Assessing the Systemic Risk of a Portfolio of Heterogeneous Banks During the Recent Financial Crisis Xin Huang 1 Hao Zhou 2 Haibin Zhu 3 1 University of Oklahoma 2 Federal Reserve Board 3 J.P . Morgan Chase Bank, N.A. Global Systemic Risk Conference by the Federal Reserve Bank of New York, the Society for Financial Econometrics, and the Volatility Institute of New York University November 17, 2011
Introduction Methodology and Findings Summary Background The global financial crisis has led bank supervisors and regulators to rethink about the rationale of banking regulation. Complement “micro-” with “macro-” prudential approach. National, regional and international levels. Financial stability and economic performance. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 1 / 27
Introduction Methodology and Findings Summary Background The global financial crisis has led bank supervisors and regulators to rethink about the rationale of banking regulation. Complement “micro-” with “macro-” prudential approach. National, regional and international levels. Financial stability and economic performance. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 1 / 27
Introduction Methodology and Findings Summary Background The global financial crisis has led bank supervisors and regulators to rethink about the rationale of banking regulation. Complement “micro-” with “macro-” prudential approach. National, regional and international levels. Financial stability and economic performance. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 1 / 27
Introduction Methodology and Findings Summary Background The global financial crisis has led bank supervisors and regulators to rethink about the rationale of banking regulation. Complement “micro-” with “macro-” prudential approach. National, regional and international levels. Financial stability and economic performance. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 1 / 27
Introduction Methodology and Findings Summary Objectives of this paper Measuring systemic risk: distress insurance premium (Huang, Zhou and Zhu (2009)). Decompose systemic risk into physical default risk and risk premia. Allocate systemic risk to individual banks. Or identify systemically important FIs. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 2 / 27
Introduction Methodology and Findings Summary Objectives of this paper Measuring systemic risk: distress insurance premium (Huang, Zhou and Zhu (2009)). Decompose systemic risk into physical default risk and risk premia. Allocate systemic risk to individual banks. Or identify systemically important FIs. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 2 / 27
Introduction Methodology and Findings Summary Objectives of this paper Measuring systemic risk: distress insurance premium (Huang, Zhou and Zhu (2009)). Decompose systemic risk into physical default risk and risk premia. Allocate systemic risk to individual banks. Or identify systemically important FIs. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 2 / 27
Introduction Methodology and Findings Summary Literature Market-based systemic risk indicator Probability of joint defaults: Lehar (2005), Chan-Lau and Gravelle (2005), Avesani et al (2006). Systemic importance of individual banks Adrian and Brunnermeier (2009): CoVaR. Tarashev, Borio and Tsatsaronis (2009): “Shapley value” approach. Acharya et al (2010): MES approach. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 3 / 27
Introduction Methodology and Findings Summary Literature Market-based systemic risk indicator Probability of joint defaults: Lehar (2005), Chan-Lau and Gravelle (2005), Avesani et al (2006). Systemic importance of individual banks Adrian and Brunnermeier (2009): CoVaR. Tarashev, Borio and Tsatsaronis (2009): “Shapley value” approach. Acharya et al (2010): MES approach. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 3 / 27
Introduction Methodology and Findings Summary Literature Market-based systemic risk indicator Probability of joint defaults: Lehar (2005), Chan-Lau and Gravelle (2005), Avesani et al (2006). Systemic importance of individual banks Adrian and Brunnermeier (2009): CoVaR. Tarashev, Borio and Tsatsaronis (2009): “Shapley value” approach. Acharya et al (2010): MES approach. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 3 / 27
