteristicsofthefinancialsystemand
feedbackamplificationmechanism. Themodelsexplainfinancialstressusingdatafromfivelargestbankholding
companies,regressinginstitutionalimbalancesusinganoptimallagmethod. Zscoresofinstitutionaldataarejustifiedas
explanatoryimbalances. Themodelsutilizebothpublicandproprietarysupervisorydata.TheSAFEEWSmonitorsmicro
prudentialinformationfromsystemicallyimportantinstitutionstoanticipatebuildupofmacroeconomicstressesinthe
financialmarketsatlarge.Tothesupervisor,SAFEpresentsatoolkitofpossibleinstitutionalsupervisoryactionsthatcan
beusedtodiffusethebuildupofsystemicstressinthefinancialmarkets.Ahazardinherentforallexantemodelsis
thatthemodeluncertaintymayleadtowrongpolicychoices.Tomitigatethisrisk,SAFEdevelopstwomodeling
perspectives:asetofmediumterm(sixquarter)forecastingspecificationstoallowthepolicymakerssufficienttimefor
exantepolicyaction,andasetofshortterm(twoquarter)forecastingspecificationsforverificationandadjustmentof
supervisoryactions.IndividualfinancialinstitutionsmayutilizepublicversionofSAFEEWStoenhancesystemicrisk
stresstestingandscenarioanalysis.ThepapershowseconometricresultsandrobustnesssupportfortheSAFEsetof
models.Discussionofresultsaddressesusabilityandtestsofusefulnessofsupervisorydata. Inaddition,thepaper
investigatesandsuggestslevelsforactionthresholdsappropriateforthisEWS.

Keywords: Systemicrisk,earlywarningsystem,financialstressindex,microprudential,macroprudential,structural
characteristics,feedback,liquidityamplification,contagion.

JELclassification: G01,G21,G28,C25,C53

1
Economist,FederalReserveBankofCleveland.Email:mikhail.oet@clev.frb.org
2
Ph.D.candidateinEconomics,IndianaUniversityBloomington(formerly,EconomicConsultant,FederalReserveBankofCleveland.Email:reiben@indiana.edu)
3
EconomicAnalyst,FederalReserveBankofCleveland.Email:timothy.bianco@clev.frb.org
4
ProfessorofBanking,BadenWuerttembergCooperativeStateUniversity.Email:gramlich@dhbwheidenheim.de
5
VicePresident,RiskSupervisionandPolicyDevelopment,FederalReserveBankofCleveland.Email:stephen.ong@clev.frb.org
6
DBAcandidateinFinance,ClevelandStateUniversity,EconomicConsultant,FederalReserveBankofCleveland.Email:jing.wang@clev.frb.org
* TheviewsexpressedinthispaperarethoseoftheauthorsandnotnecessarilythoseoftheFederalReserveBankofCleveland,theBoardofGovernors,orthe
FederalReserveSystem.
TheauthorswouldliketothankJosephHaubrich,BenCraig,andMarkSchweitzerforconstructiveguidance.Wearealsogratefultothefollowingpeoplewhohave
providedvaluablecomments:MarkSniderman,JamesThomson,TobiasAdrian,ViralAcharya,JohnSchindler,JonFrye,EdPelz,CraigMarchbanks,andAdrianDSilva.
Wewouldalsoliketoacknowledgeconstructivecommentsbytheparticipantsof2010DeutscheBundesbank/TechnischeUniversitatDresden,BeyondtheFinancial
Crisisconference,particularlyAndreasJobstandMarcellaLucchetta,2010CommitteeonFinancialStructureandRegulation,particularlyGustavoSuarezandWilliam
Keeton,2010FederalRegulatoryInteragencyRiskQuantificationForum,particularlyStevenBurton,WilliamLang,EvanSekeris,ChristopherHenderson,andScott
Chastain;feedbackbytheResearchseminarparticipantsattheFederalReserveBankofCleveland,aswellasbytheparticipantsoftheRiskCentralBankingNewYork
seminaronManagingSystemicRiskinFinancialInstitutions,FederalReserveBankofChicago2009CapitalMarketsConference,andtheNBERFRBCleveland
ResearchConferenceonQuantifyingSystemicRisk.Inaddition,wewouldliketothankthefollowingpeoplefordata,researchassistance,andhelpfulinsights:Chris
Lentz,TinaRicciardi,JuanCalzada,JasonAshenfelter,JuliePowell,andKentCherny.
Electronic copy available at: http://ssrn.com/abstract=1914862

Contents
(1)Introduction...................................................................................................................................................................3
(2)EWSelements................................................................................................................................................................5
(2.1)Measureforfinancialstressdependentvariabledata......................................................................................6
(2.2)Driversofriskexplanatoryvariablesdata..........................................................................................................7
(3)Riskmodelandresults...................................................................................................................................................7
(3.1)EWSmodels............................................................................................................................................................7
(3.2)Criteriaforvariableandlagselection.....................................................................................................................9
(3.3)EWSmodelspecificationsandresults..................................................................................................................11
(4)Discussionandimplications.........................................................................................................................................13
(4.1)PerformancesupervisoryEWSvs.publicEWS...................................................................................................13
(4.2)Applicationstosupervisorypolicy........................................................................................................................14
(5)Conclusionsandfuturework.......................................................................................................................................18
(6)References...................................................................................................................................................................20
(7)TablesandFigures.......................................................................................................................................................23
(8)Appendix......................................................................................................................................................................37
Electronic copy available at: http://ssrn.com/abstract=1914862

3
SAFE:AnEarlyWarningSystemforSystemicBankingRisk
(1)Introduction
Theobjectiveofthisstudyistodevelopanearlywarningsystemforsystemicbankingriskidentificationthatprovides
policymakersandsupervisorstimetopreventormitigateapotentialfinancialcrisis. Forecastingtheonsetofand,
perhaps,alleviatingthepressuresthatleadtosystemiccrisesisimportantbecausesucheventsproveeconomicallyand
sociallycostly,requiringsignificanttimetoreverse(Honohan,etal.,2003).CurrentUSsupervisorypolicytoolkit
includesseveralearlywarningmodelsforflaggingdistressinindividualinstitutions,yetlacksatoolforidentificationof
systemiclevelbankingdistress.
9

Gramlich,Miller,Oet,andOng(2010)reviewtheoreticalfoundationsfortheearlywarningsystems(EWSs)forsystemic
bankingriskandclassifytheexplanatoryvariablesappearinginsystemicriskEWSliterature(seeTable1).EWS
precedentstypicallyseektofindthebestmodelamongthesetofrelationshipsdescribingtheinteractionofthe
dependentvariableandtheexplanatoryvariables.Thetheoreticalprecedents
10
typicallyviewemergenceofsystemic
riskfromtheaggregatedeconomicimbalances.Theimbalancesmayfromtimetotimeresultincorrectingshocks.The
prevalentview
11
isthatsystemicfinancialriskisthepossibilitythatashockeventtriggersanadversefeedbackloopin
thefinancialinstitutionsandmarketswhichsignificantlyimpactstheirabilitytoallocatecapitalandserveintermediary
functions,thereby,generatingspillovereffectsintotherealeconomywithnoclearselfhealingmechanism.
IllingandLiu(2003and2006)expressausefulconsensustheorythat,ingeneral,thefinancialsystemsexposuremay
derivefromdeterioratingmacroeconomicconditionsandmoreprecisely,fromdivergingdevelopmentsinthereal
economicandfinancialsectors,shocksinsidethefinancialsystem,banksidiosyncraticrisks,andcontagionamong
institutions.Hence,systemicriskis
initiatedbyprimaryriskfactorsand
propagatedbymeansofmarketsstructuralcharacteristics.
12

HanschelandMonnin(2005)
13
providethemostdirecttheoreticalandmethodologicalprecedentforthepresentstudy
inapplyingaregressionapproachtoestimateamodelwhichregressesasystemicstressindexonthekobserved
standardizedpastimbalances
14
ofexplanatoryvariables.Intheirstudy,onlyoneoptimallagischosenforeach
explanatoryvariable.Theexplanatoryvariablesareconstructedasstandardizedimbalancesequaltothedistance
betweenalevelandmeanvalueoftherespectivevariablesattimeuptotimetdividedbythestandarddeviationup
timet.Implicitinthisapproachisanassumptionthatthetrendservesasaproxyforthelongertermfundamental
valueofavariable,aroundwhichtheactualseriesfluctuates(Hanschel,etal.,2005).
InsertTable1abouthere

Gramlichetal.(2010)reviewthelimitationsofexistingapproachestoEWSswhenappliedtosystemicrisk:
microprudentialEWSmodelscannot,becauseoftheirdesign,provideasystemicperspectiveondistress;forthesame

9
ExamplesofcurrentU.S.supervisoryearlywarningsystemsincludeCanary(OfficeoftheComptrolleroftheCurrency)andSR
SABR(FederalReserve),whichstrivetoidentifybanksinanearlystageofcapitaldistress.AnoverviewofEWSsformicroriskis
presentedbyGaytnandJohnson(2002,pp.2136),andKing,Nuxoll,andYeager(2006,pp.5865).Jagtianietal.(2003)test
thevalidityofthreesupervisorymicroriskEWSs(SCOR,SEER,Canary)empirically.
10
ParticularlyCallen(1991),Borioetal.(1994),BorioandLowe(2002,Assetand2002,Crisis),BorioandDrehmann(2009).
11
GroupofTen(2001)
12
IllingandLiu(2006),p.244,postulatethatfinancialstressistheproductofavulnerablestructureandsomeexogenousshock.
13
ConstructionofacontinuousindexiswelldescribedinIllingandLiu(2006),pp.250256,andHanschelandMonnin(2005),pp.
432438.
14
HanschelandMonnincalltheseimbalancesgapsfollowingtraditionestablishedbyBorioandcolleagues.

4
reason,macroprudentialEWSmodelscannotprovideadistresswarningfromindividualinstitutionsthataresystemically
importantorfromthesystemsorganizationalpattern.Theauthorsarguethatthearchitectureofthesystemicrisk
EWScanovercomethefundamentallimitationsoftraditionalmodels,bothmicroandmacroandshouldcombine
boththeseclassesofexistingsupervisorymodels.Recentsystemicfinancialcrisesshowthatpropagationmechanisms
includestructuralandfeedbackfeatures.Thus,theproposedsupervisoryEWSforsystemicriskincorporatesboth
microprudentialandmacroprudentialperspectives,aswellasthestructuralcharacteristicsofthefinancialsystemand
feedbackamplificationmechanism.
ThedependentvariablefortheproposedSAFEEWS
15
isdevelopedseparatelyasafinancialstressindex.
16
Themodelsin
theSAFEEWSexplainstressindexusingdatafromfivelargestbankholdingcompanies,regressinginstitutional
imbalancesusinganoptimallagmethod.Zscoresofinstitutionaldataarejustifiedasexplanatoryimbalances.The
modelsutilizebothpublicandproprietarysupervisorydata.ThepaperprovidessomediscussionofhowtousetheEWS
andteststoseeifsupervisorydatahelps.Inaddition,thepaperinvestigatesandsuggestslevelsforactionthresholds
appropriateforthisEWS.
Tosimulatethemodels,weselectnotonlytheexplanatoryvariablesbutalsotheoptimallags,buildingonand
extendingprecedentideasfromliteraturewithourowninnovations.Mostofthelagselectionresearchemphasizesthe
importantcriteriaofgoodnessoffit,variablesstatisticssignificance(tstatistics),causality,etc.HanssensandLiu(1983)
presentmethodsforthepreliminaryspecificationofdistributedlagsinstructuralmodelsintheabsenceoftheoryor
information.Davies(1977)selectsoptimallagsbyfirstincludingallpossiblevariablelagschosenbasedontheoretical
considerations.DavisfurthernarrowsthelagselectionbybestresultsintermsoftstatisticsandR
2
.HolmesandHutton
(1992)andLeeandYang(2006)introducetechniquesofselectingoptimallagsbyconsideringcausality.Bahmani
OskooeeandBrooks(2003)demonstratethatwhengoodnessoffitisusedasacriterionforthechoiceoflaglengthand
thecointegratingvector,thesignandsizeoftheestimatedcoefficientsareinlinewiththeoreticalexpectations.
Jacobson(1995)slagstructureinVARmodelsisbasedontestsonresidualautocorrelationandWinker(2000)uses
informationcriterialikeAICandBICascriteria.MurrayandPapell(2001)chosethefollowinglaglengthk
j
selection
methodforsingleequationmodels.Theystartwithanupperboundk
max
onk.Ifthetstatisticonthecoefficientofthe
lastlagissignificantat10%valueoftheasymptoticdistribution(1.645),thenk
max
=k.Ifitisnotsignificant,thenkis
loweredbyone.Thisprocedureisrepeateduntilthelastlagbecomessignificant.
Recentresearchfocusesonautomationproceduresforoptimallagselection.DueckandScheuer(1990)applya
heuristicglobaloptimizationalgorithminthecontextofanautomaticselectionprocedureforthemultivariatelag
structureofaVARmodel.Winker(1995)andWinker(2000)developanautomaticlagselectionmethodasadiscrete
optimizationproblem.MaringerandWinker(2004)proposeamethodforautomaticidentificationofthedynamicpart
ofVECmodelsforthemodelingofeconomicandfinancialtimeseriesandaddressthenonstationaryissues.They
employamodifiedinformationcriteriondiscussedbyChaoandPhillips(1999)forthecaseofpartiallynonstationary
VARmodels.Inaddition,theyallowforholes"inthelagstructures,i.e.lagstructuresarenotconstrainedtosequences
oflagsuptolagk,butmightconsist,e.g.,ofthefirstandfourthlagonlyinanapplicationtoquarterlydata.Usingthis
approach,differentlagstructurescanbeusedfordifferentvariablesandindifferentequationsofthesystem.Borbly
andMeier(2003)arguethatestimatedforecastintervalsshouldaccountfortheuncertaintyarisingfromselectingthe
specificationofanempiricalforecastingmodelfromthesampledata.Toallowthisuncertaintytobeconsidered
systematically,theyformalizeamodelselectionprocedurethatspecifiesthelagstructureofamodelandaccountsfor
aberrantobservations.Theprocedurecanbeusedtobootstrapthecompletemodelselectionprocesswhenestimating
forecastintervals.Sharp,JeffressandFinnigan(2003)introducetheLagoMatic,aSASprogramthateliminatesmany
ofthedifficultiesassociatedwithlagselectionformultiplepredictorvariablesinthefaceofuncertainty.Theprocedure
(1)lagsthepredictorvariablesoverauserdefinedrange;(2)runsregressionsforallpossiblelagpermutationsinthe
predictors;(3)allowsuserstorestrictresultsaccordingtouserdefinedselectioncriteria(e.g.,facevalidity,significant
ttests,R
2
,etc.).LagoMaticoutputgenerallycontainsalistofmodelsfromwhichtheresearchercanmakequick
comparisonsandchoices.

15
Collectively,thesetofmodelsisconsideredtoformasupervisoryEWSframeworkcalledSAFE,shortforSystemicAssessmentof
FinancialEnvironment.
16
OetandEiben(2009,2011).

5
TheSAFEEWSmodelsarebasedonhighqualitydata.Thedependentdataishighfrequencywithover5000daily
observations,leadingtotheconstructionofaquarterlydependentvariableseries.MostdatacomesfromBloomberg
andFRED,supplementedbytheBankofEnglanddata.Theexplanatorydatacomesfrom77quarterlypanelsfrom1
st

quarter1991to3
rd
quarter2010.Welookattoptierhistoricaltop20bankholdingcompaniesandaggregatetopfiveof
theseasaproxyforagroupofsystemicallyimportantinstitutions.Wespecifythemodelusing50insamplequarters.A
largecomponentofdatacomesfrompublicsources:mostlyfromtheFederalReserveSystem(FRS)microdatafromthe
bankholdingcompaniesandtheirbanksubsidiaries.ThepublicFederalReservedataissupplementedbyadditional
goodqualitysourcesaccessibletothepublicsuchasS&PCaseShillerandMITRealEstateCenter(forthereturndata),
Compustatdatabases(forsomestructuraldata),andMoodysKMV(forsomeriskdata).Wealsoreplicatedatafrom
somepubliclydisclosedmodelsanddatasets,forexampletheCoVaRmodel
17
andtheFlowofFundsdata.Inaddition,
foreachofthefourclassesofexplanatoryimbalances,wedependtosomeextentonprivatesupervisorydata.Our
privatedatasetconsistsofdatathatisnotdisclosedtothepublicortheresultsoftheproprietarymodelsdevelopedat
theFederalReserve.Examplesofprivatedatasetsarethecrosscountryexposuresdata,supervisorysurveillance
models,aswellasseveralsubmodelsdevelopedspecificallyforthisEWS.
18
Additionaldatadescriptionsareprovidedin
Box1intheAppendix.DatasourcesfortheexplanatoryvariablesareshowninTable15.
19
Thedefinitions,theoretical
expectations,andGrangerCausalityofexplanatoryvariablesaresummarizedinTable16throughTable19.
Therestofthispaperisstructuredasfollows.Insection2wediscusstheconceptualorganizationofelementsofthe
systemicbankingriskEWS.Section3discussesmethodologyoftheSAFEEWSmodelsandtheresults.Section4
discussestheresearchimplicationsandcasestudiesbasedonourmodels.Section5concludesbydiscussionof
interpretationsanddirectionsforfurtherpursuit.
(2)EWSelements
TheelementsofanEWSaredefinedbyameasureforfinancialstress,driversofrisk,andariskmodeltocombineboth.
Asameasureofstress,SAFEEWSusesthefinancialmarketsstressseriesbyOetandEiben(2009,2011).Thispaper
contributesanewtypologyforthedriversofriskintheEWS.Riskmodelappliesaregressionapproachtoexplainthe
financialmarketsstressindexusingoptimallylaggedinstitutionaldata.
Ourbasicconjecturesarethatsystemicfinancialstresscanbeinducedbyassetimbalancesandstructuralweakness.
Wecanviewtheimbalancesasthedeviationbetweenassetexpectationsandtheirfundamentals.Thelargerthe
deviation,thegreateristhepotentialshock(seeFigure1below).Therefore,systemicfinancialstresscanbeanticipated
toincreasewiththeriseinimbalances.
InsertFigure1abouthere

Thesecondconjectureisthatstructuralweaknessinthefinancialsystemataparticularpointintimeincreasessystemic
financialstress.Toillustrate,considerthefollowingfinancialsystemasanetworkoffinancialintermediaries.The
financialsystemischaracterizedbyanabsenceofconcentrationsandiswelldiversified. Individualinstitutionsare
interconnectedtomultiplecounterpartiesofvaryingsizesacrossthesystem. Thissystemsentitiesareofvaryingsizes,
somequitelargeandsignificant,someintermediate,andsomesmall. Afailureofoneinstitution,evenalargeone,will
resultinseveranceofseriesofconnectionsandlocalstress. Thisfailure,however,haslimitedpotentialtoinduce
systemicstressbecauseofthegreatnumberofnetworkredundanciesandcounterpartiesthatcantakeupthisstress.
Suchasystemhasinherentlystrongbalancingability.
Bycomparison,consideranalternativefinancialsystem.Here,individualinstitutionsareconcentratedinparticular
markets,interconnectedinlimitedwaysviaasmallnumberofintermediaries.Inthissystem,certainfinancial

17
AdrianandBrunnermeier(2008,2009).
18
Theliquidityfeedbackmodelandthestresshaircutmodel.
19
Toconservespace,thetablesshowonlyinformationfortheexplanatoryvariablesthatultimatelyentertheSAFEmodel.

