8. Systemic risk

The change in the value at risk of the financial system conditional on an institution being under distress relative to its median state

The risk that a default by one financial institution will lead to defaults by other financial institutions, creating risks for the whole financial system

1. systemic: about correlation and transmission of risk due to the centrality of banking system

2. Transmission channels: e.g. interbank market, common exposures

3. Trigger events: e.g. sectorial shocks

4. Target variables: e.g. increase of cost of capital, number of defaulted banks

European systemic risk board (ESRB) est. after 2008

• macroprudential oversight over EU

• prevention and mitigation of systemic risk

Single supervisory mechanism (SSM) assigns macroprudential power to national authoirities and ECB

Under ECB

• Capital-based measures (G-SIB capital buffers)

• Borrower-based measures (restriction to lending for individual borrowers)

• Liquidity-based measures

Macroprudential = mitigating risk to the financial system as a whole

• Data availability

  • esp. from small banks

  • high quality data mostly only available to regulators & incomplete

• Analysis of rare events

  • difficult estimation

• Complexity of system due to multiple sources of stress and changing environment

  • new policies make older data iancurrate

Empirically we see that banks' defaults tend to cluster over time, consistently with highly correlated defaults

use infomration on price of securities to estimate aggregate systemic risk

• Conditional tail risk: estimate risk conditional to one variable being distressed

• Network based models: estimate interconnection among institutions to assess risk of contagion among institutions

• CIMDO methodology: model joint default probability

• Measurers the impact to the systems VaR when one institution is under stress

• CoVaR can be estimated using econometric procedures based on quantile regression

• network approach to assess the interconnections, and hence the potential of risk spillovers) among financial institution

• nodes are financial institutions, edges are Granger causality

Analyses the data of financial structure (credit exposures, exposures to securities) to model transmission of shocks

• array of measure & indicators aggregated

• give a broad overview of systemic risk

• Composite Index of Systemic Risk (CISS)

  • system wide measure

  • real time monitoring and assessment of stress level in financial system

  • includes most relevant 5 segments

  • each sector gets weightes (15-30%)

• G-SIB assemssment methodology

  • a measure of systemic relevance for individual banking institutions

  • measure impact from banks failure on global financial system and economy (not PD)

  • score is a weighted average of five categories

-        ECB Financial stability review – every 6 month

-        ESRB Risk dashboard – quant. and qual. Indicators

-        ESRB Annual Report  - overview

Conclusion:

• financial systems are often resilient to shocks, but when contagion kicks in it has catastrophic effects

Limitations:

• homogeneity of banks

• simplified balance sheet structure

• random network

• Analyze the financial incoming and outcoming structure of the financial institution

Bank is solvent if this applies:

—> if one defaults, neighbouring bank can default too (separate formula)

—> Iterated until no new banks default

—

—> measure contagion rather than systemic risk

—> tests different shock types & network configurations

• Market based measures

• Microstructural measures

• Aggregated indices