Introduction Methodology and Findings Summary Literature Market-based systemic risk indicator Probability of joint defaults: Lehar (2005), Chan-Lau and Gravelle (2005), Avesani et al (2006). Systemic importance of individual banks Adrian and Brunnermeier (2009): CoVaR. Tarashev, Borio and Tsatsaronis (2009): “Shapley value” approach. Acharya et al (2010): MES approach. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 3 / 27
Introduction Methodology and Findings Summary Main findings Both spillover effects and real economy affect the movement of the systemic risk indicator. Risk premia are the main driving factors of systemic risk. Size effect is important in determining the systemic importance of individual banks, supporting “too-big-to-fail”. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 4 / 27
Introduction Methodology and Findings Summary Main findings Both spillover effects and real economy affect the movement of the systemic risk indicator. Risk premia are the main driving factors of systemic risk. Size effect is important in determining the systemic importance of individual banks, supporting “too-big-to-fail”. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 4 / 27
Introduction Methodology and Findings Summary Main findings Both spillover effects and real economy affect the movement of the systemic risk indicator. Risk premia are the main driving factors of systemic risk. Size effect is important in determining the systemic importance of individual banks, supporting “too-big-to-fail”. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 4 / 27
Introduction Methodology and Findings Summary Outlines of the presentation Construct the systemic risk indicator. Driving factors of systemic risk. Allocating systemic risk to each bank. Conclusion. Huang, Zhou and Zhu Systemic Risk of Financial Institutions 5 / 27
Introduction Risk Indicator Methodology and Findings Driving Factors Summary Allocating Risk I. Construct the systemic risk indicator Distress insurance premium (DIP). Suppose that a hypothetic insurance contract is issued to protect distressed losses in a banking system (at least a significant portion of total liabilities in default), what is the fair insurance premium? Huang, Zhou and Zhu Systemic Risk of Financial Institutions 6 / 27
Introduction Risk Indicator Methodology and Findings Driving Factors Summary Allocating Risk I. Construct the systemic risk indicator Distress insurance premium (DIP). Suppose that a hypothetic insurance contract is issued to protect distressed losses in a banking system (at least a significant portion of total liabilities in default), what is the fair insurance premium? Huang, Zhou and Zhu Systemic Risk of Financial Institutions 6 / 27
Introduction Risk Indicator Methodology and Findings Driving Factors Summary Allocating Risk Methodology: an overview CDS spreads Equity prices Step 1 Step 2 ❄ ❄ Individual PD Correlation Step 3 ❄ Simulate portfolio loss distribution Step 4 ❄ Indicator: DIP Huang, Zhou and Zhu Systemic Risk of Financial Institutions 7 / 27
Introduction Risk Indicator Methodology and Findings Driving Factors Summary Allocating Risk Methodology: an overview CDS spreads Equity prices Step 1 Step 2 ❄ ❄ Individual PD Correlation Step 3 ❄ Simulate portfolio loss distribution Step 4 ❄ Indicator: DIP Huang, Zhou and Zhu Systemic Risk of Financial Institutions 7 / 27
Introduction Risk Indicator Methodology and Findings Driving Factors Summary Allocating Risk Methodology: an overview CDS spreads Equity prices Step 1 Step 2 ❄ ❄ Individual PD Correlation Step 3 ❄ Simulate portfolio loss distribution Step 4 ❄ Indicator: DIP Huang, Zhou and Zhu Systemic Risk of Financial Institutions 7 / 27
Introduction Risk Indicator Methodology and Findings Driving Factors Summary Allocating Risk Methodology: an overview CDS spreads Equity prices Step 1 Step 2 ❄ ❄ Individual PD Correlation Step 3 ❄ Simulate portfolio loss distribution Step 4 ❄ Indicator: DIP Huang, Zhou and Zhu Systemic Risk of Financial Institutions 7 / 27
Introduction Risk Indicator Methodology and Findings Driving Factors Summary Allocating Risk Methodology Step 1: estimating PDs from CDS spreads ( s i , t ) (Duffie (1999) and Tarashev and Zhu (2008)) a t s i , t PD i , t = (1) a t LGD i , t + b t s i , t PDs are forward-looking. PDs are risk-neutral. Risk-neutral PD Actual PD Risk premium Default risk premium Liquidity risk premium Huang, Zhou and Zhu Systemic Risk of Financial Institutions 8 / 27
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