6
intermediariesactashighlyinterconnectedgatekeepers,dominatingcertainmarkets(institutionalgroups).Market
accessacrossthissystemforlessconnectedinstitutionsisonlypossiblethroughthesefewsignificantgatekeeper
institutions.Likethepreviousexample,thissystemisalsocharacterizedbyinstitutionsofvaryingsize.However,herea
limitednumberofinstitutionsdominateparticularmarketsandsomeinterlinktheentirenetwork.Thenumberof
structuralredundanciesinthissystemissmallerandperhapsminimalinsomemarkets.Afailureorhighstress
experiencedbyoneofthemoredominantinstitutionsinaparticularmarketcannotbeaseasilysustainedandthereby
increasespotentialforsystemicrisk.Inthissystem,afailureofoneofthegatekeeperinstitutionsthatinterlinks
severalmarketscanbecatastrophicleadingtoacollapseofamarketorevenofthesystem.Therefore,thissystemis
lesstolerantofstressandfailureofoneparticularsignificantmarketplayer.
TheconjectureofimportanceofstructuralcharacteristicsissupportedbyempiricalevidencediscussedinGramlichand
Oet(2011). Briefly,loanexposuresofUSbanksformahighlyheterogeneousstructurewithdistincttiering. The
structuralheterogeneityisclearlyobservedbothloantypeexposures(Figure2)andfinancialmarketsconcentrationsof
topfiveUSBHCs(Figure3).
InsertFigure2abouthere

InsertFigure3abouthere

(2.1)Measureforfinancialstressdependentvariabledata
BuildingonresearchprecedentbyIllingandLiu,inOetandEiben(2009,2011)wedefinesystemicriskasthecondition
whenobservedmovementsoffinancialmarketcomponentsreachcertainthresholdsandpersist.There,wedevelopthe
financialstressindexintheUS(CFSI
21
)asacontinuousindexconstructedofdailypublicmarketdata.Tobecertainthat
aversatileindexofstresshasbeenidentified,theresearcheraimstorepresentaspectrumofmarketsfromwhichstress
mayoriginate.Aspreviousresearchinthisfieldattests,conditionsincredit,foreignexchange,equity,andinterbank
marketsprovidesubstantialcoverageofpotentialstressorigination.TheCFSIusesdynamicweightingmethodanddaily
datafromthefollowingelevencomponents:1)financialbeta,2)bankbondspread,3)interbankliquidityspread,4)
interbankcostofborrowing,5)weighteddollarcrashes,6)coveredinterestspread,7)corporatebondspread,8)
liquidityspread,9)commercialpaperTBillspread,10)treasuryyieldcurvespread,11)stockmarketcrashes.Thedata
issourcedfromBloombergandtheFederalReserveFREDdatabase.
22

Itisimportanttonotethatin2008,atthetimeofSAFEEWSdevelopment,noseriesonfinancialstressintheUnited
Statesexisted.Interestingly,asof2010,12alternativefinancialstressindexesareavailable.ThecomparisonofCFSI
withalternativefinancialstressseriesisdiscussedinOetandEiben(2009,2011).
23

Thefinancialstressseries
t
intheSAFEEWSisconstructedseparatelyasCFSI
qt
,aquarterlyfinancialmarketsstress
index.Mathematically,thefinancialstressseriesisconstructedas:

t
CFSI
qt
|w
]t
] (z
]t
)Jz
]t
z
]
-
]
]
1uu

(1)

Here,eachofjcomponentsoftheindexisobservableinthemarketswithhigh(daily)frequencybutresultsina
quarterlyseriesoffinancialstress.z
]t
isanobservedvalueofmarketcomponentjattimet .Thefunction(z
]t
)isthe
probabilitydensityfunctionthattheobservedvaluewillliebetweenz
]t
andz
]t
+Jz
]t
.Theintegralexpression
] (z
]t
)Jz
]t
z
]
-
isthecumulativedistributionfunction(cdf)ofthecomponent z
]t
givenasasummationoftheprobability
densityfunctionfromthelowestobservedvalueinthedomainofmarketcomponentjtoz
]
.Thecdfdescribesthe
precedentsetbythecomponentsvalueandhowmuchthatprecedentmatters.Thew
]t
termistheweightgivento

21
[FederalReserveBankof]ClevelandFinancialStressIndex
22
SeeOet,Eiben(2011)fordescriptionofspecificCSFIdatasources.
23
Oet,Eiben(2009)discussesinitialCFSIconstruction.Oet,Eiben,(2011)includescomparisonswithalternativeindexes.

7
indicatorjintheCFSI
qt
attime t.Thekeytechnicalchallengeintheconstructionandvalidationofthefinancialstress
seriesisthechoicefortheweightingmethodology.Inefficientchoiceoftheweightingmethodologywouldincreasethe
potentialforfalsealarmsgivenbytheseries.Seekingtominimizethefalsealarms,wewereagnostictothechoiceof
weightingtechniqueandtestedanumberofmethods,includingtheprincipalcomponentanalysis.Theapproach
ultimatelyselectedtominimizefalsealarmsisthecreditweightsmethodasexplainedinOetandEiben(2009,2011).
(2.2)Driversofriskexplanatoryvariablesdata
ToadvancefromthesepremiseswecomeupwithamethodologythatusesZscorestoexpresstheimbalances.We
defineanimbalanceX
t
asdeviationsofsomeexplanatoryvariableX
t
fromitsmean.Weconstructitasastandardized
measure.Thatis,eachX
t
explanatoryvariableisaggregated,deflated(typicallybypricebasedindex),demeaned,and
dividedbyitscumulativestandarddeviationattimet.TheresultingZscoreisdesignated X
t
.ByconstructionX
t

describesimbalanceasthedistanceinstandarddeviationsfromthemeanoftheX
t
explanatoryvariable.X
t
imbalance
showspotentialforstress.ThedetailsofvariableconstructionaresummarizedinAppendixBox2.
SAFEEWSbuildsontheexistingtheoreticalprecedentsofTable1withanewtypologyofthesystemicriskEWS
explanatoryvariables,giveninTable2.Thedefinitions,theoreticalexpectationsandGrangerCausalityofexplanatory
variablesaresummarizedinTable16throughTable19.
InsertTable2abouthere

(3)Riskmodelandresults
Therearemanywaystoapproachamodelsuchasthis.Generally,wecanexpectthatexplanatoryvariablesdonotact
atapointintime,butareinfactdistributedintime.Theestimationbecomesverydifficultparticularlywhenthe
numberofobservationsissmallrelativetothenumberofvariables.Inpreferencetothedistributedestimation,an
optimallagapproachisusedinpractice.SAFEEWSconsistsofanumberofmodelsthatareeachanoptimallaglinear
regressionmodeloftraditionalform

t
= [
0
+ [
RL1
X
RL1,t-n
RET
+ [
RSK
X
RSK,t-n
RSK
+ [
LI
X
LI,t-n
LIQ
+[
S1R
X
S1R,t-n
STR
+ u
t
(2)
wherethedependentvariableY
t
isconstructedseparatelyasaseriesofsystemicstressintheU.S.financialmarkets,
andtheindependentvariablesX
k,t-n
k
aretypesofreturn,risk,liquidity
24
,andstructuralimbalancesaggregatedforthe
topfiveUSBankHoldingCompanies.
(3.1)EWSmodels
Basedonthepremisethatfinancialstresscanbeexplainedbyimbalancesinassetsandstructuralfeaturesofthe
system,whatarethepossibleimbalancestoriesthatcanbeproposed?Atthemostbasiclevelandwithoutanyother
information,onecanexpectthatfinancialstressatapointintimemayberelatedtopaststress.Indeed,ausefulfinding
formodeldevelopmentwasthattheFinancialStressIndexappearedtobeanautoregressiveprocess,consistingofa
singlelagandaseasonallagofthefinancialstressseriesitself.Tothiseffect,theunderlyingARstructureofFSIformsa
benchmarkmodelonwhichtheresearcherhopestoimprove.Anymodelbasedonacredibleimbalancestoryshould
outperformthisnaivebenchmarkmodelovertime.ThegeneralstrategyforconstructingtheEWSmodels,then,would
betoidentifyotherexplanatoryvariablesthatimprovetheFSIforecastoverthebenchmark.
Fromadesignperspective,ahazardinherentforallexantemodelsisthatthemodeluncertaintymayleadtowrong
policychoices.Tomitigatethisrisk,SAFEdevelopstwomodelingperspectives:asetoflonglag(sixquartersandabove)
forecastingspecificationstoallowthepolicymakerssufficienttimeforexantepolicyaction,andasetofshortlag
forecastingspecificationsforverificationandadjustmentofsupervisoryactions.

24
Sinceweviewimbalancesasdeviationsfromfundamentalexpectations,wechoosetofurtherclassifytheassetimbalancesas
return,risk,andliquidityimbalances.Theclassificationisbasedonatypologyofthedemandforfinancialassetsasfunctionof
return,risk,andliquidityexpectations(Mishkin1992).

8
Thetwomodelingperspectiveshavedistinctlydifferentfunctionsandleadtodifferentmodelforms.Theshortlag
modelsfunctiondynamically:theyseektoexplainstressintermsofrecentobservationsofstressandinstitutional
imbalancesthattendtoresultinfinancialstressrelativelyquicklyandwithashortlead.Thelonglagmodelsseekto
explainthebuildupoffinancialstresswellinadvance,intermsofinstitutionalimbalancesthattendtoanticipatestress
withalonglead.Bycontrastwithshortlagmodels,theAR1andAR4benchmarkcomponentscannotenterthelonglag
models,asthesefocusoninformationlaggedatleastsixquarters.Forthelonglagmodels,theresearchermust
determineareasonablesetofvariablestoformalonglagbasemodelwithouttheaidofabenchmarkmodel.
Toproceed,wefirstestablishparsimoniousbasemodelsfortheshortlagandlonglaghorizonsthatoutperformthe
naivebenchmarkingmodelandroughlyexplainfinancialstressinsample.Thesebasemodelsdescribecoreimbalance
storiesrelevanttoeachtimehorizon.WethenseektoestablishspecificEWSmodelsthatmaytelladditionalstoriesof
imbalancesinrisk,return,liquidity,andstructureandfurtheroutperformtherespectivebasemodels.Theparticular
imbalancestoriesmaydifferacrossmodels.Inthisstudy,foreachofthetwoforecastinghorizons,weformeight
specificationsthatrepresentamixoftheexplanatoryvariables.Eachofthesemodelsrepresentssomeversionofthe
extensionofthecorestory.
25

Acandidatebasemodel
Wecanproceedtoaparsimoniouscandidatebasemodelbyseekingtoformacorestory,composedfromsetof
imbalancesthathaveastrongandconsistentrelationshipwithfinancialstress.Consideringinstitutionalandstructural
data,whataresomeofthecandidatevariablesthatmaypossessthesedesirableexplanatorypowers?Infact,theseries
consideredearlierinFigure1showfourgoodcandidates.Amongthereturnimbalances,agoodcandidateshouldbe
equity.Wewouldexpecttherelationshiptobepositivewiththesystemicfinancialstress.Amongtheriskimbalances,a
stronghedging(negative)relationshipshouldbethroughimbalancesincreditrisk.Ontheliquidityside,apositive
influenceshouldbetheassetliabilitymismatch.Amongthestructuralimbalances,leverageshouldprovideastandard
positiverelationship.
Thelogicforthesignexpectationsoftheabovesamplechoicesofcandidateimbalancesmaygoasfollows.Forthe
returnimbalances,equityforindividualinstitutionsactsasbufferagainstpotentialcreditlosses,butalsoincreases
downsiderisk.Consideringzscoresoftheseriesinrealterms(deflatedbyCPI),thelargeristhechangethelargeris
thedifferencebetweenthelongtermequityreturnexpectationsandCPI.Thisreflectsgreaterdownsiderisk.Thus,
increaseintherealequityshouldbepositivelyrelatedtosystemicfinancialstress.
Amongtheriskimbalances,thestandardnegativevariableshouldbecreditrisk.Measuredasdistancebetweennormal
andstressedrequiredcreditcapital,thisimbalancereflectsthehedgingfunctionofcapital.Thelessthedistanceata
particularpointintime,themoreisthepotentialforsystemicstress.Thus,ariseinthisdistancemeasureshould
negativelyrelatetothesystemicfinancialstress.
Amongliquidityimbalances,weexpectthatthatassetliability(AL)mismatchshouldpositivelyreflectgreatersystemic
risk.ALmismatchdescribesasimplegapdifferencebetweenassetsandliabilityinaparticularmaturitysegment.Thus,

25
TheEWSdesignprincipleslaidoutinGramlich,Miller,Oet,andOng(2010)includeflexibilityundermultiplehorizonsandstress
scenarios.AregressionbasedEWSisatbestessentiallyamonitoringsystemhighlightingimportantassociations.Since,notwo
crisesareexactlyalike,itisimportanttoallowEWStobesensitivetoarichsetofpossibletheoreticalassociations,ratherthan
seekinganoptimumfitusinghistoricdata.Thereasonthatasetofeightmodelsisinvestigatediscombinatory:therearefour
typesofexplanatoryvariablesandtwomethodsofimbalanceconstruction:pricebasedandtotalassetsbased.However,the
twopresentsetsofeightmodelsarerevisionsoftherespectivesetsdevelopedinthe2009versionofSAFEEWS.Inthatearly
development,themodelpopulationwasaproductofamoregeneraliterativeprocessusingavarietyofregressionspecification
methods:forwardregression,backwardregression,stepwiseregression,MAXRregression,andMINRregression.Wefound
thata)backwardregressiondidnotleadtotheoreticallymeaningfulspecifications;b)forward,MAXR,andMINRmethods
producedverysimilarandvariablerichtheoreticallymeaningfulspecifications;c)stepwisemethodproducedconcise,
technicallyefficienttheoreticallymeaningfulregressions.Accordingly,inthefinalselectionstageforthe2009versionofSAFE,
weappliedonlytwospecificationmethods(stepwiseandMAXR)tofourclassesofmodelsdefinedasfollows.ClassAmodels
usedconstantmeanpricebasedimbalances.ClassBmodelsusedrollingmeanpricebasedimbalances.ClassCmodelsused
constantmeantotalassetsbasedimbalances.ClassDmodelsusedrollingmeantotalassetsbasedimbalances.

9
increasedmismatchbyitselfindicatesanincreasedimbalanceinrepricingatparticularmaturityandreflectsincreased
interestrateriskexposure.Thus,thelargeristhemismatch,thelargeristhepotentialforsystemicstress.
Definedinastandardmanner,leverageisratioofdebttoequity.Useofleverageallowsaninstitutiontoincreasegains
onitsinherentequitypositionbytakingonriskydebt.Thus,leverageisadoubleedgemagnifierofreturns,increasing
bothpotentialgainsandpotentiallosses.Anincreaseinleveragedescribeshigherlevelsofriskydebtrelativetosafer
equity.Increasedleveragehasbeenwidelyassociatedwithfuelingthefireofmanyfinancialcrises.Thus,our
theoreticalexpectationforleverageispositive.
Shortlagandlonglagbasemodels
Clearly,thecandidatebasemodeldescribedaboveisonlyoneofthepossibleparsimoniousmodelsandisformed
withoutaparticularconsiderationofthevariablelagstructure.Amorerigorousprocedureforformingtheshortlagand
longlagmodelsisasfollows.Toaidinidentifyingasetofkeyvariablesintheconstructionofbasemodel,wefirstutilize
thetoolofGrangerCausalitytofindthesetofvariableswithGrangerlagsappropriateforeachmodelingperspective:
exclusivelyfromlag6tolag12forthelonglagmodels,andinclusivelyfromlag1tolag12fortheshortlagmodels.We
thenexaminethecorrelationforallourvariablesandseparatethevariableswithhighcorrelation(morethan60%).For
eachgroupofpotentialvariableswithGrangerlags,weusestepwiseandmaxRsquareprocedurestosimulatethebase
models;identifythekeyimpactvariables,highrateofoccurrencevariables,thevariableswithlargecoefficientsandhigh
explanatorypower.Finally,ineachpotentialbasemodel,wetrytoselectthekeyvariableswithGrangerlagsfromeach
categoryofreturn,liquidity,structure,andriskimbalances.Ifanykeyvariablelosessignificanceafteritisenteredinto
thebasemodel,
26
wereiteratethevariableoptimallagtogetthedesiredsignificanceandexpectedsign.Inaddition,as
weintendtotestthemodelsontheoutofsampleperiodthatincludesthefinancialcrisisof2007,weonlyexaminethe
relationshipbetweenFSIandourXsthroughthefirstquarterof2007.
(3.2)Criteriaforvariableandlagselection
Startingfromtheshortandlonglagbasemodels,weformadditionalshortandlonglagEWSmodelsbyextendingthe
basemodelswithotherexplanatoryvariables.Weutilizethecriteriabelowtodeterminewhetheranewvariableshould
beincluded.
1) Theoreticalreview:Considerwhetherinclusionofthevariableintheequationisunambiguousandtheoretically
sound.Allthevariablesinthemodelshouldmeettheexpectedsign(seeAppendixTable16Table19for
theoreticalsign).
2) Hypothesistesting(tstatistics):Considerwhetherthecoefficientofthevariabletobeincludedissignificantin
theexpecteddirection.Wegenerallyacceptthevariablessignificantat10%confidencelevel.Toavoid
heteroskedasticityproblem,wereportwhiletstatisticstoinvariableandlagselectionprocedure.
3) Stationarity:Considerationofstationarityisimportantfortimeseriesdata.Weconductthestationaritytests
fortheentiremodelandeachvariable.TheindividualseriesstationarityisverifiedviaAugmentedDickeyFuller
unitroottests.Ifthedependentvariableisfoundtobenonstationary,wecheckforcointegration,before
furtheradjustments.CointegrationofthetrialOLSspecificationsisverifiedviaAugmentedDickeyFullerunit
roottestsontheresiduals.Thetestsshowthatnullhypothesisofunitrootintheresidualsisstronglyrejected
inallthreeRWcases:randomwalk(RW1),randomwalkwithdrift(RW2),andrandomwalkwithdriftandtrend
(RW3),asADFteststatisticsineachcaseismorecriticalthenthetestcriticalvaluesevenat1%level.Fornon
stationaryvariables,weapplyfirstdifferencingandreverifytheabovecriteria.
4) GrangerCausality:Considerwhetherthevariabletobeincludedconsistentlyandpredictablychangesbeforethe
dependentvariable.AvariablethatGrangercausesfinancialstressonewayat20%significancecanberetained
forfurthertesting.Thusfar,weseektoretainthevariableswithsignificantGrangerlags,expectedsigns,and
significantcoefficients.However,ifuponinclusionintothemodel,thevariablecoefficientlosessignificanceor
changessign,wereiteratethevariablesoptimallag,seekingthereestablishmentofallthreecriteria:
theoreticalexpectation,significantcoefficient,andGrangercausality.

