How many factors and shocks cause financial stress?

The aim of this paper is to assess the dimension of factors and shocks that drive financial conditions, and in particular financial stress in the euro area. A second aim is to construct summary indices on the conditions and level of stress in financial markets with the aid of a dynamic factor model. By analysing 149 newly compiled monthly time series on financial market conditions in the euro area, our results suggest that the data respond quite differently to fundamental shocks to financial markets but the dimension of these shocks is rather limited. Consequently, countries or segments of the financial sector in the euro area react fairly heterogonously to such shocks. We estimate several common factors and by means of an exploratory analysis we give them an economic interpretation. We find that the existence of a Periphery Banking Crisis factor, a Stress factor and a Yield Curve factor explains the bulk of variation in recent euro area financial sector data.