Bank of Israel : New study: A Composite Index for Tracking Financial Markets in Israel

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• Research at the Bank of Israel presents a new index which examines, on a daily basis, the level of stress in financial markets.
  
• Based on the index, in the past 15 years, financial markets in Israel went though 5 occurrences of extreme stress-Russia's debt crisis/LTCM in 1998, the 2002 crisis, the subprime crisis which broke out in 2007, the collapse of the Lehman Brothers investment house at the end of 2008, and the warnings of a rating downgrade of the US in 2011 and the European debt crisis.
  
• The index indicates that over the years, the financial markets in Israel developed resilience to security and political events, as the stress generated in financial markets by such events has declined over the years.

Research conducted by Dr. Yossi Saadon, Bank of Israel Spokesperson, and Meital Graham of the Bank's Research Department, constructs a new index of financial market stress in Israel. The index incorporates several bond, stock, and foreign exchange market variables into one series. The index can receive a value of between 0 and 1 (or 0-100 percent). A figure near 0 indicates calm, while a figure near 1 indicates a financial crisis. Figure 1 shows the values of the index since 1997, while emphasizing major events. The index facilitates an analysis of events with crisis elements and a comparison of the extent of the impact on financial markets caused by various factors.Uniform and objective assessment of financial markets, in real time, can simplify the policy setting process. The index is based on a methodology which is similar to that used by the US Federal Reserve.

The research indicates that since the LTCM crisis in 1998, there have been another 4 occurrences which similarly shook the markets-the 2002 crisis, the outbreak of the subprime crisis, the collapse of Lehman Brothers, and the warnings of a US rating downgrade and the European debt crisis. Of those four, only the 2002 event originated domestically.

The 2002 crisis occurred at the same time as security events which added to pressure in the markets during that time. The crisis featured depreciation and considerable volatility in the exchange rate, declines in stock market indices, a sharp increase in bond yields, and more. It should be noted that financial markets' recovery from this occurrence took much longer than other events which originated outside of Israel's economy.

The subprime crisis, which began in the summer of 2007, first left a significant mark on Israeli markets on July 29, when the index reached 99 percent. However, within a short time frame the index returned to relatively low levels. Later, the index responded to various events with values that did not rise above 35 percent. Shortly after the collapse of Lehman Brothers, the index reached values near 100 percent. Beginning in the second quarter of 2009, markets calmed down for a relatively long time. The next event occurred in August-December 2011, following the expansion of the debt crisis in Europe, the cut in the US credit rating, and apparently the continued social protest as well-the index at that time again reached high levels, near 100 percent. From then until the end of the sample period, October 2012, the index maintained normal levels.

Besides the analysis of the index's movement following various occurrences, the index allows the assessment of the extent of markets' stress in response to events external to them. The study's authors examined the stress index's behavior around security and political events. For example, the resignation of then Finance Minister Benjamin Netanyahu (August 8, 2005) led to a stress index reading of 30 percent. An event with the potential to markedly impact on the government-the announcement of a significant deterioration in the health of Prime Minister Ariel Sharon (January 5, 2006)-led to an index reading of 10 percent, lower than that measured following the resignation of then Finance Minister Netanyahu.

In analyzing security events, the authors examined the index's movement over time, following similar types of security events. Recall that the State of Israel unfortunately suffered from many terror attacks, which differed in their severity. In most of the cases, financial markets were affected by these incidents, but to different extents, depending on the severity of the incident and the background conditions at that time. In order to compare the effect of these events on financial markets, the events had to be divided into categories, based on their severity. Figures 2 and 3 present the index's values over time, following events rated low-severity or high-severity.

These analyses imply that over the years, the economy has developed resilience to security and political occurrences, and this can be seen in the moderation of the increase in the index around these events. It appears that the knowledge that the economy has dealt successfully with certain types of events reduces the uncertainty of their possible effects on the economy. Thus, markets react with less intensity as time goes by.

It is important to note that in analyzing the effects of security events on the index, the authors did not include the year 2002, which was a year of financial crisis. That year, the economy also faced a difficult security situation. Security events led to sharp increases in the index-more than similar events during other periods. It appears that against the background of a financial crisis, markets are more vulnerable, and less able to absorb security incidents. Of course, it is possible to draw the converse conclusion as well, that markets are more vulnerable during periods of security crisis, and are less able to absorb financial incidents.

The study develops and implements a methodology to analyze shocks through an extensive examination of their development, from the moment that the information is disclosed. It is likewise possible to follow the amount of time that elapsed until the shock affected each sub-market, the severity of the impact, the path of contagion, and more. Such an analysis indicates, for example, that after the attack on the World Trade Center (September 11, 2001), when the stress in the markets reached 95 percent, about 9 out of the 11 variables which make up the index were significantly negatively impacted. (The variables include inflation expectations, the exchange rate, foreign exchange market liquidity, the Tel Aviv 100 Index, bond spreads, volatility in long term and short term bonds, and volatility of the exchange rate and stock markets.) (See Table 1.) In contrast, with the outbreak of the Second Lebanon War, a local development, pressure in the markets only reached 35 percent, and only 2-3 of the index's components were substantially negatively impacted (indices of stock market and foreign exchange market volatility, stock indices, the exchange rate level, and others were less negatively impacted). (See Table 2.) In contrast to these, at the worst part of the subprime crisis (October 12, 2008), the index reached a level of 100 percent, and all its components were negatively impacted. The impact was almost immediate and continued for several months.

The index is expected to be computed on a regular basis at the Bank of Israel.