Will this index spot financial trouble brewing?

Two economists from the Federal Reserve Bank of Chicago have developed an index to monitor financial stability and spot trouble brewing across traditional and shadow financial markets.

The index uses 100 financial indicators including repo volume, which they view as a measure of market-wide leverage and liquidity, and other repo measures.

In normal times, increased repo volume means more liquidity, more stability and less risk. But as bankers discovered during the financial crisis of 2007-08, it can also mean too much debt is building up in the system, a bubble is forming and there’s danger ahead. Historically, this would show as periods of high liquidity in the repo market, as the bubble develops, followed by periods of low liquidity when it bursts.

Economists Scott Brave and R. Andrew Butters use that historical pattern to develop an index they say will spot a healthy market trend as it slips into the danger zone.

In an e-mail with RepoWatch Feb. 10, economist Brave said the difference between safe and risky repo is a feature they are interested in, still studying and plan to expand on in coming publications.

From the report:

One of the key observations to come out of the recent crisis is that financial innovation has made it difficult to capture broad financial conditions in a small number of variables covering just a few traditional financial markets. The network of financial firms outside the traditional
commercial banking system—that is, the so-called shadow banking system—was at the forefront of many of the major events of the crisis, as were newer financial markets for derivatives and asset-backed securities.

In the wake of the crisis, policymakers, regulators, financial market participants, and researchers have all affirmed the importance of the interconnections between traditional and newly developed financial markets, as well as their linkages to the nonfinancial sectors of the
economy. The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 sets forth a financial stability mandate built on this widespread affirmation.

Monitoring financial stability, thus, now explicitly requires an understanding of both how  traditional and evolving financial markets relate to each other and how they relate to economic conditions. Indexes of financial conditions are an attempt to quantify these relationships.