Provide two definitons for 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
What are the “Common Themes” of Systemic Risk?
systemic: about correlation and transmission of risk due to the centrality of banking system
Transmission channels: e.g. interbank market, common exposures
Trigger events: e.g. sectorial shocks
Target variables: e.g. increase of cost of capital, number of defaulted banks
How is systemic risk regulated in the EU?
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
What are the three macroprudential power lines?
Under ECB
Capital-based measures (G-SIB capital buffers)
Borrower-based measures (restriction to lending for individual borrowers)
Liquidity-based measures
What does macroprudential mean?
Macroprudential = mitigating risk to the financial system as a whole
How can systemic risk be measured?
What to measure
How to measure
which indicator?
Realized or warning measures?
System-wide or dingle institution
Systemic relevance or fragility?
Market based measures (CDS spreads & equity prices)
Correlation-based instruments (CDO indices)
Balance sheet measures (easiest & safest)
microstructural contagion models based on bilateral exposure (simulate system)
What are challenges for measuring risk?
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
What is the role of default correlations in systemic risk?
Empirically we see that banks' defaults tend to cluster over time, consistently with highly correlated defaults
Explain the three types of market based models for measuring systemic risk
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
What are pros and cons of market based models for measuring systemic risk?
Pros
Cons
data availability (equity and CDS)
long time series (several decades)
no behavioral assumptions (only statistical relations)
Volatility paradox (crisis may be preceeded by calm periods)
only listed corporations
no causation, only correlation
cannot reproduce extreme events
What is the CoVaR?
Measurers the impact to the systems VaR when one institution is under stress
CoVaR can be estimated using econometric procedures based on quantile regression
Explain Granger Causiality Networks (Network based models)
network approach to assess the interconnections, and hence the potential of risk spillovers) among financial institution
nodes are financial institutions, edges are Granger causality
What are microstructural models for measuring systemic risk generally speaking?
Analyses the data of financial structure (credit exposures, exposures to securities) to model transmission of shocks
What are pros and cons of microstructural models for measuring systemic risk?
very flexible
interpretable results
suitable also for small banks
data avilability
strong behaviorlal assumptions
Risk measues // Aggregate indices - explain and name pros and cons
array of measure & indicators aggregated
give a broad overview of systemic risk
easy to compute
transparent
robust
simple and most useful
weight definition (weighting affects measure of systemic risk)
linear aggregation
Risk measures // Aggregate Indices - Explain two approaches
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
Name three Systemic Risk Reports
- ECB Financial stability review – every 6 month
- ESRB Risk dashboard – quant. and qual. Indicators
- ESRB Annual Report - overview
What are the conclusion and limitations of the microstrcutural contagion model by Gai & Kapadia
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
Explain the Formula of the microstructural contagion model by Gai & Kapadia and what it measures
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
What are the three types of systemic risk measures
Market based measures
Microstructural measures
Aggregated indices
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