During the recent past central banks around the world have increased their efforts to improve the analysis of systemic financial stability. Examining situations of stress for the financial system has gained particular attention reinforced by the IMF’s Financial Sector Assessment Program (FSAP) that explicitly requires stress testing exercises, in particular for banks.
While many new contributions have been made it is fair to say that a canonical framework of analysis has not yet emerged. In this paper we suggest a method that might provide such a framework for the analysis of banking systems of financially highly developed economies relying mostly on market data. We apply these ideas to the major UK banks. Our analysis gives us new insights into the role played by correlations between the values of bank assets on the one hand and on interbank linkages on the other hand for Systemic Risk - the large scale breakdown of financial intermediation. In our view correlations and interlinkages capture the two central aspects of systemic risk and should indeed form the focus of analysis for an institution in charge of systemic risk monitoring. This is because these two properties of financial networks will usually result in simultaneous bank failures. If banks have correlated exposures a consequence of an adverse economic shock may directly result in simultaneous multiple bank defaults. Banks in distress may default on their interbank liabilities and hence cause other banks to default triggering a domino effect. Modeling these two aspects requires a risk analysis that looks at banks simultaneously and that captures credit linkages between them.
Recognizing the importance of correlated exposures and interlinkages we propose a new stress testing framework that allows us to study the consequences of idiosyncratic and systematic shocks for financial stability. While previous research only analyzed bank defaults that result from idiosyncratic events, such as fraud, we extend the literature by also analyzing systematic shocks to the banking system, such as adverse macroeconomic developments. We demonstrate that the latter have a much higher impact on the banking system and therefore pose a more dangerous threat to the supervisor than idiosyncratic shocks. Correlations in bank asset portfolios and interlinkages, which are important for the assessment of a banking systems current level of systemic risk, should therefore also be included in a rigorous analysis of systemic risk based on stress testing.
The empirical analysis gives the following main insights. First, the simultaneous consideration of correlation and interlinkages does indeed make a difference for the assessment of systemic financial stability. In particular systemic events like the joint breakdown of major institutions are underestimated when correlations between banks are ignored. We can also show that ignoring interlinkages leads to an underestimation of joint default events. Secondly the UK banking system appears very stable. In particular domino effects are extremely unlikely and have a very low probability. Thirdly the analysis uncovers substantial differences between individual banks concerning their impact on others in stress scenarios and clearly identifies institutions with a high systemic impact.
Finally, we demonstrate the importance of the implicit assumption of the source of the shock when studying the consequences of a bank default. While the previous literature has studied idiosyncratic shocks only our model captures pure systematic shocks. We suggest a hypothetical decomposition into idiosyncratic and systematic sources for the shock that may hit a bank. In this way we can investigate not only the polar cases studied so far but intermediate cases as well. Measuring the expected loss for all other banks in the system conditional on the default of one bank we demonstrate that a systematic shock has a much higher impact on financial stability than an idiosyncratic one. Basing a stress test on idiosyncratic shock scenarios only may therefore considerably underestimate the impact of the shock on the banking system as a whole. The impact of a bank’s default on the banking system is much smaller if we assume an idiosyncratic shock than if we believe that the bank defaults because of a macroeconomic shock.
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Using Market Information for Banking System Risk Assessment
