Working Paper No. 697
By Somnath Chatterjee, Ching-Wai (Jeremy) Chiu, Thibaut Duprey and Sinem Hacioglu Hoke
In this paper we develop an index to monitor the intensity of financial stress in the UK over a period of 45 years. By aggregating various market-based indicators of financial stress from six major markets, we allow each indicator to be assessed in terms of its systemic importance. This enables the index to capture the interconnectedness of financial markets. The index successfully captures three episodes of heightened stress in UK financial history. We also attempt to determine how much a financial shock to the UK economy is amplified in a period of stress vis-à-vis a tranquil period. It involves exploring the dynamic relationship of the index with the UK real economy by two specifications of threshold vector auto-regression models. We find empirical evidence for the existence of feedback loops in the shock propagation between the real and the financial sector in the United Kingdom.