Since its creation in 2009, the Kansas City Financial Stress Index (KCFSI) has used the London Interbank Offered Rate (LIBOR) to measure conditions related to money market borrowing. However, regulatory changes in the United Kingdom eventually will eliminate LIBOR.
Kansas City Fed Data Scientist Thomas R. Cook and Senior Economist Taeyoung Doh have constructed a revised financial stress index with a variable that measures the cost of borrowing collateralized by Treasury securities (the Treasury repo rate) instead of LIBOR. This revised measure of the KCFSI is highly correlated with the current KCFSI, suggesting that the Treasury repo rate can replace LIBOR.
What is the KCFSI, and what information does it convey?
The index is a monthly measure of stress in the U.S. financial system based on 11 financial market indicators. These indicators are classified in two groups: one represents yield spreads and the other summarizes the volatility of asset prices.
The statistical method underlying the KCFSI eliminates idiosyncratic noises in the indicators to extract the common component driving all of them. Although the current index identifies widely recognized episodes of financial stress over recent decades, some input variables are likely to become less relevant over time as economic and regulatory environments change.
Why was the index revised?
We revamped the KCFSI to reflect the diminishing relevance of LIBOR. Regulatory changes announced by the Financial Conduct Authority in the United Kingdom will eliminate LIBOR by 2021 and are likely to force financial institutions to use another benchmark interest rate in their contracts. The current KCFSI relies on LIBOR for the TED spread, which is the difference between the three-month LIBOR and the three-month secondary market Treasury bill rate. The TED spread captures the stress in the money market, meaning that a higher spread is associated with a greater difficulty in obtaining funding in money markets.
However, the cost of borrowing collateralized by Treasury securities (also known as the Treasury repo rate) increasingly is being used instead of LIBOR as an alternative benchmark for money market rates. Motivated by this change, we replaced the TED spread in the KCFSI with the spread between the Treasury repo rate and the three-month Treasury bill rate to construct a revised measure of financial stress. We concluded that the Treasury repo rate is an appropriate replacement for LIBOR in the KCFSI and in November 2018 began publishing the revised index using the repo rate. Read The Macro Bulletin to learn more about the KCFSI.