Non-stationary financial risk factors and macroeconomic vulnerability for the UK

Tracking the build-up of financial vulnerabilities is a key component of financial stability policy. Due to the complexity of the financial system, this task is daunting, and there have been several proposals on how to manage this goal. One popular way is through the creation of indices that act as a signal for the policy maker. While factor modelling in finance and economics has a rich history, most of the applications tend to focus on stationary factors. Nevertheless, financial stress can exhibit a high degree of inertia, which could be better captured by non-stationary factors. To this end, we advocate moving away from the stationary paradigm. In this paper we outline how to select and estimate the correct number of factors in the presence of non-stationary data. In doing so we create a financial stress index for the UK financial market, whose performance we compare to other popular financial stress indices. In a growth-at-risk and a connectedness exercise we show that the proposed method yields better performance at the short forecast horizons, which is of key interest for policy makers.