26
Forexample,duetothevariablemulticollinearityandholesinthelagstructure.

10
5) Multicollinearity:Althoughmulticollinearityisnotaseriousissueforforecasting,toensurethatourtstatistics
arenotinflatedandtoimprovemodelstabilityovertime,wetrytominimizepotentialmulticollinearityissuesby
consideringthevarianceinflationfactor(VIF).WeseektoreplacethevariableswithVIFhigherthan10.
6) Optimallagselection:WeutilizeSASforautomaticlagselectionandthemodelsimulationprocess.Starting
fromthebasemodels,weenternewcandidatevariablespassingtheabovetests,oneatatimefromthereturn,
risk,liquidity,andstructureimbalanceclasses.Foreachnewvariable,wetestandselecttheoptimallagamong
thevariablelagsinclusivelyfromonetotwelveforshortlagmodelsandexclusivelyfromsixtotwelveforlong
lagmodels.Theoptimalitycriteriaincludesignexpectations,tstatistics,Grangercausality,VIF,R
2
,andnumber
ofobservations.
27
Ifnolagsforthatvariableshowsignificanceinthetheoreticallyexpecteddirection,we
excludethisvariablefromthemodel.Ifmorethanonelagmeetsourselectionrequirements,wenarrowthe
optimallagselectiontothelagwithGrangercausalityandmostadjustedR
2
increases.Insummary,the
variableslistedinthetwoGrangercausalitytables(seeAppendixTable16Table19)formtheprincipal
regressorsintheEWSmodels.ThevariableswithGrangerlagssignificanceat10%levelareconsideredfirstas
theydemonstrateastrongerGrangerrelationshipwithFSIthanthosesignificantat20%level.
7) Forecastingaccuracyreview:Considerandcompareasetforecastingaccuracymetrics.
o DoesAdjusted R

2
increasewhenthevariableisaddedtotheequation?
o DoesMAPEdecreasewhenthevariableisaddedtotheequation?
o DoesRMSEdecreasewhenthevariableisaddedtotheequation?
o Dotheinformationcriteria(AICandSC)decreasewhenthevariableisaddedtotheequation?
o DoesTheilUdecreasewhenthevariableisaddedtotheequation?
8) Reviewofbias:Doothervariablescoefficientschangesignificantlywhenthevariableisaddedtotheequation?
o Functionalformbias:Theconsequencesofthisissuegenerallymanifestthemselvesinbiasedestimates,
poorfitanddifficultiesreconcilingtheoreticalexpectationsandempiricalresults.Forseveralvariablesin
themodel,thetransformationfromlevelrelationshiptochangesintheindependentvariableisfoundto
improvethefunctionalform.
o Omittedvariablebias:Thisbiastypicallyresultsinsignificantsignsoftheregressionvariablesthat
contradicttheoreticalexpectations.Whenmisspecificationbyomittedvariablesisdetectedintrialmodels,
wefurtheradjustthemodelbyseekingtoincludetheomittedvariable(oritsproxy)orreplacethe
misspecifiedvariables.
o Redundantvariable:Typically,thisissueresultsindecreasedprecisionintheformofhigherstandard
errorsandlowertscores.
28
Irrelevantvariablesinthemodelgenerallyfailmostofthefollowingcriteria:
failedtheoreticalexpectations,lackofGrangercausality,statisticalinsignificance,deterioratingforecasting
performance(e.g.RMSE,MAPEandTheilUbias),andlackofadditionalexplanatorypowertodeterminethe
dependentvariable(e.g.R
2
,AIC,andSC).Whenastrongtheoreticalcaseexistsforanindependentvariable
tobeincludedthatisnototherwiseproxiedbyanotherrelatedvariable,weseektofindaproxyvariable
thatisboththeoreticallysoundandisnotredundanttothetrialspecification.
9) Robustnesstesting:Totheextentthatviolationsofclassicallinearregressionmodel(CLRM)assumptionsarise,
certainadjustmentsneedtobemadeinthemodelspecification.
o Treatmentofserialcorrelation:TheresultsoftheBreuschGodfreyLMtestsforshortlagdynamicmodels
showevidenceofserialcorrelationinthreeofthesevendynamicspecifications(models(1),(5),and(8)in
Table6).Sincealloftheseequationsaretheoreticallycorrectlyspecified,theserialcorrelationispureand
doesnotcausebiasinthecoefficients.Thus,wecanapplyNeweyWeststandarderrorstothese
specifications,whilekeepingtheestimatedcoefficientsintact.DurbinWatsonstatisticsofthelonglag
modelsshowinconclusiveevidenceofpositiveserialcorrelationandmanyrejectnegativeserialcorrelation
ata5percentsignificancelevelfortheestimationperiodofQ4:1991toQ1:2007.Anexpandedestimation
periodwhichincludesthefinancialcrisis(Q4:1991toQ4:2010)yieldsDurbinWatsonstatisticsthatconfirm
serialcorrelationoftheforecasterrors.TheadditionofAR,MA,orbothtermsasexplanatoryvariablesin

27
TheinnovationofouroptimallagselectionprocedureconsistsininclusionofGrangercausalityandmulticollinearitycriteria.In
addition,thenumberofobservationsservesasanoperationalthreshold:variableswithlessthan50insampleobservationsare
rejected.
28
Studenmund(2006),p.394.

11
thesemodelscanpotentiallyremedyserialcorrelation.Modelsestimatedwithanautoregressivetermas
anexplanatoryvariableweresuccessfulateliminatingserialcorrelationforshortlagmodels.Sinceweaim
toestimatemodelswithlongerforecastinghorizonwithoutautoregressivevariables,weincludeMAterms
asexplanatoryvariablestoremoveserialcorrelationandimproveourforecasts.
o Heteroskedasticity:Heteroskedasticitycanbeanadditionalpenaltyassociatedwithbaddataandinherent
measurementerrorsinthefinancialtimeseriesdata.WeconductamodifiedWhiteandBreuschGodfrey
teststoinsurethatthevarianceoftheresidualisconstant(homoskedasticityCLRMassumption).Thetests
failtorejectthenullhypothesisofhomoskedasticityinallcases,awelcomefinding.
o Otherspecificationproblems:RamseyRESET(RegressionSpecificationErrorTest)
29
iscommonlyusedasa
generalcatchalltestformisspecificationthatcanbecausedbyalitanyofpossiblereasonsofthefollowing:
omittedvariables,incorrectfunctionalform,correlationbetweentheresidualandsomeexplanatory
variable,measurementerrorinsomeexplanatoryvariable,simultaneity,andserialcorrelation.Thevery
generalityofthetestmakesitausefulbottomlinecheckforanyunrecognizedmisspecificationerrors.
WhileinacorrectlyspecifiedOLSregressiontheresidualfollowsamultivariatenormaldistribution,Ramsey
showedthattheaboveconditionscanleadtoanonzeromeanvectoroftheresidual.RamseyRESETtestis
setupasaversionofageneralspecificationFtestthatdetermineslikelihoodofsomeomittedvariableby
measuringwhetherthefitofagivenequationcanbeimprovedbytheadditionofsomepowersof
`
.Allthe
RamseyRESETtestsshowwelcomeresultwithsimilarfitbetweentheoriginalandtherespectivetest
equationwiththeFstatisticislessthanthecriticalFvalue.Providednootherspecificationproblemsare
highlightedbyearliertests,RamseyRESETtestsfurthersupporttheresearchclaimofabsenceof
specificationproblems.
(3.3)EWSmodelspecificationsandresults
Insampleresultsofthebenchmark(panelA),candidatebasemodel(panelB),shortlagbasemodel(panelC),andlong
lagbasemodel(panelD)aredetailedinTable3below. Informingabasemodel,weseektofindacorestoryof
theoreticallyconsistentlongtermrelationshipsbetweensystemicstressYtandinstitutionalimbalancesXt. Candidate
modelofpanelBisformedbyselectingrepresentativeimbalances,oneperexplanatoryvariableclass,discussedinthe
introduction.Inthiscandidatemodel,realequity,assetliabilitymismatch,andleverageincreasethepotentialfor
systemicstress,offsetbycreditriskimbalances.CandidatemodelinpanelBimprovesonthebenchmarkmodel
insample,asdemonstratedbytheadjustedcoefficientofdeterminationandtheAkaikeandSchwarzinformation
criteria.ShortlagbasemodelinpanelCisformedbyestablishingacorestory:positiveinfluencesofstructural
imbalancesandnegativeinfluencesofriskimbalances.IncreasingthepotentialforsystemicstressareimbalancesinFX
concentration,leverage,andequitymarketsconcentration.Theyareoffsetbytheimbalancesininterestraterisk
capitalandcreditriskdistancetosystemicstress.Theshortlagbasemodelfurtherimprovesonthebenchmarkand
candidatemodels.LonglagbasemodelinpanelDisformedbymodifyingthecorestoryforthelongerrun:positive
influencesofstructuralandriskimbalancesandnegativeinfluencesofriskandliquidityimbalances.Increasingthe
potentialforsystemicstressareimbalancesininterbankconcentration,leverage,andexpecteddefaultfrequency.They
areoffsetbytheimbalancesinfiresaleliquidityandcreditriskdistancetosystemicstress.Thelonglagbasemodel
providesausefulperformancetargetforthelonglagEWSmodels.
AllofthebasemodelsvariablesarestatisticallysignificantintheexpecteddirectionandshowsignificantGranger
causalitywiththedependentfinancialstressseries.Statisticalsignificanceat10%,5%and1%levelsisindicatedby*,
**,***,respectively.Significanceofcausalrelationshipsat20%and10%isindicatedby,,respectively.The
sampleperiodisfromOctober1991toMarch2007.

29
Ramsey(1969)

12
InsertTable3abouthere

OutofsampleresultsofthebenchmarkandbasemodelsareshowninTable4below. Viewedoutofsample,the
candidatebasemodelfailstooutperformthebenchmarkingmodelinrootmeansquareerror(RMSE)andbias(TheilU)
measures,butoffersmodestimprovementinmeanabsolutepercentageerror.Theshortlagbasemodel,however,
consistentlyimprovesonthebenchmarkingmodelinallthreestatisticalmeasures.
InsertTable4abouthere

Table5belowsummarizestheshortlagmodelstoriesthatfurtherimproveonthecorestoryofthecorrespondingbase
modelinexplainingfinancialstressinsample.Itisclearthatthepositiveandnegativerelationshipswithfinancialstress,
colorcodedastheyare,tendtofallintoessentiallytwostories:apositivestoryofstructureandnegativestoryofrisk
30
,
supplementedandenhancedbyadditionaltypesofreturnandliquidityimbalances,bothpositiveandnegative.
31

InsertTable5abouthere

IntheTable5above,consider,forexample,model7.Onecanseethecorestoryinmodel7likeintheothermodelsis
thestoryofpositivestructureandnegativeriskinfluence.Wesupplementthisstoryforthismodelbycertainpositive
returnimbalancesandadditionalnegativeimpactofriskimbalancesbeyondthoseincludedinthecoremodel.Themost
significantvariableinthismodelthatincreasesthepotentialforsystemicriskistheinterestriskdistancetostress.Itisa
measurerelatedtobookvalueofequitythatexpressestheequitysusceptibilitytostressandconstructedthrougha
proprietarystressdiscountingmodel,sothisisnotanobservablemeasure.Thestoryofsusceptibleequityis
supplementedinthismodelbythestoryoftotalcreditdiscountedbyCPI,discussedabove,andbythestoryofchangein
foreignexchangeconcentrations.Decreasingthepotentialforsystemicstressaretheriskmeasures:solvencydistance
tosystemicstress,creditriskdistancetosystemicstress,andthechangeinthecreditriskdistancetostressallnot
directlyobservableandconstructedfortheSAFEEWS.
InsampleresultsoftheeightcompetingEWSspecificationsforeachforecastinghorizonaredetailedinthefourpart
Table6(shortlag)andTable7(forlonglags)below.OutofsampleresultsaregiveninTable8(shortlag)andTable9
(longlag).
InsertTable6abouthere

InsertTable7abouthere

InsertTable8abouthere

30
Thereasonthatriskimbalancesdescribeanegativerelationshipwithstressisthatbyconstructiontheyarepredominantly
defensivefunctionsofcapitalandsolvency.
31
Thelonglagmodelstellfundamentallysimilarstoriesofpositivestructuralimbalancesandnegativeriskimbalances.The
correspondingtableisomittedforbrevity.

13
InsertTable9abouthere

(4)Discussionandimplications
(4.1)PerformancesupervisoryEWSvs.publicEWS
ThestoriestoldbythevariousshortandlonglagEWSmodelsdiffer.Therefore,weexpectthatsomeofthestories
tendtodobetterovertime,whileothersaremoresuitedtoparticulartypesofcrises.Ingeneral,thestoriesmighthave
differentperformance.Itisinstructivetolookatthestatisticalperformanceofthesemodelsinsample(Table6,Table7)
andtheiroutofsampleforecastingability(Table8,Table9).Theforecastingparametersaredefinedthroughthe
windowendingin2010.Someinterestingobservationsarise,suchthatsomemodelstendtobemorestableovertime.
Thatisanimportantconsideration,sincefinancialconditionschange,regulatoryregimechanges,newproductscome
andgo.Therefore,itisimportantfortheEWSresearchertoseekastablemodelortorecognizethedynamicsandto
adjustforit.Fromthiswork,itwouldappearthatthemodels2,4,and7maybeexpectedtobebothstableandpossess
attractiveexplanatorypowers.
Wecomparerelativeperformanceoftheeightshortlagspecificationsbyrunningaforecastinghorseracewithresults
showninTable10.Inthehorserace,welookatfourdifferentknownstressepisodes:LTCMcrisis,thedotcomcrisis,
thestockmarketdownturnof2002,andthesubprimecrisis.Wethenrankordertheperformanceofthemodelsbased
ontheRMSE.Somemodelsconsistentlydobetterinthishorserace,butotherswithlessshiningstatisticsalsoemerge
somewhatsurprisinglyasprovidingpowerfulinsights.
InsertTable10abouthere

Itmightbetemptingtothinkthatoneshouldseektofindthewinner,however,weargueagainstthis!Itisvery
importantforapolicymakerusingthisEWSframeworktoresistthetemptationtofindthebestmodelbecauseevery
crisisisdifferent!SAFEmodelsrepresentdistinctstoriesofcrisesthatovertimemostconsistentlyexplainfinancial
stressinthemarkets.Futurestressmayevolveinwaysnotseeninthepastorbedrivenbyimbalancecombinations
thatmayberelativelyrareanddifferentfromthebesthistoricmodel.Inordertostudyapossiblebuildupoffinancial
stressusingthisEWS,oneshouldthereforeconsideravarietyofplausiblestoriesthatmayberealizedthroughtime.
SinceSAFEEWSincorporatesbothpublicandsupervisorydata,animportantquestionthatmaybeaskediswhether
supervisoryinformationoffersadditionalvalue.WeaddressthisquestioninCaseStudy1,whichconsiderscompetitive
performanceofasystemicriskEWS,basedonpubliclyavailableinformationvs.anEWSusingprivateinformation.
CaseStudy1:supervisoryvs.publicEWSspecifications
Anassumptionoftheresearcheristhatnonpublicdataprovidesforamoreaccurateandamoreactionableearly
warningSystem.Totestthis,weremoveallsupervisoryFRSvariablesfromthemodelsuggestionstageandrespecify
theSAFEmodels.
Therearethreebroadcategoriesofexplanatoryldata:(1)confidentialinstitutionspecificdatainternaltotheFederal
ReserveSystem,(2)undisclosedFederalReservemodelsandtheiroutput,and(3)datafromthepublicdomain.
Category1consistsofconfidentialinstitutionaldatanototherwiseavailabletothepublic.Category2,theundisclosed
FRSmodelsmayuseeitherpubliclyavailabledataorFederalReservedata.Category3dataincludesrawdatafromthe
publicdomainaswellasoutputfrompubliclyavailablemodelsthatutilizesdatafromthepublicdomain.Wedefine
privatesupervisorydataasFRSinternaldata(category1)andtheundisclosedoutputofFRSmodels(category2).
Wecanexpectaqualitativedifferencebetweencategory1andcategory2supervisorydata.Theconfidentialdata(1),
althoughopaquetothepublic,isgenerallyofhighquality.Theconstructeddata(2)ispronetoanumberof

14
measurementerrorsandisinherentlymuchmoreunstable.Manyofthepublicseriesfromtheoriginalspecifications
arepreserved.Removalofprivatesupervisoryseriesmostseverelyaffectstheriskvariables,andtoalesserextentthe
liquidityvariables.Thus,wecanexpectthatthosevariableswouldbemostaffectedwhenwetaketheprivatedataout
toonlyseethepublicformulationsoftheEWSmodels.Table11belowshowsthedistributionofcategory2data
(marketwith)andcategory3data(markedwith)amongtheimbalanceclasses.Table12showsproportionof
supervisoryvariablesamongthespecifiedindependentvariables.
InsertTable11abouthere

InsertTable12abouthere

ComparingthepublicdataonlyversionsofSAFEmodelswiththoseusingsupervisorydata(Table13andFigure4),we
findthatmodelsusingsupervisorydataoutperformthepublicformulations,bothinthegoodnessoffitandthe
forecastingabilityasseenintheRMSE,MAPEandthebiasstatistics.Whenappliedtotheoutofsample20072009
period,bothprivateandpublicspecificationscatchtheincreaseinstressduring2Q2007.However,whiletwoofthe
privatemodelsdowellinprojectingexplanationsintothe4thquarter2007,thepublicmodelsfailcompletelyin
explainingthelaterepisode.We,thus,findevidenceoftheimportanceandusefulnessofprivatedatainthecreationof
asystemicriskearlywarningsystem.
InsertTable13abouthere

Fromthepointofviewoffinancialinstitutions,itisclear,thatevenpublicdatabasedsystemicriskEWSmodelswould
allowinstitutionstostudythecorrelationsandsensitivitiesoftheirexposuresandstructuralpositionswithinthe
financialsystemandusetheframeworktoenhancesystemicriskstresstestingandscenarioanalysis.
ThiscasestudyonlyconsiderstherelativeoutofsampleperformanceofpublicandprivateSAFEmodels.Many
interestingquestionslieaheadinthislineofinvestigation.Forexample,futureworkcanaddressadditionalanalytical
questions,suchas(a)whatfactorsmatteredmostintherecentcrisis,(b)whatmaybetheresultsoflikelihoodtestsfor
StructuralCs(concentration,connectivity,contagion),and(d)whatmaybetheresultsoflikelihoodtestsforblocksof
datatriggeredbybehavioraleffects.
InsertFigure4abouthere

(4.2)Applicationstosupervisorypolicy
HowcanSAFEfacilitatetheworkofpolicymakers?Oneofitskeybenefitsisraisingpolicymakersattentionto
imbalancesthathavestrongpositiveandnegativeassociationswithfinancialstress.SAFEEWSmodelshelpexplain
financialmarketstressintermsofseveralimbalancesbothescalatingstressandoffsettingit.
Anumberofquestionsspringimmediatelytomind.Cannottheimbalancesbeobservedreadilyinthefinancialsystem?
Howcananearlywarningsystemhelp?Afterall,weallknowthatwhatgoesupmusteventuallycomedown.Intuition
tellsusthatthelongerthegrowth,thecloseristheprecipice.Shouldnotbeanobservationofevenasingleimbalance
besufficientgroundforregulatoryaction?Indeed,inthecaseofarecentcrisis,afeweconomists,amongthemRobert
Shiller,observedthatthedifferencebetweenaresidentialhousingpricingindexanditslongtermaveragevaluehas

15
reachednewheightsandcalledthisnotsustainable.Yetnoeconomicmodelprovidedarigorousforecastofthecoming
downturnandcrisis.Whycannooneanswerwhenthingswillcomedown?
Somesaysuchforecastisimpossible.Fromanefficientmarketperspective,financialcrisesareshockeventsand
thereforecannotbepredicted.Efficientmarketstheorytellsusthatitisimpossibletoknowthetimingoftheseshocks.
Furthermore,evenifthiswerepossible,thisperspectivetellsusthatbubbleprickingpolicywouldbeproblematic,
becauseitpresumesthatyouknowmorethanthemarket.
32
Italsohighlightsaserioustechnicalchallengefor
monitoringassetbubbles,claimingabsolutelythatsinceembeddedpricingfactorsareunobservableinthemarkets,itis
empiricallyimpossibletoverifyassetpricebubbles.
33
Furthermore,thedivergencemaybedueeithertotheembedded
pricefactorsorsomeunderlyingeconomicfundamentals(statevariables),andthatitisimpossibletodeterminewhich
oneisresponsibleforsuchdivergence.
34
Economiststhatbelievethatmarketsarefundamentallyefficientarguethatit
isthereforebettertofocusoncrisisresolutionmechanismsoncetheyoccur.
Fromanempiricalperspective,however,thecrisesarenotstrictlyabouttimingofassetpricebubbles,butabouta
varietyoffactorsthatevolveslowlyovertime.Thesefactorsareobservable
35
andtendtohavecommonfactors:
Excessiveassetprices,relativetocentraltendencyortrendwhichimplicitlyrepresentalongertermequilibrium
basedonastablesetofexpectations,financialtechnology,etc.;
Lotsofleveragefuelingexcessiveassetprices.Becausefinancialinstitutionbalancesheetsandcertainassetclasses
(e.g.realestate)arehighlyleveraged,theytendtoplayamajorpartinfinancialcrises;
Networkedfinancialsystem,combinedwithleveragedfinancialfirms,canspillassetlossesandfundingproblems
fromoneinstitutiontoanother,placingtheentiresystematrisk.
36

