This paper examines why some financial stress episodes lead to
economic downturns. The paper identifies episodes of financial
turmoil 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 severe and protracted downturns than stress
mainly in securities or foreign exchange markets. Economies with
more arms-length financial systems appear to be particularly
vulnerable to sharp contractions, due to the greater procyclicality
of leverage in their banking systems.
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