Financial stress and economic contractions

This paper examines why some financial stress episodes lead to economic downturns. The paper identifies episodes of financial turmoil in advanced economies using a financial stress index (FSI), and proposes an analytical framework to assess the impact of financial stress – in particular banking distress – on the real economy. It concludes that financial turmoil characterized by banking distress is more likely to be associated with deeper and longer downturns than stress mainly in securities or foreign exchange markets. Economies with more arm's-length financial systems seem to be more exposed to contractions in activity following financial stress, due to the greater procyclicality of leverage in their banking systems.