Onepracticalconstraintinobservingimbalancesisthedifficultyofrelatingthemtotheeconomy.RobertSchiller
measureshousingimbalancesbydeflatingthembyaggregatehousingvalue.
37
Borioandcolleaguesmeasure
imbalancesbydeflatingthembyGDP.SAFEEWSmeasuresimbalancesbydeflatingthembyaggregateassetsor
relevantpriceindexes.
Secondmajordifficultyisrelatinganobservedimbalancetoothers.Innormallyfunctioningmarkets,institutionscan
efficientlyestimateriskandhedgeit,whilesustainingthefinancialsystembalanceandgrowth.Howcanapolicymaker
makeaninformedjudgmentthatinstitutionsestimatesofriskarebecomingbiasedataparticulartime,andthe
marketsgrowthbecomesirrationallyexuberant?SAFEfacilitatesthischallengebyconsistentlyestimating
fundamentalsofvariousassetclassesandstructuralcharacteristicsofthesystem.Thus,anerrorinmeasurementofa
singleimbalanceduetoabiasedestimateofitsfundamentalvalueisminimizedwhencombininganumberofpositive
andnegativeimbalanceswithinaSAFEOLSmodel.Bylookingatseveraloffsettingimbalancestogether,SAFEOLS
estimatesareBLUEbestlinearunbiasedestimators.
Inaddition,SAFEEWSassistspolicymakersdecisionprocessbyallowingthemtotargetaparticularactionthreshold
abovethepreviousmeanofthefinancialstressseries.Whatshouldthethresholdbe?Shouldpolicymakerstargethalfa
standarddeviationoffinancialstress,oronestandarddeviation,oranotherthreshold?Inabsenceofamorerigorous
theoreticalframework,SAFEEWScanhelpempirically.Asweshowinthecasestudy2below,iterativereviewof
retrospectiveSAFEforecastsinaseriesofhistoricalstressepisodescanestablishthedifferenceinstandarddeviations

32
AlanGreenspan,quotedintheNewYorkTimes,November15,1998.
33
Acommonfeatureofassetbubblesisthatpricesincreaseatarategreaterthanexplainedbyunderlyingfundamentals
(Kindleberger,1992).
34
Cogley(1999).
35
RobertShillernotesthatitissurprisingthattheexpertsfailedtorecognizethebubbleasitwasforming(Shiller,2008).Strictly
speakingthisisnotquiteaccurate.AsAlanGreenspantestifiedtoCongress,in2005thebuildupwasobservedandgave
policymakersseriousconcernsthattheprotractedperiodoftheunderpricingofriskwouldhavedireconsequences
(Greenspan,2008).
36
TheabovefactorsarenotuniquetotheUnitedStatesandcanalsobeobservedindevelopingcountriesfinancialcrises.The
UnitedStatespossessesareservecurrencythatiscapableofstoppingspillovereffects.Bycontrast,adevelopingcountrymay
beforcedtoappealtotheIMFforhelpinstoppingcrisisspillover.
37
Standard&Poors(2008),p.10.

16
betweenSAFEEWSforecastsandthecoincidentfinancialstressatthetimeoftheforecast.Thepolicymakerwouldthen
formasetofstressepisodeswhenadditionalsupervisoryinvolvementcouldbecontemplatedtoreducetheeconomic
losses.ComparingthedifferencebetweenSAFEforecastsoffinancialstressandthecoincidentstressmeanforallstress
episodeswouldleadtoidentificationofthedesiredtargetlevelatwhichpolicymakerswouldbecomeinvolved.When
theforecastsofstressfallshortofthetargetactionlevel,thehistoricalevidencewouldsupportthecasethatmarkets
areabletoselfresolvetheparticularlevelofstress.Whenforecastofstressexceedsthetargetlevelofstress,the
policymakerscanweightheeconomiccostsofregulatorypreventiveactionagainsttheeconomiccostsofashock
bringingtheaggregateimbalancesbacktothefundamentals.
ThefollowingsimplifiedcasestudyillustratestheprocessbywhichSAFEEWScanfacilitatethepolicymakersselection
ofactionthresholds.
CaseStudy2:selectionofactionthresholdsinhistoricstressepisodes
Inthiscasestudy,wetesttheperformanceofSAFEagainstthreehistoricepisodes:DotComstressepisode(4Q1999/1Q
2000),StockMarketDownturnstressepisode(2Q2002/4Q2002),andSubprimestressepisode(4Q2007/1Q2008).
Consideringthesethreeepisodesexpostandtheireconomiccosts,thepolicymakerswilllikelyagreethatnoregulatory
actionwouldhavebeenneededduringthe2002stockmarketdownturn.Thepolicymakerswillbelikelytoagreethat
regulatorypreventiveactionpriortotheSubprimeepisodemaybeefficientinalleviatingtheeconomiccostsofthecrisis
andperhapsevenforestallingit.Thedecisionmaybelessclearinthecaseofthedotcomepisode.Thosethatwould
rejecttheideaofregulatoryinterventioncanpointoutthefactthestressepisodewasessentiallyastockmarket
correctionofovervaluedhightechnologyrelatedfirms.Thosethatwouldsupporttheideacanpointoutthatthe
correctionwasfarfromsoftandgavetheUSeconomyaprecipitouspushtowardtheEarly2000sRecession.
Table14showstheresultsofthepolicyhorseraceamongthemodels.Asthetableshows,thefinancialstressseriesz
scoredropped0.3standarddeviationsfromitslevelsixquartersaheadoftheStockMarketdownturn,supportingthe
notionthatepisodewasbenign.Bycontrast,thestressseriesmovedupalmost0.7standarddeviationsfrom2
nd
quarter
1998totheDotComcrisis,andmovedalmost2.9standarddeviationsfrom2
nd
quarter2006totheSubprimecrisis.
DependingonthepolicymakersbeliefinthecostefficiencyofpreventiveactionfortheDotcomcrisis,thepolicymakers
usingtheSAFEEWStohelpestablishatargetthresholdmightchooseanactionthresholdbeloworabove0.7standard
deviationsfromthefinancialstressseriesmeanatthetimeofaforecast.
TheresultsofthetablealsosupportourpreviousargumentthatselectingasinglebestSAFEmodelisnotwelladvised.
Thepolicyhorseraceshowsthatbestmodelcontinuallychanges.ItalsoshowsthatsomeSAFEmodelsdoconsistently
well.ItisclearthatthecurrentsetofSAFEmodelscanbeusedinvariousways:forexample,thepolicymakerscan
consideronlythetopmodelatthetimeofeachquarterlyforecast,orseveraltopmodels.
InsertTable14abouthere

WeconcludethisCaseStudy2illustrationofapolicyapplicationbyaretrospectivecasestudyintheoutofsample,
Subprimeepisodestress(seeFigure5below).LetussupposethatthepolicymakershavetheuseofSAFEEWSduring
the2
nd
quarter2006.Observingthefinancialstressseriesatthistimewouldgiveregulatorsnoreasonsforconcern.In
fact,bythetimethedataforafreshquarterlyobservationofFSIisassembledfromthedailyobservations,onewould
observeevenashorttermtrenddownwardasthefinancialmarketscontinuetoboom.Thepolicymakerswouldliketo
anticipatepossiblescenariosoffuturestatesofthefinancialstresssixquartersforward:duringthe4
th
quarter2007and
1
st
quarter2008.Todothis,assuggestedbythepolicyhorseresultsabove,theywouldliketoconsideralternative
plausibleimbalancestoriesasgivenbyseveraltopSAFEEWSmodels.Calibratedupto2
nd
quarter2006,thetopthree
shortlagmodelsaremodels(2),(4),and(7).Astheforecastisrun,allthreemodelsshowsignificantriserelativetothe
currentlevelofstress.Moreover,allofthemshowthatthetrenddoesnotpeakattheforecasthorizon,butinfact

17
originatesmuchearlierduring2ndquarter2007.
38
Thisforecastposestwocriticalquestionstothepolicymakers.
First,istheanticipatedincreaseinfinancialstressrealorillusory?Second,iftheincreaseisreal,isitcriticalenoughto
riskintroductionofsomecorrectivemeasuresearlyin2006todiffusethisprojectedbuildupofstress?Ifthebuildupof
stressisillusoryandthepolicymakersintroducesomeprophylacticmeasurestoreducetheimbalances,theyrisk
crampingahealthyeconomy.Ifnothingisdone,thefinancialmarketsstressthreatenstobecomelarge.Thequestion
ofactionorinactionisthecriticalchoice.Inordertoprovidefurtherpolicymakinginsight,aEWSresearchermustalso
bereadytoanswerwhichchannelsofprophylacticactionshouldbeopentothepolicymakers.Weintendtoaddress
bothofthesequestionsfromamorerigoroustheoreticalfoundationinafollowuptothisstudy.
InsertFigure5abouthere

CaseStudy3:thefinancialcrisis
Thefinancialcrisisof2008offersatestoftheforecastingaccuracyofboththeshortlagandloglagmodels.Whilethe
pinnacleofthecrisiswillberememberedbythefailureofLehmanBrothersandtheresultingquantitativeeasing,there
mayhavebeensignsofstressasearlyasthefirstquarterof2007.Thiswouldhaveallowedtimetoconsidermonetary
and/orsupervisorypolicyactionspriortothecrisistohelpmitigatedevelopingstress.Wewillconsiderforecastsfrom
shortlagandlonglagmodels.
ShortLagForecasts
SeveralshortlagmodelspredictedtheadventofstressstartingQ2:2007andcontinuingthroughout2007insomecases.
Inparticular,sixofeightshortlagmodelspredictedstresswhichwassignificantlylargerthanstressobservedinthe
comparativelyquietyearsleadingtothecrisis.ThesepredictionscanbeseeninFigure6.Inparticular,models(2)and
(8)predictedearlystressinQ2:2007,whileothermodelssuchas(4)predictedstresswithalag.
Whilethemajorityoftheshortlagmodelscontainanautoregressiveexplanatoryvariable,severaladditionalkey
explanatoryvariableswerefoundtobevaluableatpredictingfinancialstress.Thedegreesofthecontributiontoearly
financialstressaredependentuponthechosenlagoftheexplanatoryvariablesandupontheactualvariablesincluded
intheforecast.Forexample,model(2)predictedrapidstressincreasebeginninginQ2:2007.Theobservedshrinking
valueofLiq_5(liquidity)andtheincreasingvalueofStr_4(FXcurrencymarketconcentration)inthismodelwerethe
leadingcontributorstotheincreaseinstressintheforecastperiod.ThisforecastindicatesthatpreviousvaluesofLiq_5
weredecreasingwhichisasignthatthemodelstopfiveinstitutionshadliquidityconstraints.Moreover,arisingvalue
ofStr_4indicatesanincreaseinfuturefinancialstressbecausethismeasuresthedegreetowhichlargerfirmsare
exposedrelativetotheaggregateforeignexchangecurrencymarkets(i.e.largerfirmsbearalargersegmentofrisk
associatedwiththismarket).Specifically,Liq_5andStr_4added29.1and22.5unitsrespectivelyinQ2:2007aswellas
adding28.9and21.5unitsinQ3:2007.
InsertFigure6abouthere

Othermodelssuchasmodel(4)predictedthatstresswouldbepresentatdifferenthorizons.Model(4)predictedthat
financialstresswouldbesubduedinthefirsttwoquartersbutwouldincreasesignificantlyinQ4:2007.Further,thiswas
drivenmainlybyslightlydifferentvariablesincludingLiq_6(stresssaleliquidity)andStr_4.1(interbankcurrencymarket
concentration).TheremainingmodelsrevealedothernoteworthyvariablessuchasRet_2cpi(capitalmarkets),Rsk_8a
(expecteddefaultfrequency),andRsk_L(solvencystressdistancetosystemicstress).
LongLagForecasts

38
Simulatingforecastsinsubsequentquarters,onecanobservethatastheforecastingwindownarrows,themodelstendto
converge,asexpected.

18
Longlagmodelsallowustoforecaststressatlongerhorizonswhichissuitableforexantepolicyactions.Thevalueofa
forecastwithalongerhorizonisthatithighlightsfactorsthattendtocontributetostressinthelongerterm(atleast6
quarters).
Similartotheshorterhorizonforecasts,wecananalyzethevariableswhichwereimportantatsignalingfinancialstress.
Figure7illustratesthatseverallonglagforecastspredictedanotableincreaseinstressthroughQ3:2008.Two
significantdriversofstressthroughouttheforecastperiodareLiq_6(3monthforwardsale)andLiq_7(firesale).Similar
toLiq_5inshortlagmodel(2),adecreasingvalueofLiq_6andLiq_7signalsanincreaseinfuturefinancialstress
becausethisisasignthatthesefirmsarelackingliquidityrelativetothepast.Thesevariablesaddedasmuchas18units
tostressinthefirsttwoquartersoftheforecastperiod.
InsertFigure7abouthere

AnotherimportantdriverofstresswasRsk_8a(expecteddefaultfrequency)whichaddedasmuchas21unitstostress
inthefirstquarteroftheforecast(LL4)andasmuchas21unitstowardtheendoftheforecastperiod(LL3).Expected
defaultfrequency(EDF)isameasureoftheprobabilityofdefaultoftheinstitutionasdescribedbyMoodysKMV,anda
growingvalueofEDFsignalsfuturefinancialstress.Theincreasinglikelihoodofadefaulthasseveralcauseandeffect
connections.Forexample,anincreasingEDFcouldleadanincreaseincounterpartyriskwhichcouldleadtodifficulties
inraisingliquidity,thusaccentuatingthelikelihoodofstress.Weseesimilarexamplesofthesetypesofconnections
uponfurtheranalysisofthelonglagforecasts.AsEDFandliquidityvariablesleadtofinancialstress,weobservean
additionalincreaseinStr_9(leverage).Str_9becomesalargedriverofstresssolelytowardstheendoftheforecast
period.Thisimpliesthatfirmshadahigherdegreeofriskydebtrelativetosafercapital.Thishashistoricallybeena
criticaldriveroffinancialstressduringfinancialcrises.Theriseinleveragemayhavebeeninturnindirectlycausedby
previousincreasesinLiq_6,Liq_7,andRsk_8a.
(5)Conclusionsandfuturework
Themaincontributionofthispaperhasbeentodemonstratefirst,theexistenceofsignificantassociationbetween
institutionalimbalancesandfinancialmarketsstress.Furthermore,thepaperalsoshowsthatsignificantresultsare
obtainedwhentheseassociationsareexplainedintermsofinstitutionalreturn,risk,liquidity,andstructural
characteristics:bothintermsofstatisticalsignificanceinexpecteddirectionandGrangercausality.
Theresultsoftheearlywarningsystemdevelopedinthepaperraiseattentiontoimbalancesthathavestrongpositive
andnegativeassociationswithfinancialstress.TheSAFEEWSteststheoreticalexpectationsofpositiveandnegative
impactsonfinancialstressatthesametimeandallowsaconsistentapproachtoevaluationofthesystemicbankingrisk.
Bycomparingperformanceofmodelsbasedonpublicdataandthoseusingprivate(supervisory)information,thepaper
findsevidenceofvalueinsupervisorydata.Further,thestudydiscussestheuseandrelativeperformanceofSAFEEWS
calibratedusingonlydatapubliclyavailabletotheUSfinancialinstitutions.
Bycomparisonwithprecedentsinsystemicriskearlywarningsystems,SAFEEWSadditionallyoffersanumberof
innovativefeatures.Itisahybridearlywarningsystemframework,integratingbothmacroeconomicvariablesand
institutionspecificdata.SAFEEWSbenefitsfromaveryrichdatasetofpublicandprivatesupervisorydata,integratinga
numberofpreviouslystandalonesupervisorytoolsandsurveillancemodels.Fromthepointofviewofmethodology,
SAFEEWSextendstheoptimallagapproachandclarifiesthemodelselectioncriteria.Inaddition,SAFEEWSprovidesa
toolkitofalternativeimbalancestoriestomeetavarietyofpossiblepropagationmechanismsinagivensystemicstress
episode.
Intermsofitsarchitectureandtypology,SAFEextendsthetheoreticalprecedentsinEWSvariablesbysuggestingthat
theyfallintofourclassesofimbalances:return,risk,liquidity,andstructure.Althoughresearchershavelongrecognized
structuraleffects,theyhaveuptonownotbeenincorporatedintoanearlywarningsystemofsystemicrisk.Inaddition,
afeedbackamplificationmechanismhasbeenincorporated.Feedbackmechanismsaremodelsthatareparticularly
pronetomeasurementerrorandshouldbetreatedcautiouslybytheEWSresearcher.Nevertheless,asSAFEshowsin
theanalysisofpublicandprivatedatablocks,theamplificationmechanismcanaddsignificantexplanatorypowerand

19
deservesfurtherconsideration.Inparticular,theliquidityfeedbackmechanismappearsinmostSAFEmodelsthrougha
liquidityindependentvariableandservesasacriticalvaluationengineforsomeofthemoredominantriskimbalance
variables.Fromthefinancialsupervisorspointofview,anEWSinvolvesanexanteapproachtoregulation,targetingto
predictandpreventcrises.Ahazardinherentforallexantemodelsisthatthemodeluncertaintymayleadtowrong
policychoices.Tomitigatethisrisk,SAFEdevelopstwomodelingperspectives:asetoflonglag(sixquartersandabove)
forecastingspecificationstoallowthepolicymakerssufficienttimeforexantepolicyaction,andasetofshortlag
forecastingspecificationsforverificationandadjustmentofsupervisoryactions.
Thispaperonlybeginstoaddresstheimportantanalyticalexerciseoftheperformanceofthevariousspecificationsin
varioushistoricperiodsoffinancialstress.Itcanbeextendedinseveralways.Forexample,itwouldbeusefultodiscuss
furthertheimportantvariablesselectedbythemodel,theirapplicabilityforuseinsupervisorypolicy,theirmarginal
impacts,andverificationthatthevariablesindeedmatteredornotandwhy.Specificattentionshouldbeattributedto
thetimepatternofevolvingfinancialstress,e.g.thespeedandamplificationdynamicofupcomingfinancialcrises.A
specialattentionshouldfurtherbedevotedtotheanalysisofthemodelperformanceoutofsamplewithconsideration
giventotheeconomicinterpretationoftheresults.Thismayalsoincludetestingthemodelfordifferentscenariosand
theinclusionofnewvariables.Toprovidefurtherpolicymakinginsights,EWSresearchershouldbereadytosupportthe
channelsofprophylacticaction,whichmaybeopengivenaparticularsetofimbalances,andbeabletoevaluatethe
impactofregulatorychangesonfinancialstressinrealtime.Importantly,theEWSmodelshouldbeextendedto
financialintermediariesotherthanbankholdingcompanies.

