Financial Stress, Downturns, and Recoveries

IMF Working Papers, May 1, 2009

Source details

The paper examines why some financial stress episodes lead to economic downturns.
Episodes of financial turmoil are identified using a financial stress index (FSI).
An analytical framework is proposed to assess the impact of financial stress— in particular banking distress— on the real economy.
The paper concludes:
- Financial turmoil characterized by banking distress is more likely to be associated with severe and protracted downturns than stress mainly in securities or foreign exchange markets.
- Economies with more arms-length financial systems appear to be particularly vulnerable to sharp contractions, due to the greater procyclicality of leverage in their banking systems.

Identification of turmoil episodes: uses a financial stress index (FSI).
Focus of analysis: the transmission of financial stress, with particular attention to banking distress, to real economic activity.

Banking distress versus other market stress:
- Banking distress → higher likelihood of severe and protracted economic downturns.
- Stress concentrated in securities or foreign exchange markets → less likely to produce similarly severe/protracted downturns.
Financial system structure:
- Economies with more arms-length financial systems → greater vulnerability to sharp contractions.
- Mechanism identified: greater procyclicality of leverage in banking systems in arms-length financial systems.

Subject: Asset prices, Banking, Currency markets, Economic recession, Financial crises
Keywords: asset price, banking system, cost of capital, monetary policy, stress episode, WP

_wp09100 - Executive Summary
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