20
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23
(7)TablesandFigures
Table1Systemicriskexplanatoryvariablesinliterature
39

D
e
m
i
r
g

K
u
n
t

a
n
d

D
e
t
r
a
g
i
a
c
h
e

1
9
9
8

K
a
m
i
n
s
k
y

a
n
d

R
e
i
n
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p
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9

Nationaleconomic
a)GDPnational x x x x x
b)Credit/GDPnational x x x x x x x (x)
c)Equity x x x x x (x) x x x (x) x
d)Property x x (x) x x
e)Investments x x
Internationaleconomic
a)GDPinternational x
b)Credit/GDPinternational
c)Equity (x) x (x) (x) x
d)Foreignexchangerate (x) x x x (x) x
e)Exports/Imports (x) x x x
Financialsystem
a)Interbanklending x (x) (x) (x)
b)Leverage (x) x
c)Interestrate x x x x x x
d)Competition,concentration x x
e)Riskappetite,discipline x (x) x
f)Complexity x x
g)Dynamics,volatility x x x

39
ThetableistakenfromGramlich,Miller,Oet,andOng(2010),p.205.

24
Figure1Imbalancesasdeviationsfromfundamentalsreflectpotentialshocks

25
Figure2TopologyofloanUSDconcentrationsacrosstiersandloantypes

TierI
TierII
TierIII
TierIV

200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
C
&
I
C
o
n
s
u
m
e
r
O
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h
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D
e
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y

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h
e
r
C
R
E
R
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a
l

E
s
t
a
t
e
Billions

26
Figure3TopologyoffinancialmarketconcentrationsoftopfiveUSBHCsacrossmarketsandtime

EquityMarkets
CreditMarkets
FXMarkets
CurrencyMarkets
InterbankMarkets
SecuritizationMarkets
CreditDerivativeMarkets
InterestRate DerivativeMarkets
1.0
0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
6
/
3
0
/
1
9
9
1
6
/
3
0
/
1
9
9
2
6
/
3
0
/
1
9
9
3
6
/
3
0
/
1
9
9
4
6
/
3
0
/
1
9
9
5
6
/
3
0
/
1
9
9
6
6
/
3
0
/
1
9
9
7
6
/
3
0
/
1
9
9
8
6
/
3
0
/
1
9
9
9
6
/
3
0
/
2
0
0
0
6
/
3
0
/
2
0
0
1
6
/
3
0
/
2
0
0
2
6
/
3
0
/
2
0
0
3
6
/
3
0
/
2
0
0
4
6
/
3
0
/
2
0
0
5
6
/
3
0
/
2
0
0
6
6
/
3
0
/
2
0
0
7
6
/
3
0
/
2
0
0
8
STD
1.00.5 0.50.0 0.00.5 0.51.0 1.01.5 1.52.0 2.02.5 2.53.0 3.03.5 3.54.0

27
Table2ExplanatoryvariableclassesintheSAFEmodel
ExplanatoryVariableClasses Constructionclasses
Returnimbalances
Throughassetpriceboom/bust
|Bymarkets/productsin:
CAPITALMARKETS
||Equitymarkets
||Creditmarkets
|||Propertymarkets:residential/commercial)
CURRENCYMARKETS
||FX
||Interbank
RISKTRANSFER/DERIVATIVESMARKETS
||Securitizationsmarkets
||CreditDerivativesmarkets
||InterestRateDerivativesmarkets
Riskimbalances
Credit
Interestrate
Market
Solvency
Liquidityimbalances
ThoughFundingLiquiditychannels
ThoughAssetLiquiditychannels
Structuralimbalances
Connectivity
Concentration
Contagion

28
Table3BenchmarkandBasemodelsinsample
PanelA:
BenchmarkFSI
model
FSI

= 7.8S + u.6uFSI
-1
+u.24FSI
-4

DF=58K=2

Constant LaggedFSI SeasonalFSI Adjusted

Rsquared
Akaikeinfo
criterion
Schwarz
criterion
Estimates
7.85 0.60 0.24
0.49 6.72 6.82 tvalue
(1.44) (5.86) (2.31)
Granger

PanelB:
CandidateBase
Model
FSI

= S6.S8 +u.SSFSI
-1
+1.7u0I_AIS
-5
+7.u40I_IEIN
-9
+2.S4PHKICP
-5
- 12.62CRCAP_NI
-11

DF=61K=5

Constant LaggedFSI AL
mismatch
Leverage RealEquity CreditRisk Adjusted
Rsquared
Akaikeinfo
criterion
Schwarz
criterion
Estimates
36.58 0.35 1.70 7.04 2.34 12.62
0.60 6.51 6.71
tvalue
(5.72) (3.24) (3.65) (2.97) (1.89) (2.29)
Granger

PanelC:Short
LagBaseModel
FSI

= S8.77 + u.4uFSI
-1
+2.u6EFX4
-6
+ 8.6SEES
-8
+ 8.1S0I_IEIN
-5
-2.94EI0wS
-7
-4.SSCR_EISI
-8

DF=61K=6

Constant LaggedFSI FX
concentr.
Equity
Market
concentr.
Leverage Interest
RateRisk
capital
CreditRisk Adjusted
Rsquared
Akaikeinfo
criterion
Schwarz
criterion
Estimates
38.77 0.40 2.06 8.65 8.15 2.94 4.55
0.63 6.49 6.74 tvalue
(5.65) (3.93) (2.78) (3.14) (3.38) (1.03) (3.16)
Granger

PanelD:Long
LagBaseModel
FSI

= S7.8S -9.880I_AI0S
-9
+ 2.29EF
-11
-2.24CR_EINI
-6
+4.SS0I_EIB
-8
+11.2u0I_IEIN
-7

DF=57K=5

Constant ALmismatch Expected

Default
Frequency
CreditRisk Currency
Market
concentr.
Leverage Adjusted
Rsquared
Akaikeinfo
criterion
Schwarz
criterion
Estimates
37.85 9.88 2.29 2.24 4.55 11.20
0.51 6.75 6.96 tvalue
(6.20) (3.05) (2.06) (1.85) (2.13) (3.68)
Granger

29
Table4BenchmarkandBasemodelsoutofsample
PanelA:
Benchmark
FSImodel

FSI

= 7.8S + u.6uFSI
-1
+ u.24FSI
-4

DF=58K=2
RMSE MAPE TheilU
8.35 12.42 0.081


PanelB:
Candidate
BaseModel
FSI

= S6.S8 + u.SSFSI
-1
+1.7u0I_AIS
-5
+7.u40I_IEIN
-9
+2.S4PHKICP
-5
-12.62CRCAP_NI
-11

DF=61K=5
RMSE MAPE TheilU
11.70 15.24 0.112


PanelC:
ShortLag
BaseModel
FSI

= S8.77 +u.4uFSI
-1
+2.u6EFX4
-6
+8.6SEES
-8
+8.1S0I_IEIN
-5
-2.94EI0wS
-7
-4.SSCR_EISI
-8

DF=61K=6
RMSE MAPE TheilU
9.04 11.83 0.084


PanelD:
LongLag
BaseModel
FSI

= S7.8S - 9.880I_AI0S
-9
+ 2.29EF
-11
- 2.24CR_EINI
-6
+4.SS0I_EIB
-8
+11.2u0I_IEIN
-7

DF=57K=5
RMSE MAPE TheilU
14.62 16.73 0.138

20
30
40
50
60
70
80
90
100
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
0
20
40
60
80
100
120
140
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
20
40
60
80
100
120
140
160
1994 1996 1998 2000 2002 2004 2006 2008 2010
20
40
60
80
100
120
140
160
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

30
Table5Summaryofshortlagmodelstories
Model Story Positive Negative
(1)ASLSadjFSI
Structure
+
Leverage CreditRiskcapital
Risk

FXconcentration InterestRateRiskcapital
Return
+/
MarketCapitalization Commercialpropcredit
(2)ASLMRadj
Structure
+
FXconcentration InterestRateRiskcapital
Risk

EquityMktconcentration Shock_Liquidity
Liquidity

Leverage Solvency
(3)BSLSadj
Structure
+
FXconcentration Shock_Liquidity
Risk

Leverage CreditRiskdisttosyststress
Return
+
Liquidity

MarketCapitalization Solvency
(4)BSLMRadj
Structure
+
FXconcentration InterestRateRiskcapital
Risk

EquityMktconcentration CreditRiskcapital
Risk
+
Return

ExpectedDefaultFrequency Commercialpropertycredit
(5)CSLSadj
Structure
+
EquityMktconcentration CreditRiskdisttosyststress
Risk

Connectivity Solvencydisttosyststress
Connectivity
(6)CSLMRadj
Structure
+
EquityMktconcentration CreditRiskdisttosyststress
Risk
+
Leverage InterestRateRiskcapital
Liquidity
+
Return

ALmismatch InterestRiskDerivatives
(7)revDSLSadj2
Structure
+
IntRateRiskdisttostress Solvencydisttosyststress
Risk TotalCreditcpi CreditRiskdisttosyststress
Risk
+
Return
+
FXconcentration CreditRiskdisttostress
(8)DSLMRadj
Structure
+
FXconcentration CommercialPropertycredit
Risk

FXconcentration Solvencydisttosyststress
Return

Interbankconcentration CreditRiskdisttosyststress

Legend:

Structure Risk
Return Liquidity

31
Table6InsampleregressionresultsforSAFEEWSshortlagmodels

VARIABLE SERIES EXPOSURE

(1)
cpi
ASL
Sadj
(2)
cpi

ASL
MRadj
(3)
ta

BSL
Sadj
(4)
ta

BSL
MRadj
(5)
cpi

CSL
Sadj
(6)
cpi

CSL
MRadj
(7)
ta

DSL
Sadj
(8)
ta

DSL
MRadj
RETURN VARIABLES
RET_1.1cpi APHKICPS
+
CapitalMarkets Equity(pricebased) 11.810
(4.56) ***

RET_2cpi INSI0_t
+
CapitalMarketsBonds(pricebased) 7.723
(4.16) ***
RET_4ta INSCIA0t
-
CapitalMarketsCommercialProperty(totalassetsbased) 7.958
(6.93) ***
5.195
(2.74) ***

RET_4ta AINSCAIS
-
CapitalMarketsCommercialProperty(totalassetsbased 10.673
(5.06) ***
RET_5.2ta IXRIA0t
-
InterbankDerivative Exposure 1.192
(1.78) ***

RET_6cpi IIRBNK0_t
-
CurrencyMarkets InterbankExposures(pricebased) 3.076
(2.86) ***
RET_6ta IIBKIA0t
+
CurrencyMarkets InterbankExposures(totalassetsbased) 2.193
(3.43) ***
3.686
(3.46) ***
1.023
(1.23)
3.686
(4.52) ***
2.600
(2.28) **

RET_9ta IREIA0t
-
RiskTransferMarkets IRDerivatives (totalassetsbased) 4.298
(2.48) **

RISKVARIABLES
RSK_2 AEI0wS
-
IRRIndicators throughthecyclefunction 11.536
(7.59) ***

RSK_2.1 IRCAP_NI
+
IRRIndicators throughthecyclefunction 3.344
(4.93) ***
1.655
(2.68) **
4.859
(5.40) ***
2.319
(9.07) ***
RSK_4 IRCAP_SI
+
IRRIndicators pointintime/stress function 13.243
(4.33) ***
RSK_6 AIRCEIS
-

AIRCAP_EI
-

IRRIndicators extreme stress/crisis function 13.443

(4.63) ***
9.156
(2.66) **
5.095
(3.15) ***

RSK_7.1 ACRCAP_NI
-
CreditRiskIndicators through the cycle function 13.191
(5.81) ***
7.290
(2.02) **

RSK_8a EF
+
CreditRiskIndicators pointintime/stress function 3.281
(4.38) ***
2.252
(2.81) ***
2.081
(2.66) **
1.301
(1.17)
2.588
(2.80) ***
2.809
(8.02) ***
RSK_9 INS_EI
-
EconomicValue:12callreportloan portfolios99.5%BankCaR 2.588
(2.16) ***

RSK_14 S0II_NI
-
Solvencythrough the cycle function 2.378
(3.42) ***

RSK_15 S0II_SI
-
Solvencypointintime/stress function 3.514
(1.74) *

RSK_16 S0II_EI
-
Solvencyextreme stress/crisisfunction 4.554
(3.90) ***
RSK_F IR_EINI
-
InterestRate Risknormaldistancetosystemicstress 2.421
(3.30) ***

RSK_G IR_SINI
+
InterestRate Risknormaldistancetostress 2.811
(2.66) **
2.811
(10.32) ***
2.637
(2.73) ***

RSK_H CR_EISI
-
CreditRiskstress distancetosystemicstress 4.997
(3.86) ***
2.291
(1.46) ***
2.291
(1.78) *
53.223
(6.09) ***
RSK_H ACR_EISI
-
CreditRiskstress distancetosystemicstress 8.422
(1.70) *
8.422
1.86 *
12.133
(4.68) ***

RSK_I CR_EINI
-
CreditRisknormaldistancetosystemicstress 4.036
(3.60) ***
RSK_I AICEINIS
-
CreditRisknormaldistancetosystemicstress 9.465
(4.15) ***
9.465
(7.50) ***
5.924
(3.44) ***
RSK_K AtCRSINI4
+
CreditRisknormaldistancetostress 4.731
(4.22) ***
RSK_L SII_EISI
-
Solvencystress distancetosystemicstress 72.690
(5.63) ***
RSK_L AISEISIS
-
Solvencystress distancetosystemicstress 5.251
(2.53) **
5.251
(6.88) ***

RSK_M SII_EINI
-
Solvencynormaldistancetosystemicstress 2.531
(4.71) ***
2.183
(2.17) ***
3.662
(3.73) ***

LIQUIDITYVARIABLES
LIQ_1 0t_AIuS
+
ALGap Indicators '0to3months'maturityband 1.491
(2.04) **

LIQ_2 0t_AIS12
+
ALGap Indicators '3to12months'maturityband 1.556
(2.17) **

LIQ_2 AtAIS122
+
ALGap Indicators '3to12months'maturityband 2.453
(2.43) *
LIQ_4 0t_AI0S
+
ALGap Indicators 'greater than 3years'maturityband 3.007
(5.84) ***
3.007
(7.64) ***
5.665
(6.14) ***

LIQ_5 0t_IX_NI
-
LiquidityIndex Indicators1yearforward sale 5.027
(3.49) ***
4.009
(3.43)
3.751
(2.75) ***
LIQ_6 0t_IX_SI
-
LiquidityIndex Indicators3month forward sale 1.702
(2.37) **
1.740
(3.18) ***
1.702
(6.11) ***
0.962
(1.24)

STRUCTUREVARIABLES
STR_1.2 0t_PSPCI
+
ConnectivityIndicators CoVaRat5% 3.667
(6.69) ***
1.596
(2.90) ***
STR_1.3 AI1PCIS
+
ConnectivityIndicators DeltaCoVaRat1% 6.278
(1.69) *
6.278
(2.51) **

STR_1.4 0t_SPCI
+
ConnectivityIndicators DeltaCoVaRat5% 6.586
(4.08) ***
1.479
(2.22) **
6.586
(5.52) ***
4.421
(2.91) ***
1.565
(2.29) **
STR_2 AEES
+
ConcentrationIndicatorsCapitalMarkets (Equity) 14.322
(4.07) ***
13.369
(3.93) ***
10.320
(7.35) ***
10.274
(4.27) ***
3.952
(2.17) **
STR_4 0t_EFX
+
ConcentrationIndicatorsCurrencyMarkets (FX) 21.051
(3.14) ***
3.873
(5.50) ***
4.128
(5.67) ***
STR_4 AEFX4
+
AConcentrationIndicatorsCurrencyMarkets (FX) 54.066
(10.08) ***
1.579
(2.24) **
31.770
(4.48) ***
1.579
(3.60) ***
3.891
(4.84) ***
5.318
(4.24) ***
5.584
(6.86) ***
STR_4.1 0t_EIXP
+
ConcentrationIndicatorsCurrencyMarkets (FX) 2.778
(7.43) ***
10.320
(4.33) ***
1.436
(2.73) ***
STR_5 0t_EIB
+
ConcentrationIndicatorsCurrencyMarkets (Interbank) 3.686
(2.17) **
3.368
(2.53) **
STR_8 AtEIRS
+
ConcentrationIndicatorsRiskTransferMarkets (IRDerivatives) 3.310
(5.41) ***
STR_9 0t_IEIN
+
Contagion (normal leverage) 9.463
(6.689) ***
6.488
(2.85) ***
13.065
(4.69) ***
7.071
(2.36) **
4.717
(1.39)
DYNAMIC FSIt-1
+
Lagged FinancialStress Index 0.289
(3.9) ***
0.327
(4.43) ***
0.308
(3.37) ***
0.242
(2.75) ***
0.308
(4.59) ***
0.239
(2.77) ***
0.134
(2.07) **
SEASONAL FSIt-4
+
Lagged FinancialStress Index
CONSTANT 21.440
(5.396)
39.182
(8.03)
28.388
(6.19)
40.873
(6.68)
28.388
(9.12)
52.213
(6.48)
22.284
(3.33)
26.935
(8.49)
OBSERVATIONS 56 54 56 55 53 55 56 58
Rsquared 0.84 0.83 0.78 0.85 0.78 0.80 0.87 0.81
AIC(OLS) 5.90 5.88 6.19 5.83 6.19 6.11 5.66 6.00
SC(OLS) 6.48 6.28 6.72 6.42 6.72 6.77 6.23 6.49
Absolutevalueoftstatistics in parentheses.
+//0
theoreticalexpectations

* estimated coefficientssignificantat10%;**estimated coefficientssignificantat5%;***estimated coefficientssignificantat1%

Grangercausalitysignificantat20%; Grangercausalitysignificantat10%

NeweyWesterrors

32
Table7InsampleregressionresultsforSAFEEWSlonglagmodels

VARIABLE SERIES EXPOSURE

(1)
longLag
(2)
longLag
(3)
longLag
(4)
longLag
(5)
longLag
(6)
longLag
(7)
longLag
(8)
longLag
RETURN VARIABLES
RET_1.1cpi APHKICPS
+
CapitalMarkets Equity(pricebased) 2.535
(1.663)*
4.293
(2.236)**

RET_2cpi INSI0_t
+
CapitalMarketsBonds(pricebased) 10.025
(4.300)***
6.763
(3.031)***
RET_2ta INSIIA0t
-
CapitalMarketsBonds(totalassetsbased 11.549
(2.442)**

RET_4ta AINSCAIS
-
CapitalMarketsCommercialProperty(totalassetsbased 4.819
(1.902)
4.941
(2.458)

RET_6cpi IIRBNK0_t
-
CurrencyMarkets InterbankExposures(pricebased) 4.077
(3.149)***
2.298
(2.599)***
3.855
(3.769)***
3.153
(3.609)***
RET_6ta IIBKIA0t
+
CurrencyMarkets InterbankExposures(totalassetsbased) 2.112
(2.251)**
4.426
(5.245)***

RET_7cpi SECE0_t
+
RiskTransferMarkets Securitizations(pricebased) 2.555
(1.592)**
3.209
(4.254)***
3.250
(1.847)*
5.555
(1.847)*
3.225
(2.250)**
4.016
(2.962)***
RET_7ta SECEIA0t
-
RiskTransferMarkets Securitizations(totalassetsbased) 3.409
(1.693)*
4.183
(3.111) ***
2.843
(1.449)^
RET_9ta IREIA0t
-
RiskTransferMarkets IRDerivatives (totalassetsbased) 4.525
(3.601)***
4.755
(3.180)***

RISKVARIABLES
RSK_2 AEI0wS
-
IRRIndicators throughthecyclefunction 6.019
(2.142)**
8.577
(2.617)**
7.284
(2.285)**
RSK_6 AIRCEIS
-

AIRCAP_EI
-

IRRIndicators extreme stress/crisis function

RSK_7.1 ACRCAP_NI
-
CreditRiskIndicators through the cycle function 21.638
(4.947)***
8.138
(1.799)*

RSK_8a EF
+
CreditRiskIndicators pointintime/stress function 3.066
(2.929)***
3.743
(4.298)**
3.450
(4.298)***
2.955
(3.214)***
RSK_81 LNS_MVEDF

MarketValue : 12call report loan portfolios (w. EDF

uncertainty)
22.744
(2.911)***

RSK_11 SABRDPR
+
Supervisory Rating Indicatorspointintime/stressfunction 30.093
(3.427)***

RSK_12 SEERPR
+
Supervisory Rating Indicatorsextreme stress/crisis function
RSK_14 S0II_NI
-
Solvencythrough the cycle function 7.377
(2.835)**

RSK_15 S0II_SI
-
Solvencypointintime/stress function 6.120
(3.152)***

RSK_16 S0II_EI
-
Solvencyextreme stress/crisis function 2.416
(2.464)**
RSK_E IR_EVSV

Inteiest Rate Risk stiess uistancetosystemic stiess 1.620

(2.485)**

RSK_F IR_EINI
-
InterestRate Risknormaldistancetosystemicstress 4.070
(1.313)^

RSK_G IR_SINI
+
InterestRate Risknormaldistancetostress 3.268
(2.673)***

RSK_H ACR_EISI
-
CreditRiskstress distancetosystemicstress 18.655
(3.230)***
12.476
(3.169)***

RSK_I CR_EINI
-
CreditRisknormaldistancetosystemicstress 6.921
(3.07)***
2.320
(2.207)**
2.914
(2.013)*
3.549
(3.292)***
RSK_K AtCRSINI4
+
CreditRisknormaldistancetostress 4.086
(2.269)**

RSK_L SII_EISI
-
Solvencystress distancetosystemicstress 5.366
(2.728)***

RSK_L AISEISIS
-
Solvencystress distancetosystemicstress 8.851
(2.103)**
16.239
(4.197)***
RSK_M SII_EINI
-
Solvencynormaldistancetosystemicstress 5.910
(3.422)***
3.437
(2.732)***

RSK_N SLV_SVNV

Solvencynormaldistancetostress 7.423
(3.416)***

LIQUIDITYVARIABLES
LIQ_2 AtAIS122
+
ALGap Indicators '3to12months'maturityband 5.382
(2.861)***
4.893
(2.458)**
5.528
(2.998)***
4.098
(2.642)***
LIQ_5 0t_IX_NI
-
LiquidityIndex Indicators1yearforward sale 16.240
(4.875)**
7.697
(1.849)**

LIQ_6 0t_IX_SI
-
LiquidityIndex Indicators3month forward sale 16.240
(4.875)***
10.190
(2.453)**
13.718
(3.793)***

LIQ_7 0t_IX_EI
-
LiquidityIndex Indicatorsimmediate firesale 8.159
(2.076)**
4.799
(1.687)*
9.308
(2.131)***
17.174
(3.743)***
6.974
(1.795)*
STRUCTUREVARIABLES
STR_1.2 0t_PSPCI
+
ConnectivityIndicators CoVaRat5% 2.406
(2.001)*
3.853
(3.666)***
4.851
(4.999)***
STR_1.3 AI1PCIS
+
ConnectivityIndicators DeltaCoVaRat1% 3.912
(2.883)***
STR_1.4 0t_SPCI
+
ConnectivityIndicators DeltaCoVaRat5% 3.393
(2.310)**
2.610
(1.660)^
STR_2 AEES
+
ConcentrationIndicatorsCapitalMarkets (Equity) 9.118
(3.565)***
8.354
(3.426)***

STR_4 0t_EFX
+
ConcentrationIndicatorsCurrencyMarkets (FX)
STR_4 AEFX4
+
AConcentrationIndicatorsCurrencyMarkets (FX) 1.843
(2.622)***

STR_4.1 0t_EIXP
+
ConcentrationIndicatorsCurrencyMarkets (FX) 2.953
(3.193)***
2.090
(2.294)**
STR_5 0t_EIB
+
ConcentrationIndicatorsCurrencyMarkets (Interbank) 7.928
(3.732)***
7.379
(4.225_***
7.191
(4.783)***
4.777
(2.414)**
5.510
(3.082)***

STR_8 AtEIRS
+
ConcentrationIndicatorsRiskTransferMarkets (IRDerivatives) 2.834
(1.732)*
3.954
(2.564)**
4.633
(3.083)***

STR_9 0t_IEIN
+
Contagion (normal leverage) 15.449
(4.461)***
9.755
(3.276)***
14.244
(5.161)***
16.239)
(4.938)***
13.287
(5.766)***
19.400
(9.857)***
20.221
(8.920)***
20.269
(5.898)***
CONSTANT 68.430 20.321 26.290 43.936 29.955 49.921 59.861 55.316
OBSERVATIONS 56 50 53 52 52 53 50 52
Rsquared 0.708 0.778 0.834 0.703 0.739 0.766 0.754 0.815
AIC(OLS) 6.354 6.156 5.891 6.423 6.294 6.162 6.246 5.947
SC(OLS) 6.860 6.615 6.411 6.911 6.782 6.646 6.667 6.434
Absolutevalueoftstatistics in parentheses.
+//0
theoreticalexpectations

* estimated coefficientssignificantat10%;**estimated coefficientssignificantat5%;***estimated coefficientssignificantat1%

Grangercausalitysignificantat20%; Grangercausalitysignificantat10%

33
Table8OutofsamplestatisticsforSAFEEWSshortlagmodels
VARIABLE SERIES EXPOSURE (1)cpi
ASL
Sadj
(2)cpi
ASL
MRadj
(3)ta
BSL
Sadj
(4)ta
BSL
MRadj
(5)cpi
CSL
Sadj
(6)cpi
CSL
MRadj
(7)ta
DSL
Sadj
(8)ta
DSL
MRadj
RMSE 9.54 5.40 4.93 6.18 5.08 8.10 4.77 5.21
MAPE 8.34 7.59 8.00 7.38 7.84 7.80 6.41 7.56
TheilU 0.093 0.050 0.050 0.060 0.051 0.081 0.048 0.052

Table9OutofsamplestatisticsforSAFEEWSlonglagmodels
VARIABLE SERIES EXPOSURE (1)LL1 (2) LL2 (3) LL3 (4) LL4 (5) LL5 (6) LL6 (7)LL7 (8) LL8
RMSE 7.736 10.264 11.031 11.82 12.134 12.444 13.53 11.694
MAPE 13.168 14.351 14.507 15.645 17.56 18.541 21.701 17.409
TheilU 0.0736 0.0973 0.105 0.1123 0.116 0.119 0.127 0.112

Table10ShortlaghorseraceresultsrankedbyRMSE
LTCM
Crisis
Q31998
DotComCrisis
Q41999
StockMarket
Downturn
Q22002
SubprimeCrisis
Q42007
Horse
Race
(5) (6) (6) (4) (4)
(7) (4) (7) (2) (7)
(4) (5) (4) (7) (6)
(3) (7) (1) (8) (5)

Table11Distributionofsupervisorydataamongimbalanceclasses
Return
Imbalances
Liquidity
Imbalances
Risk
Imbalances
Structure
Imbalances
- FRSFDRmicrodata
- CRSP
- S&PCaseSchillerdata
- MITCREdata
- FRSFDRmicrodata
- Moodys
- FRSFDRmicrodata
- Moodys
- FRSFDRmicrodata
- CRSP
- FRSCoVaRmodel
- FRSFlowofFunds
FRSXCountrydata FRSIRRFOCUS
FRSBankCaR
FRSSABR/SEER
FRBCSCAPhaircut
FRBCLFM
FRSIRRFOCUS
FRSBankCaR
FRSCAMELS
FRSSABR/SEER
FRBCSCAPhaircut
FRBCLFM
FRSXCountrydata

Table12Proportionofsupervisoryvariablesamongimbalanceclasses
ImbalanceClass Supervisoryseries ProportionFRS
Total 33 50.0%
ReturnImbalances 1 10.0%
LiquidityImbalances 3 42.9%
RiskImbalances 28 82.4%
StructureImbalances 1 7.1%

34
Table13Comparativestatisticsofsupervisoryandpublicspecifications
PanelA:shortlag
comparison
Bench
mark
Base
(1) (2) (3) (4) (5) (6) (7) (8)
PUBLIC
insample
Obs 59 62 59 54 62 55 59 58 56 59
Rsquared 0.51 0.59 0.75 0.71 0.59 0.69 0.64 0.63 0.76 0.77
AIC(OLS) 6.78 6.6 6.27 6.38 6.6 6.49 6.55 6.63 6.23 6.15
SC(OLS) 6.89 6.81 6.72 6.71 6.81 6.9 6.84 7.02 6.63 6.53
PUBLIC
outof
sample
RMSE 8.48 7.68 9.34 8.49 8.66 6.97 6.13 8.18 6.38 5.73
MAPE 12.32 5.68 9.39 10.37 12.35 9.69 10.54 10.85 8.59 8.44
TheilU 0.082 0.073 0.093 0.077 0.082 0.07 0.063 0.082 0.064 0.058

PRIVATE
insample
Obs 53 56 54 56 55 53 55 56 58
Rsquared 0.61 0.84 0.83 0.78 0.85 0.78 0.8 0.87 0.81
AIC(OLS) 6.59 5.9 5.88 6.19 5.83 6.19 6.11 5.66 6
SC(OLS) 6.84 6.48 6.28 6.72 6.42 6.72 6.77 6.23 6.49
PRIVATE
outof
sample
RMSE 7.88 9.54 5.4 4.93 6.18 5.08 8.1 4.77 5.21
MAPE 10.94 8.34 7.59 8 7.38 7.84 7.8 6.41 7.56
TheilU 0.074 0.093 0.05 0.05 0.06 0.051 0.081 0.048 0.052

PanelB:longlagcomparison LLBase LL1 LL2 LL3 LL4 LL5 LL6 LL7 LL8
PUBLIC
insample
Obs
57 56 50 57 56 60 53 50 56
Rsquared
0.36 0.50 0.55 0.53 0.50 0.39 0.66 0.67 0.39
AIC(OLS)
6.99 6.84 6.78 6.76 6.82 6.99 6.49 6.51 7.02
SC(OLS)
7.13 7.24 7.01 7.08 7.11 7.30 6.87 6.85 7.31
PUBLIC
outof
sample
RMSE
17.85 15.07 21.15 25.21 17.86 16.45 28.70 26.48 19.47
MAPE
20.49 18.15 21.08 24.17 20.11 19.16 26.19 25.08 20.63
TheilU
0.164 0.138 0.184 0.221 0.159 0.154 0.248 0.235 0.178

PRIVATE
insample
Obs
57 56 50 53 52 52 53 50 52
Rsquared
0.52 0.71 0.78 0.82 0.70 0.74 0.77 0.75 0.82
AIC(OLS)
6.75 6.35 6.16 5.89 6.42 6.29 6.16 6.25 5.95
SC(OLS)
6.96 6.86 6.61 6.41 6.91 6.78 6.65 6.67 6.43
PRIVATE
outof
sample
RMSE
14.62 18.82 12.64 19.95 18.91 16.85 27.56 27.01 26.29
MAPE
16.72 17.86 13.79 18.40 19.13 16.59 24.53 23.78 21.93
TheilU
0.138 0.167 0.118 0.179 0.166 0.156 0.241 0.241 0.228

Table14PolicyhorseraceresultsrankedbySAFEtoFSIvariance
Episode FSI Ave Best Top2 Top3 Top4 (1) (2) (3) (4) (5) (6) (7) (8)
Dotcomcrisis 0.68 1.41 2.08 0.61 1.61 1.46 2.08 1.01 0.13 0.31 2.17 3.30 3.61 2.86
StockMarket
downturn
0.32 0.18 0.64 0.17 0.30 0.33 0.34 0.35 0.36 0.57 0.42 0.64 0.21 0.30
Subprime
crisis
2.86 1.71 3.44 2.16 1.84 1.74 1.43 2.51 0.88 3.44 1.13 1.23 1.20 1.85
Legend:
Best 2nd 3rd 4th

35
Figure4Outofsampleperformanceofprivateandpublicmodels

Figure5SAFEEWSoutofsampleforecasts(casestudy2)

30
40
50
60
70
80
90
100
110
I II III IV I II III IV I II III IV I II III IV I II III IV I
2004 2005 2006 2007 2008
Model (2) Model (4) Model (7) Actual Financial Stress
(2)
(4)
(7)
30
40
50
60
70
80
90
100
110
I II III IV I II III IV I II III IV I II III IV I II III IV I
2004 2005 2006 2007 2008
Model(2)
Model(7)
Model(7)Public
Model(8)Public
ActualFinancial Stress

36
Figure6ShortlagforecastonQ1:2007

Figure7LonglagforecastonQ1:2007

-2
-1
0
1
2
3
I II III IV I II III IV I II III IV
2005 2006 2007
Actual FSI
Short Lag 2
Short Lag 4
Short Lag 8
-2
-1
0
1
2
3
4
5
I II III IV I II III IV I II III IV I II III
2005 2006 2007 2008
Actual FSI
Long Lag 1
Long Lag 2

37
(8)Appendix
Box1Descriptionofexplanatorydata
Fourclassesofexplanatoryvariablesaretested:return,risk,liquidity,andstructure.Financialstressisfrequentlyassociatedwith
shocksfromdeflatingassetsbubblesthatcharacterizeirrationalexpectationsofreturns.Accordingly,returnindicatorsconsistof
datausefultomonitorformationofexpectationbubblesinreturns.Theindicatorsaredesignedtocapturerespectiveasset
imbalancesinvariousassetmarkets,akeyaspectoftheexpectationbubbles.Thedefinitionandmethodologyusedfortheasset
gapsinthemodelextendtheworkofBorio(Borio,etal.,1994)andCallen(Callen,1991).Borioanalyzedthreeseparateasset
classes(equities,residentialpropertyandcommercialproperty).TheEWSmodelexpandsthisapproachtoincludethefollowing
assetclasses:equities,bonds,residentialpropertyandcommercialpropertyinthecapitalmarkets;internationalexposuresand
interbankexposuresinthecurrencymarkets;securitizations,creditderivatives,andinterestratederivativesintherisktransfer
markets.
Riskindicatorsconsistofdatausefultomonitoranunsustainableorirrationalrisktaking,whichcanleadtoinstitutionaland
aggregateaccumulationofriskbeyondarationalequilibriumvalue.Theriskdataarebasedbothonpubliclyavailablefinancial
informationandonprivatesupervisoryEWSofindividualinstitutionsrisk.Publicinformationisusedinriskindicatorsfortworisk
components,marketandcredit,andcanbeobservedintimebycomparisonofthreedistincttimeseriesforeachrisk:thebook
value,themarketvalue,andtheeconomicvalueofthecorrespondingassets.Theeconomicvaluetimeseriesisobtainedthrough
privatesupervisoryFRBIRRFocusandFRBBankCaR(FryeandPelz,2008)models.Privatesupervisoryriskdataisbasedon
applicationoftheFRBSABRmodeltohistoricdata.
Liquidityindicatorsconsistoftimeseriesdataincorporatingbothfundingliquidityandassetliquiditydatathroughamaturityband
differentiatednetliquiditytimeseries.Eachtimepointisrepresentedbytwosetsofliquiditycomponents:1)asetofgapmeasures
byeachmaturityband,and2)asetofliquidityindexmeasuresbasedonvaluationsofallassetsandliabilitiesrelativetothreetime
horizonpoints:(a)immediatefiresale,(b)threemonthforwardsale,(c)oneyearforwardsale.Thedataappliesassetliability
classificationandassumptionsfromtheFRBIRRFocusmodel.Thefollowingfourmaturitybandsareusedforbothassetsand
liabilities:0to3months,3to12months,1to3years,andgreaterthan3years.Availablefundingliquidityforeachmaturity
bandistrackedthroughtwosetsofdata:componentsofTotallargeandsmalltimedeposits,andcomponentsofOtherBorrowed
money(includingFHLBAdvances).Availableassetliquidityforeachmaturitybandistrackedthroughfoursetsofdata:components
ofFirstLien14FamilyMortgagesLoansandPassThrus,componentsofCMOsandMortgageDerivatives,AllOtherLoansand
AllOtherSecurities.

38
Box1Descriptionofexplanatorydata(contd)
Structuralindicatorsconsistoftimeseriesdatadescribingorganizationalfeaturesofthefinancialsystem.Threedistincttypesof
structuraldataaretestedinthemodel:connectivity,concentration,andcontagion.
40
Connectivitydatadescribesstructuralfragility
throughameasureoftheinterconnectednessandthemarginalimpactofindividualinstitutionsontheaggregatefinancialsystem.
Thedataisobtainedviaasubmodelusingacorrelationapproach.ThemodelappliesAdrianandBrunnermeier(2008,2009)CoVaR
techniquemeasuringrelativecontributionofthefirmstosystemicrisk(CoVaR).CoVaRismeasuredasthevalueatrisk(VaR)of
financialinstitutionsconditionalonotherinstitutionsbeingindistress.TheincreaseofCoVaRrelativetoVaRmeasuresspilloverrisk
amonginstitutions
41
CoVar,asconnectivityindicator,isestimatedusingquantileregressions.Concentrationdatadescribes
structuralfragilityduetoconcentrationsintheexposureprofile,bothonbalancesheetandoffbalancesheets.Alarger
concentrationisindicativeofincreasedsusceptibilitytostressduetoexpectationshocks.Concentrationismeasuredthroughthe
marketshareforinstitutionsandtheaggregateHerfindahlIndexmeasuredforthecapital,currency,andrisktransfermarkets.
SeparatemarketshareandHerfindahlmeasuresareobtainedineachofthesemarkets.Institutionsconcentrationinaparticular
marketexpressedthroughthecorrespondingmarketshareisausefulexplanatoryindicatorofstructuralfragility,sinceitmeasures
therelativepositionofsignificantinstitutionsinthefinancialsystem.Similarly,aggregateconcentrationexpressedthroughthe
Herfindahlindexisausefulexplanatoryindicatorofstructuralfragility,sinceitmeasurestherelativepositionoflargeenterprisesin
theeconomy.Contagiondatadescribesstructuralfragilityofindividualinstitutionsandtheaggregatefinancialsystembythe
transmissionofsomeshockfromoneentitytootherdependententities.Economicliteraturedescribesfinancialcontagionthrough
avarietyofthesetransmissionchannels,e.g.directtransmissionsviainterbankcreditandliquiditymarketsandindirecttransmission
duetoageneraldeteriorationofconditionsonfinancialmarkets.Thisstudyconsidersleveragebasedratiostobeausefulbasisfor
describingfinancialcontagionisameasureoffinancialimmunityofanindividualinstitutionorclusterofinstitutionsagainsta
varietyofshocks.

40
ThemodelevolvedindependentlyfromconcurrentworkofJamesThomsononidentificationofsystemicinstitutions(see
Thomson,2009).JamesThomsonproposed4Cs(Correlation,Concentration,Contagion,Conditions)asabasisforconsidering
theselectionofsystemicallyimportantinstitutions.TheConditionscomponentisakintoexpectationsintheSAFEmodel.Thus,
thereisaconceptualparallelbetweenthe4CsandSAFEarchitecture,whentheCorrelation,Concentration,andContagionare
consideredasformsofstructuralvariablesandConditionsaformoftheexpectationsvariables.
41
AdrianandBrunnermeier(2008).

39
Box2Explanatoryvariableconstruction
ConstructionofAggregateImbalances
Allexplanatorytimeseriesindicators(i.e.indicatorsofreturnexpectations,indicatorsofriskexpectations,indicatorsofliquidity
expectations,andstructuralIndicators)areaggregatedasrollingstandardizedimbalances,anapproachdevelopedbyBorioand
Lowe(Borio,etal.,2002),andexpandedbyBorioandDrehmann(Borio,etal.,2009)andHanschelandMonnin(Hanschel,etal.,
2005).Thistransformationinformstheresearcherastothedegreeofdeviationfromlongterm,historicaltrendsinbehavior.
Implicitinthisapproachisanassumptionthatthehistoricaltrendservesasaproxyforthelongertermfundamentalvalueofa
variable,aroundwhichtheactualseriesfluctuates(Hanschel,etal.,2005).Inasense,thegapbetweentheoriginalseriesandits
trendreflectsaneconomicimbalance.Toobtainimbalancemeasuresforeachindicator,dataforthefivelargestbankholding
companies,accordingtototalassetssizebyquarter,areaggregatedthroughsimpleaddition.Theequationbelowarticulatesthis
logicforanarbitraryindicatorX.
X
t
= X
1,t
+X
2,t
+X
3,t
+X
4,t
+X
5,t
(3)
OnceX
t
isgenerated,imbalancetransformationsareperformedusingthefollowingequation:
X
t
Stanuaiuizeu Imbalance of X
t
=
(X
t
-
t
X
)

t
X
_ (4)
whereX
t
istheobservedvalueofthereferencevariableinquartert,p
t
X
isthehistoricalmeanofthisvariableuptoquartert,and
o
t
X
isthehistoricalstandarddeviationofthevariableuptoquartert.
Asaggregationsinthiscategoryofvariableswillhaveunitsindollars,thereisalikelihoodthatourimbalancemeasurescouldgrow
simplyduetoinflation.Assuch,wecontrolforinflationaryeffectsusingtwoseparatemethodspriortoapplyingimbalance
transformations.Onemethodistodeflatetheaggregatedollarvaluesbyapriceindex.Wechosetodeflatethemajorityofseries
withtheConsumerPriceIndexlessenergyandfood.Residentialandcommercialrealestatevaluesweremoreappropriately
deflatedusingabettertargetedindex.TheCaseShillerpriceindexandtheMITtransactionsbasedcommercialrealestateprice
index(TBI)wereusedrespectively.Totheextentthatconsumerpricesmoveatdifferentpacesthanfinancialassetprices,this
methodwillallowaresearchertoexaminevalueimbalanceswithinassetclassesratherthanrealimbalancesasrelativepricesare
nonconstant.
Asecondmethodthatweemploytodeflatedollarvaluesistodivideeachvariablebytheaggregatevalueoftotalassetsforthefive
largestinstitutions.Thismethodissimilartothefirstmethod;however,bydeflatingwithtotalassets,relativepricesarereasoned
tobemuchclosertoconstantsoanyincreaseintheimbalancemeasureinanassetclasscanbeattributabletochangesinthelevel
offirmactivity.Hence,thismethodwillproducemeasuresofwhatcanbecalledquantityimbalances.
ConstructionofReturnVariables
AccumulatedReturnimbalancesarespecifictoeachassetbasedonitsindividualcharacteristics.Returnsofmanyassetclassescan
beobservedwithindifferentfinancialmarkets.Becausemoneyflowsacrossthesevariousassetmarkets,disturbancesinone
marketcanaffectothermarkets.Capitalmarkets(equityandcreditmarkets)providefinancingthroughissuanceinprimarymarkets
andtradingofstocksandbondsinsecondarymarkets.Currencymarketssupportshorttermfinancingandinvestmentthroughboth
dollarbasedinterbankmarketsandforeignexchangemarkets.Returnsofrisktransferinstruments(securitizations,credit
derivatives,andinterestratederivatives)canbeobservedintherisktransfermarketswhichprovideopportunitiestomanageriskby
hedgingandbalancesheettransformations.
Returnindicatorsconsistofdatausefultomonitorformationofexpectationbubblesinreturns.Financialstressisfrequently
associatedwithexpectationshocksfromdeflatingassetsbubbles.Theindicatorsaredesignedtocapturerespectiveimbalancesin
variousassetmarkets,akeyaspectoftheexpectationbubbles.TheEWSmodelutilizesthefollowingassetclasses:equities,bonds,
residentialpropertyandcommercialpropertyinthecapitalmarkets;internationalexposuresandinterbankexposuresinthe
currencymarkets;securitizations,creditderivatives,andinterestratederivativesintherisktransfermarkets.Mostdataforreturn
variablesispubliclyavailable.

40
Box2Explanatoryvariableconstruction(contd)
ConstructionofRiskVariables
SAFEcollectsandmonitorsriskindicatordataalongfourriskdimensions:marketrisk,interestraterisk,creditrisk,andsolvency.
42

Accumulatedimbalancesinmarketriskexposuresgiverisetomarketshockstotheinstitutionsmarktomarketportfolios.
Accumulatedimbalancesininterestrateriskexposuresgiverisetointerestrateshockstotheinstitutionsassetsandliabilities.
Accumulatedimbalancesincreditriskexposuresgiverisetoshocksassociatedwithfailuretomeetcontractualpaymentobligations.
Market,interestrate,andcreditriskscancausesignificantfinancialstresstotheinstitutionsandthefinancialsystem.Ingeneral,
unsustainableorirrationalrisktakingcanleadtoinstitutionalandaggregateaccumulationofriskbeyondarationalequilibrium
value.
Marketriskindicatorsareconstructedonsecuritiestocapturetheimpactsofmarketriskshockstothemarktomarketsecurities
portfolios.SAFEmonitorsthedistancebetweenhypotheticalnormal,stress,andcrisisscenariovaluationsofmarketriskofon
balancesheetsecurities,usingthefollowingdata:fornormal(throughthecycle)scenariobookvalueofsecurities;forstress
(pointintime)scenariomarketvalueofsecurities;forcrisisscenariochangeineconomicvalueofsecurities.
Interestriskindicatorsareconstructedonequitytocapturetheimpactofinterestrateshockstothebalancesheetsoffinancial
institutions.SAFEmonitorsthedistancebetweenhypotheticalnormal,stress,andcrisisscenariovaluationsofinterestrateon
balancesheetexposures,usingthefollowingdata:fornormal(throughthecycle)scenariobookvalueofequitylessgoodwill;for
stress(pointintime)scenariocorporatevalueofequityatmarketvalue;forcrisisscenariochangeineconomicvalueofequity.
Creditriskindicatorscapturebookvalue,marketvalue,andeconomicvalueofthecreditportfolios.Bookvalueofthecredit
portfoliosismodeledasadifferencebetweencombinedvalueofthetwelvecallreportloanportfoliosandreportedAllowancesfor
LoanandLeaseLosses(ALLL).Marketvalueofthecreditportfoliosismodeledasdifferencebetweencombinedvalueoftheabove
twelvecallreportloanportfoliosandmarketexpectedloss.Economicvalueofthecreditportfoliosismodeledasdifference
betweencombinedvalueofthetwelvecallreportloanportfoliosandtheirsimulated99.5%stresslossfromthesupervisoryBank
CaRmodel(Frye,etal.,2008).
Solvencydirectlyreflectsthecapacityofcapitaltoabsorblossesandoffundstorepaydebts.Insolvencyofoneormoresignificant
financialinstitutioncreatesshockstothefinancialsystemthatmaybeabsorbedoramplifieddependingontheotherstructural
fragilityfactors:connectivity,concentration,andleverage.Solvencyindicatorsareconstructedtocapturethedifferencebetween
anaggregateriskbasedcapitalneed(definedassumofcreditrisk,marketrisk,interestraterisk,andoperationalriskexposures
43
)
andavailablefinancialresources(definedasTierIcapitalplusALLL).Similartootherriskmeasures,SAFEmodelconsidersthe
solvencyindicatorsbothasstandardizedimbalancesconstructedfrominterimaggregatelevelsofsolvency(underseparatebook,
market,andeconomicvaluations)andasstandardizedimbalancesconstructedfromdifferencesintherespectivesolvency
valuations.
ConstructionofLiquidityVariables
Whenamarketforaparticularassetbreaksdownforanyreason,buyersandsellersfailtoreachconsensusontheprice.Regardless
ofitsunderlyingvalue,theassetbecomesilliquid.Managinginstitutionalliquidityisastoryofmatchingdemandforliquidity,
reflectedthroughcurrentliabilities,andsupplyofliquidity,reflectedthroughcurrentassets.Matchinginvolvesbothfunding
liquidityandassetliquidity.Relianceoncontinuoussupplyofshorttermfinancinginvolvesfundingrisktiedtotheinstitutions
abilitytomatchfundwithcashinflowsfromcurrentassets.Amismatchexistsataparticulartimepointwhenincomingcashflows,
suchasfees,interestdue,principalpaymentsandprepayments,etc.areinsufficienttomeetcurrentliabilitiesdueatthatpointin
time.Totheextentmismatchexists,financialinstitutions(FIs)havefundingliquidityneedsforshorttermfinancing.Shortterm
financingistypicallycheap,soFIsarecontinuallytemptedtorelyonshorttermfinancingformeetingobligationsofallmaturities.
This,ofcourse,onlyexacerbatesthemismatchacrossallmaturities.Inaddition,theavailabilityandpricingoftheshortterm
financingishighlydependentonFIsowncreditworthinessandvaluationsofassetspledgedascollateral.Exogenousshocksto
eithercurrentliabilitiesorcurrentassetscanincreasetheriskoftheinstitutionanditsunderlyingcollateralasperceivedbyits
creditors/counterparties.Aggregateliquiditymismatchesindicatepresenceoffundingandassetliquidityonasystemicscale.

42
Solvencymayalsobeconsideredausefulindicatorofstructuralfragility.Agoodargumentforconsiderationofsolvencyasa
structuralindicatorcanbemadeonthegroundsthatinsolvency,likesystemicriskitself,mayarisethroughavarietyof
mechanisms:e.g.throughfailedexpectationsofreturn,risk,orliquidity.Capitalforasinglefinancialinstitutionisastructural
bufferforaninstitutionagainstrisk.Aggregatecapitalofthefinancialsystematlargerepresentsameasureofcollective
safeguardsagainstdisjointedfailures.Capitallevelneedstobeconsideredtoassesssafetyandsoundnessofindividualand
aggregatefinancialinstitutions.FortheSAFEmodelingapproach,thechoiceofwheretoincludesolvencyindicators(as
componentsofriskorascomponentsofstructure)isnotrelevant.Wemadeachoicetoincludesolvencyintothesetofrisk
indicators,becausetheconstructionanduseofthisindicatormorecloselyparallelsotherriskindicatorsthanthestructural
indicators.
43
Duetocurrentdatalimitationsinoperationalriskexposures,SAFEimplementsameasureofoperationalriskexposuresimilarto
theBaselIIbasicindicatorapproach.Inthefuture,thiscomponentofriskexpectationsmaybeexpandedandimproved.

41
Box2Explanatoryvariableconstruction(contd)
Liquidityriskindicatorsconsistoftimeseriesdataincorporatingbothfundingliquidityandassetliquiditydatathroughamaturity
banddifferentiatednetliquiditytimeseries.Eachtimepointisrepresentedbytwosetsofliquiditycomponents:1)asetof
standardizedimbalancemeasuresofmaturitymismatchsortedbyeachmaturityband,and2)asetofstandardizedimbalance
measuresofaliquidityindexthatisbasedonvaluationsofallassetsandliabilitiesrelativetothreetimehorizonpoints.Thesethree
horizonpointsare:(a)immediatefiresale,(b)3monthforwardsale,(c)1yearforwardsale.Mostbutnotalloftheunderlyingasset
andliabilitydatausedforthematuritymismatchmeasurementispubliclyavailable.However,somecoarsenessinthegranularityof
theavailabledatanecessitatesafurthersetofprivatesupervisorytransformationsandvaluationassumptions.SAFEappliesthe
assetliabilityclassificationandassumptionschemefromtheFederalReserveprivateassetliabilitysupervisorymodel(FRBIRRand
SecuritiesFocusModel).WhiletheoriginaldataisallpublicdomainCallReportfinancialdata,theclassification,aggregation,and
maturityassumptionschemeisuniquetotheFRBFocusmodel.Thefollowingfourmaturitybandsareusedforbothassetsand
liabilities:0to3months,3to12months,1to3years,andgreaterthan3years.Availablefundingliquidityforeachmaturity
bandistrackedthroughtwosetsofdata:componentsofTotallargeandsmalltimedeposits,andcomponentsofOtherBorrowed
money(includingFHLBAdvances).Availableassetliquidityforeachmaturitybandistrackedthroughfoursetsofdata:components
ofFirstLien14FamilyMortgagesLoansandPassThrus,componentsofCMOsandMortgageDerivatives,AllOtherLoansand
AllOtherSecurities.
Theliquidityindexiscomputedforthethreehorizonpoints(immediatefiresale,3monthforwardsale,and1yearforwardsale),
followingPierce(Pierce,1966)as:
I

= |(w
k
)(P
kt+
P
kt
)
N
k=1
] (5)
Valuationsfortheassetandliabilityclassesarebasedonaprivatesupervisorysetofliquidityhaircutsseparatelydevelopedasapart
ofthisstudy.TheliquidityhaircutschemewasbasedonthepublishedsupervisoryhaircutsusedfortheSCAPexerciseandwere
supplementedasrequiredbypublicstandardizedsources(e.g.Moody'sInvestorsService(2001,2002)andIOSCO(2002)).
44,45

Riskbasedliquidityamplificationisincorporatedforthethreetimehorizonpointsextendingmethodologyproposedby
Krishnamurthy(Krishnamurthy,2009).KrishnamurthyshowsthatinbothcrisisandnoncrisisconditionspriceofanassetPsatdate
sisafunctionofthreefactors:longtermfundamentalvaluefortheassetP,timedependentliquiditydiscountP
t
(I)and
counterpartyuncertaintyfunction. Innormallyfunctioningmarkets,assetpricemaybemodeledas:
P
s
= P - P
t
(I)
2
(6)
Whileincrisisshockedmarkets,uncertaintygetsmagnifiedasfollows:
P
s
= P - P
t
(I) (7)
Weimplementthemodelasfollows:
1. Normaluncertaintyisquantifiedascreditratingequivalentlongterm(throughthecycle)defaultprobability;
2. StressconditionuncertaintyinstresstimesisquantifiedaspointintimeexpecteddefaultprobabilityusingMertonmodel
expecteddefaultfrequencyMoodysKMVEDF.
3. Shockconditionuncertaintyinextremestressisquantifiedmaximumvalueofstressconditionuncertaintyatapeer
institution;
4. Theliquidityindexiscomputedforthethreehorizonpoints(immediatefiresale,3monthforwardsale,and1yearforward
sale)quantifyingimmediatefiresaleasashockcondition,3monthforwardsaleasastresscondition,and1yearforwardsale
asanormalcondition.
ConstructionofStructureVariables
Theimpactthatasystemicinstitutionhasonmacroeconomicmarketsisconditionaluponvariousstructuralfactors.Inthispaper,
weconsiderhowstructuralrelationshipsaffectmacroeconomicconditionsthroughexaminationofthreetypesofstructural
indicators:measuresofconnectivity,measuresofmarketconcentration,andmeasuresofmarketcontagionthroughleverage.

44
Matz,2007
45
Raffis,2007

42
Box2Explanatoryvariableconstruction(contd)
Connectivity
Connectivitydescribesinterconnectednessandinterdependenceofthesystemicfirms.Aconnectivitymeasureisdesignedto
captureanaspectofstructuralfragilitythroughameasureoftheinterconnectednessandthemarginalimpactofindividual
institutionsontheaggregatefinancialsystem.Toidentifyconnectivity,weemployAdrianandBrunnermeiersConditionalValueat
Risk(CoVaR)technique,estimatedusingquantileregressions.CoVaRmeasurestheValueatRisk
46
ofonefinancialportfolio
conditionalondistressofanotherfinancialportfolio.
47
Inparticular,weareinterestedintheextenttowhichpoorstockmarket
returnsarecorrelatedwithweakmarketreturnsforourquarterlysystemicinstitutions.Wedeterminetherelationshipby
computing1%and5%CoVaRandsubtractingthe1%and5%ValueatRiskofthestockmarketrespectivelyforeachinstitutionand
aggregatingthroughsimplesummation.Mathematically,wecanexpressourconnectivityindicatorasfollows:
CoIoR
q
|]
-IoR
q
5
]=1
(8)
whereiisabroadbasedstockmarketportfolioandjreferstoeachofourquarterlysystemicinstitutions.Wealsocomputea
percentagebasedconnectivitymeasurebydividingeachdifferenceinthesummationabovebythecorrespondingVaRinorderto
controlforsharpdifferencesineachinstitutionsmarketcapitalization.
Concentration
Concentrationdescribesthediversificationoffinancialinstitutionsorlackthereof.Highlyconcentratedsystemicfirmscreate
pocketsofconcentrationsthatarehighlysusceptibletoshocksthroughtheconcentrationchannels.Therefore,concentration
indicatorsaredesignedtocaptureanaspectofstructuralfragilityduetoconcentrationsintheexposureprofile,bothonbalance
sheetandoffbalancesheets.Concentrationinthesevariousexposuresismeasuredthroughthemarketshareforinstitutionsand
theaggregateHerfindahlIndexmeasuredforthecapital,currency,andrisktransfermarkets.SeparatemarketshareandHerfindahl
likemeasuresareobtainedineachofthesemarkets.
Institutionsconcentrationinaparticularmarketexpressedthroughthecorrespondingmarketshareisausefulexplanatory
indicatorofstructuralfragility,sinceitmeasurestherelativepositionofsignificantinstitutionsinthefinancialsystem.Similarly,
aggregateconcentrationexpressedthroughaformofHerfindahlindexisausefulexplanatoryindicatorofstructuralfragility,sinceit
measurestherelativepositionoflargeenterprisesintheeconomy.Therationaleunderlyingtheinclusionofconcentrationasan
indicatorofstructuralfragilityistheideathat,otherthingsbeingequal,higherlevelsofmarketconcentrationareincreasinglyless
efficientinabsorbinganddiversifyingtheimpactofsmallshockstoexpectations.Thus,alargerconcentrationisindicativeof
increasedsusceptibilitytostressduetoexpectationshocks.
WemeasuremarketconcentrationbycomputingmodifiedHerfindahlindicesforcapital(equityandcredit),currency(FXand
interbank),andrisktransfer(securitizations,creditderivatives,andinterestratederivatives)markets.Tocomputethemodified
Herfindahlswefirstcalculatemarketsharesforeachofourfivesystemicinstitutions.Wethenaggregatethemarketsharesas
follows:
EcrinJobl
m
= ( S
]
2 5
]=1
) +(N -S) _
1- S
]
S
]=1
(N-5)
_
2
(9)
whereS
j
isthemarketshareoffirmjinmarketmandNisthenumberofbankholdingcompanies.Formarketswheretotalsizeis
unavailable,wecalculatemarketsharesasproportionsoftotalvolumeofthetwentylargestinstitutionsbysizeoftotalassets,andN
becomestwenty.

46
VaR
i
isdefinedmathematicallyasPi(R

IoR
q

) = q,whereR
i
isthedollarreturnofportfolioiandIoR
q

istheunconditional
q
th
percentileofportfolioishistoricaldollarreturns.
47
CoVaR
i|j
isdefinedmathematicallyasPi(R

CoIoR
q
|]
|R
]
= IoR
q
]
) = qwhereR
i
isthedollarreturnofportfolioi,IoR
q
]
isthe
q
th
percentileofportfoliojshistoricaldollarreturns,andCoIoR
q
|]
istheq
th
percentileofportfolioishistoricaldollarreturns
conditionaluponthefactthatportfoliojsreturnsareequaltoitsq
th
percentilehistoricaldollarreturns.

43
Table15ExplanatoryVariablesDataSources
RETURNVARIABLES
INDICATOR DATA SOURCE VARIABLE STARTDATE
CapitalMarketsEquity Corporatevalueofequityatmarketvalue CRSP RET_1.1cpi 3/31/1980*
ResidentialRealEstateNationalPriceIndex S&P/CaseShillerHomePrice 3/31/1987
CapitalMarketsCredit Callreportloanportfolios FRSFDR RET_2cpi 9/30/1990

ResidentialRealEstateNationalPriceIndex S&P/CaseShillerHomePrice
Indices
3/31/1987
CapitalMarkets
CommercialProperty
CallReportCommercialpropertyportfolios
(Construction,Nonfarmnonresidential,
Multifamily)
FRSFDR RET_4ta 9/30/1990

CommercialRealEstateNationalPriceIndex MITTransactionsBasedIndex 3/31/1984

CurrencyMarkets
InternationalExposures
BankConstructedInterbankDerivativeExposure FRSFDR RET_5.2ta 3/31/1995
CurrencyMarkets
InterbankExposures
BankConstructedInterbankExposure FRSFDR RET_6ta
RET_6cpi
3/31/2002

ResidentialRealEstateNationalPriceIndex S&P/CaseShillerHomePrice
Indices
3/31/1987
RiskTransferMarkets
InterestRateDerivatives
BankConstructedIRDerivativesExposure FRSFDR RET_9ta 3/31/1995

RISKEXPECTATIONS
INDICATOR DATA SOURCE VARIABLE STARTDATE
IRRIndicatorsthroughthe
cyclefunction
Equitylessgoodwill FRSFDR RSK_2 6/30/1986
InterestRateRiskCapitalthroughthecycle
function
Calculated RSK_2.1 6/30/1986
IRRIndicatorspointin
time/stressfunction
InterestRateRiskCapitalstressfunction Calculated RSK_4 6/30/1997
IRRIndicatorsextreme
stress/crisisfunction
Changeineconomicvalueofequity FRSIRRFOCUS RSK_6 6/30/1997

CreditRiskIndicators
throughthecyclefunction
BookValue:12callreportloanportfolios
reportedALLL
FRSFDR RSK_7.1 12/31/1976
CreditCapitalthroughthecyclefunction Calculated 9/31/1991*
CreditRiskIndicators
extremestress/crisis
function
EconomicValue:12callreportloanportfolios
99.5%BankCaR
FRSBankCaRModel RSK_9 9/31/1991*
Solvencythroughthecycle
function
Solvencynormalvalue InternalModel RSK_14 9/31/1991*
Tier1Capital FRSFDR 9/31/1991*
Solvencypointin
time/stressfunction
Solvencystressvalue InternalModel RSK_15 9/31/1991*
Solvencyextreme
stress/crisisfunction
Solvencyextremevalue InternalModel RSK_16 9/31/1991*
IRRstressdistancefunction InterestRateRisknormaldistancetosystemic
stress
InternalModel RSK_F 9/31/1991*
IRRstressdistancefunction InterestRateRisknormaldistancetostress InternalModel RSK_G 9/31/1991*
CreditRiskstressdistance
function
CreditRiskstressdistancetosystemicstress InternalModel RSK_H 9/31/1991*
CreditRiskstressdistance
function
CreditRisknormaldistancetosystemicstress InternalModel RSK_I 9/31/1991*
CreditRiskstressdistance
function
CreditRisknormaldistancetostress InternalModel RSK_K 9/31/1991*
Solvencystressdistance
function
Solvencystressdistancetosystemicstress InternalModel RSK_L 9/31/1991*
Solvencystressdistance
function
Solvencynormaldistancetosystemicstress InternalModel RSK_M 9/31/1991*

44
Table15ExplanatoryVariablesDataSources(contd)
LIQUIDITYEXPECTATIONS
INDICATOR DATA SOURCE
VARIABLE
STARTDATE
ALGapIndicators'0to3
months'maturityband
ALGapIndicators'0to3months'maturity
band
Calculated
IRRFOCUSspecification
LIQ_1 6/30/1997

ALGapIndicators'3to12
months'maturityband
ALGapIndicators|3to12Months Calculated
IRRFOCUSspecification
LIQ_2 6/30/1997

ALGapIndicators ALGapIndicators|'greaterthan3years' Calculated LIQ_4 6/30/1997

LiquidityIndexIndicators
1yearforwardsale
LiquidityIndexIndicators1yearforwardsale InternalModel LIQ_5 9/31/1991*
LiquidityIndexIndicators
3monthforwardsale
LiquidityIndexIndicators3monthforwardsale InternalModel LIQ_6 9/31/1991*
LiquidityIndexIndicators
immediatefiresale
LiquidityIndexIndicatorsimmediatefiresale InternalModel LIQ_7 9/31/1991*

STRUCTURE
INDICATOR DATA SOURCE VARIABLE STARTDATE
ConnectivityIndicators
CoVaR
ConnectivityIndicatorsCoVaR CoVaRModel(FRS) STR_1.2
STR_1.3
STR_1.4
9/31/1991*
ConcentrationIndicators
CapitalMarkets(Equity)
ConcentrationIndicatorsCapitalMarkets(Equity) Calculated
FRSFlowofFunds
STR_2 9/31/1991*
ConcentrationIndicators
CurrencyMarkets(FX)
ConcentrationIndicatorsCurrencyMarkets(FX) Calculated
FRSFlowofFunds
STR_4
STR_4.1
9/31/1991*
ConcentrationIndicators
CurrencyMarkets
(Interbank)
ConcentrationIndicatorsCurrencyMarkets
(Interbank)
Calculated
FRSFlowofFunds
STR_5 9/31/1991*
ConcentrationIndicators
RiskTransferMarkets
(InterestRateDerivatives)
ConcentrationIndicatorsRiskTransferMarkets
(InterestRateDerivatives)
Calculated
FRSFlowofFunds
STR_8 9/31/1991*
LeverageIndicatorsnormal LeverageIndicatorsnormal FRSFDR STR_9 6/30/1986
denotesprivatesupervisorydatacomponents.
* Startdatesetbydatarequest.
Earlierdataispartiallyavailable.
Gapincomponentdata.

45
Table16Returnvariables:definitions,expectations,andGrangercausality
VARIABLE SERIES EXPOSURE GRANGERLAG THEORETICALEXPECTATION
RET_1.1cpi AHKICP
+
CapitalMarketsBonds
(totalassetsbased)
Foranindividualfirm,agreatermarketcapitalizationprovidesan
additionalmarketequitybufferagainstpotentiallosses,butalso
increasesthedownsiderisk.AlargerRET_1.1cpidescribesalarger
differencebetweenlongtermreturnexpectationsandCPIand
reflectsgreaterdownsiderisktoequity,positivelyrelatedtothe
systemicfinancialstress.
RET_2cpi INSI0_I
+
CapitalMarketsBonds
(totalassetsbased)
:11,12 Foranindividualfirm,alargerloanportfolioprovidesabuffer
againstpotentialcreditlosses,butalsoincreasesthedownsiderisk.
HereweusetimeseriesofZscoresofaggregateofloanportfolios
deflatedbyCPI.Alargervaluedescribesalargerdifference
betweenlongtermreturnexpectationsandCPIandreflectsgreater
downsideriskinthecreditmarkets.
RET_4ta INSCIA0t
-
CapitalMarkets
CommercialProperty
(totalassetsbased)
Foranindividualinstitution,anincreasingcommercialproperty
indicatorreflectsalargercreditriskexposureinthecommercial
propertyassetclass,butmayalsoreflectanunderlyingorganic
growthinassets.Theaggregatedcommercialpropertyportfoliosare
deflatedbytotalassets,themeasuredescribesanaturalhedge
againstsystemicstress.
RET_4ta AINSCAI
-
CapitalMarkets
CommercialProperty
(totalassetsbased)

RET_5.2ta IXRIA0t
-
InterbankDerivative
Exposure
:11
:10,12
Thelargeandstandardizedderivativemarketsinvolvealarge
numberofparticipants,andalthoughafirmlevel,anunwise,ill
informedorplainlyspeculativepositioncanleadtoanindividual
firmloss,themarketoveralliswelldiversifiedandwellinsulated
fromoverallcollapse,sincethemarketparticipantslossesandgains
arebalancedout.Intheeventthatamajordealeroruserof
interbankderivatescollapsed,theinterbankderivativesmarketsare
structuredtoselfresolveinanorderlyfashion.Thus,ariseina
longtermrealtimemeanoftheinterbankderivativeexposure
shouldbenegativelyrelatedtothesystemicfinancialstress.
RET_6cpi IIRBNK0_t
-
CurrencyMarkets
InterbankExposures
(pricebased)
:2 Ofthetwoavailableseries,theCPIbasedseriesreflectsgrowthin
interbankmarketsrelativetoinflationaryexpectationsandcaptures
greateraggregateliquidityandeconomicoptimismreflectedinthe
interbankmarkets,thusnegativelyrelatedtosystemicfinancial
stress.Ontheotherhand,thetotalassetsbasedseriesofaggregate
interbankexposures,reflectsthegrowthinterbankconcentration
relativetoaggregateassets,andthus,capturethestructuralaspect
ofinterbankmarketsthatispositivelyrelatedsystemicfinancial
stress.
49

RET_6ta IIBKIA0t
+
CurrencyMarkets
InterbankExposures(TA
based)
:2,4
:5
RET_9ta IREIA0t
-
RiskTransferMarkets
InterestRateDerivatives
:11,12
:8,10
Wearguethatinterestrateriskderivativemarkethasanestablished
defensivefunction.Ariseinalongtermrealtime(accumulated)
meanoftheinterestrateriskderivativeexposureshouldbe
negativelyrelatedtothesystemicfinancialstress.
plussignindicatespositiveexpectation indicatesGrangercausalitywith90%orbetterconfidence
minussignindicatesnegativeexpectation indicatesGrangercausalitywith79%orbetterconfidence

49
SeeBlvargandNimander(2002),Rajan(1996),Furfine(2003),andDegryseandNguyen(2004).

46
Table17LiquidityVariables:definitions,expectations,andGrangercausality
VARIABLE SERIES EXPOSURE GRANGER LAG THEORETICALEXPECTATION
LIQ_1 0t_AIuS
+
ALGapIndicators'0to3
months'maturityband
:3,4 AssetLiabilitymismatchdescribesasimplegapdifferencebetween
assetsandliabilities.Alargermismatchindicatesalargerimbalance
inrepricingandmaturityandreflectsalargerinterestraterisk
exposure.
LIQ_2 0t_AIS12
+
ALGapIndicators'3to
12months'maturityband
:4
LIQ_4 0t_AI0S
+
ALGapIndicators
'greaterthan3years'
maturityband

LIQ_5 0t_IX_NI
-
LiquidityIndexIndicators
1yearforwardsale
:8,9,10 AlargervalueoftheLiquidityIndexisassociatedwithamoreliquid
andthereforelessriskyconditions.Hence,ariseinalongterm
realtime(accumulated)meanofthisindexshouldbenegatively
relatedtothesystemicfinancialstress.
LIQ_6 0t_IX_SI
-
LiquidityIndexIndicators
3monthforwardsale

LIQ_7 0t_IX_EI
-
LiquidityIndexIndicators
immediatefiresale

plussignindicatespositiveexpectation indicatesGrangercausalitywith90%orbetterconfidence
minussignindicatesnegativeexpectation indicatesGrangercausalitywith79%orbetterconfidence

47
Table18Riskvariables:definitions,expectations,andGrangercausality
VARIABLE SERIES EXPOSURE GRANGER LAG THEORETICALEXPECTATION
RSK_2 EI0w
-
IRRIndicators
throughthecycle
function
:2,3,4,5,6,
7,12
:8,10,11
Foranindividualinstitution,thisindicatorisconstructedasthe
institutionsbookvalueequitylessgoodwill.Ariseintheaggregate
seriesindicatesmorecapacitytheinstitutionhastowithstandlosses
andshouldbenegativelyrelatedtothesystemicfinancialstress.
RSK_2 AEI0w
-
IRRIndicators
throughthecycle
function
:3,4,5,12
:7,8,10,11
RSK_2.1 IRCAP_NI
+
IRRIndicators
throughthecycle
function
:2,4,7,8
:3,5,9,10,11,
12
Foranindividualinstitution,thisindicatorisconstructedasthe
institutionsbookvalueequitylessgoodwillinflatedbythesupervisory
probabilityofdefault(RSK_2.1)anddowngrade(RSK_4).Themeasure
proxiesaneconomiccapitalviewofinterestratecapitalthatwouldbe
requiredthroughthecycle(RSK_2.1)andunderstress(RSK_4).The
largerthevalue,themoreisthelongtermpressureontheinstitution
andhigherthepotentialfordefaultinducedbyinterestraterisk
capitalneeds.
RSK_4 IRCAP_SI
+
IRRIndicatorspoint
intime/stressfunction
:2,7,8,9,10,
11
:4,5,12
RSK_6 AIRCAP_EI
-
IRRIndicatorsextreme
stress/crisisfunction
:2,3,4,5,6,
7
Thisseriesdescribesaggregateeconomicvalueofthebalancesheet
evaluatedunderextremestress.Thelargerthevalue,thebetteristhe
residualcapacitytocounteractstressandlosses.Therefore,ariseina
longtermrealtime(accumulated)meanofthisseriesshouldbe
negativelyrelatedtothesystemicfinancialstress.
RSK_7.1 CRCAP_NI
-
CreditRiskIndicators
throughthecycle
function
:2,3,4,5 Foranindividualinstitution,thisseriesdescribesthroughthecycle
creditcapital,quantifiedasaveragepositiveALLLforpast3years.A
riseinthereservesindicatesgreatercapacitytowithstandlosses,
therefore,ariseinalongtermrealtime(accumulated)meanofthis
seriesshouldbenegativelyrelatedtothesystemicfinancialstress.
RSK_7.1 ACRCAP_NI
-
CreditRiskIndicators
throughthecycle
function
:3,4,5,6
RSK_8a EF
+
CreditRiskIndicators
pointintime/stress
function
:9
:7,8,10
ThisseriesmeasuresanaggregatedZScorefortheMoodysKMV
ExpectedDefaultFrequency(EDF).Ariseintheseriesindicates
greaterlikelihoodofsystemicdefault.Thus,ariseinalongtermreal
time(accumulated)meanofthisseriesshouldbepositivelyrelatedto
thesystemicfinancialstress.
RSK_9 INS_EI
-
EconomicValue:12call
reportloanportfolios
99.5%BankCaR
:2,3,9 Foranindividualinstitution,thisindicatormeasuresresidualeconomic
valueoftheloanportfolioevaluatedatextremestress(proxiedby
99.5%BankCaR).Riseintheseriesindicatesgreaterresidualcapacity
towithstandextremestressandlesserpotentialforsystemicstress.
RSK_14 S0II_NI
-
Solvencythroughthe
cyclefunction
:2,3,4,5,8
:7,9,10,11
Solvencyateachpointintimeismeasuredasthedifferencebetween
availablefinancialresourcesandrequiredinternalcapital.Theseries
measuresthesafetybufferhelpingtoalleviatepotentiallossesand
stress.Ariseinthesolvencyseriesindicatesmoreavailablecapacity
tohandlestressandlossesandshouldbenegativelyrelatedtothe
systemicfinancialstress.
RSK_15 S0II_SI
-
Solvencypointin
time/stressfunction
:2,3,4,5,7,
8
:9
RSK_16 S0II_EI
-
Solvencyextreme
stress/crisisfunction
:8,9
RSK_F IR_EINI
-
InterestRateRisk
normaldistanceto
systemicstress
:2,4
:3,5,7,8,9,
10,11
Theseriesmeasurestheresidualvaluebetweencrisisandnormal
valuationofthecompanysbalancesheet.Thelessthevalue,the
greaterthepotentialforsystemicstress.
RSK_G IR_SINI
+
InterestRateRisk
normaldistanceto
stress
:2,4
:3,5,6,7,8,9
Theseriesmeasurestheincrementalgrowthininternallyrequired
interestrateriskcapitalastheinstitutionalbalancesheetstransition
fromnormaltostressvaluations.Thelessthevalue,thesmalleristhe
incrementalcapitalrequiredandthelessisthepotentialforsystemic
stress.
RSK_H CR_EISI
-
CreditRiskstress
distancetosystemic
stress
:2,3
:4
Theseriesmeasuresthedifferencebetweeninternallyrequiredcredit
capitalatextremevalueandinternallyrequiredcreditcapitalatstress
value.Asthedistanceincreasesataparticularpointintime,the
potentialforsystemicstressdecreases. RSK_H ACR_EISI
-
CreditRiskstress
distancetosystemic
stress
:3,5

48
RSK_I CR_EINI
-
CreditRisknormal
distancetosystemic
stress
:2,3,4,8,9 Theseriesmeasuresthedifferencebetweeninternallyrequiredcredit
capitalatextremevalue(RSK_I)orstressvalue(RSK_K)andinternally
requiredcreditcapitalatnormalthroughthecyclevalue.Asthe
distanceincreasesataparticularpointintime,thepotentialfor
systemicstressdecreases.
RSK_K CR_SINI
-
CreditRisknormal
distancetostress

RSK_L SII_EISI
-
Solvencystress
distancetosystemic
stress
:2,3,4,5,7,
8
:6,9
Thetimeseriesofsolvencystressdistance(RSK_L)ornormaldistance
(RSK_M)tosystemictressmeasuresthepotentialdeficitinthe
solvencybufferateachpointintime.Byconstruction,thisdistance
seriesisalwaysnegative,butmayapproachzero.Thus,thelargeris
thisdeficit,thecloseritistozero,thelessisthepotentialforsystemic
stress.
RSK_M SII_EINI
-
Solvencynormal
distancetosystemic
stress
:3,4,5,8
:6
plussignindicatespositiveexpectation indicatesGrangercausalitywith90%orbetterconfidence
minussignindicatesnegativeexpectation indicatesGrangercausalitywith79%orbetterconfidence

Table19Structurevariables:definitions,expectations,andGrangercausality
VARIABLE SERIES EXPOSURE GRANGER LAG THEORETICALEXPECTATION
STR_1.2 0t_PSPCI
+

ConnectivityIndicators
CoVaRat5%
:5
Foranindividualinstitution,theconditionalvalueatriskindicates
therelativecontributionoftheinstitutiontotheaggregate5%
quantileValueatRisk.Ariseintheaggregatedseriescorrespondsto
greatercontributiontosystemicrisk.
STR_1.3 0t_1PCI
+

ConnectivityIndicators
DeltaCoVaRat1%

Foranindividualinstitution,themarginalvalueatriskindicatesthe
differenceintheinstitutionsx%quantileCoVaRandtheaggregate
x%quantileValueatRisk.Ariseintheseriescorrespondstogreater
contributiontosystemicrisk.
STR_1.4 0t_SPCI
+

ConnectivityIndicators
DeltaCoVaRat5%

STR_2 0t_EE
+

ConcentrationIndicators
CapitalMarkets(Equity)

Thisseriesmeasurestheconcentrationtimeseriesofmarket
capitalizationoftopfiveUSBHCsrelativetothetotalUSequity
marketfromtheFlowofFunds.Theriseintheseriesshows
increasingmarketdominanceofsmallernumberoffirmsandreflects
agrowingpotentialformarketdisruptionduetofailureofthe
individualparticipants.
STR_4 0t_EFX
+

ConcentrationIndicators
CurrencyMarkets(FX)
:2,3,4
:5,8
ThisseriesmeasurestheconcentrationtimeseriesofFXexposuresof
topfiveUSBHCsrelativetothetotalFXmarketfromtheFlowof
Funds.Theriseintheseriesshowsincreasingmarketdominanceof
smallernumberoffirmsandreflectsagrowingpotentialformarket
disruptionduetofailureoftheindividualparticipants.
STR_4.1 0t_EIXP
+

ConcentrationIndicators
CurrencyMarkets(FX)
:6
:2,4,7
STR_5 0t_EIB
+

ConcentrationIndicators
CurrencyMarkets
(Interbank)
:6,8,9,10,
11
:5,7
Thisseriesmeasuresconcentrationincurrencyinterbankmarkets
assumingthismarketcanberepresentedbythetoptwentybank
holdingcompanies.Althoughthisisarelativemeasureofmarket
concentrationascapturedbytheBHCs,riseintheconcentration
indicatorshowsincreasingmarketdominanceofsmallernumberof
firmsandreflectsagrowingpotentialformarketdisruptiondueto
failureoftheindividualparticipants
STR_8
0t_EIR
+

ConcentrationIndicators
RiskTransferMarkets
(InterestRateDerivatives)
Thisseriesmeasurestheconcentrationtimeseriesinrisktransfer
marketsforinterestratederivatives.Theriseintheseriesshows
increasingmarketdominanceofsmallernumberoffirmsandreflects
agrowingpotentialformarketdisruptionduetofailureofthe
individualparticipants.
STR_9 0t_IEIN
+

Contagion(normal
leverage)
:2,3,4,12
:5
Normalleverageismeasuredasratioofdebttoequity.Useof
leverageallowsfinancialinstitutionstoincreasepotentialgainsonits
inherentequityposition.Sinceincreasesindebtcarriesavarietyof
risks,typicallycredit,market,andinterestraterisk,increased
leverageisadoubleedgedmagnifierofreturns,increasingboth
potentialgainsandpotentiallosses.Theriseinthenormalleverage
describeshigherlevelofriskydebtrelativetosaferequity.
plussignindicatespositiveexpectation indicatesGrangercausalitywith90%orbetterconfidence
minussignindicatesnegativeexpectation indicatesGrangercausalitywith79%orbetterconfidence