Systemic Risk Analysis

The RISK page of the Volatility Laboratory presents a variety of risk measures for major Global Financial Firms. These measures are updated weekly and reveal several dimensions of risk. Historical estimates of each of these risk measures can be plotted to see the changing performance of individual firms.

A financial firm will be unable to function when the value of its equity falls to a sufficiently small fraction of its outstanding liabilities. In good times, such a firm will likely be acquired, may be able to raise new capital or may face an orderly bankruptcy. If this capital shortage occurs at a time when the financial sector is already financially constrained, then the government faces the question of whether to rescue the firm with taxpayer money as other avenues are no longer available. In the theoretical analysis of Acharya, Pederson, Phillipon and Richardson (2010), such a capital shortage is damaging to the real economy as the failure of this firm will have repercussions throughout the financial and real sectors. Consequently a firm is systemically risky if it is likely to face a capital shortage just when the financial sector itself is weak.

The analysis presented in this web site seeks to measure these concepts for US financials. The program calculates the expected capital shortage faced by a firm in a potential future financial crisis. Conceptually this calculation is like the stress tests that are regularly applied to financial firms, however here it is done with only publicly available information and is quick and inexpensive to compute.

This calculation takes three steps. First it estimates the daily drop in equity value of this firm that would be expected if the aggregate market falls more than 2%. This is called Marginal Expected Shortfall or MES. The measure incorporates the volatility of the firm and its correlation with the market, as well as its performance in extremes. These are estimated using asymmetric volatility, correlation and copula methods similar to those in other sections of V-Lab. In a second step this is extrapolated to a financial crisis which involves a much greater fall over a much greater time period. Finally, equity losses expected in a crisis are combined with current equity market value and outstanding measures of debt to determine how much capital would be needed in such a crisis. A firm is assumed to require at least 8% capital relative to its asset value.

The Systemic Risk Contribution, SRISK%, is the percentage of financial sector capital shortfall that would be experienced by this firm in the event of a crisis. Firms with a high percentage of capital shortfall in a crisis are not only the biggest losers in a crisis but also are the firms that create or extend the crisis. This SRISK% is the NYU Stern Systemic Risk Ranking of the US Financial sector. Some of the firms on this list are already under government protection. Their risk status is a reflection of the costs to the system if the government guarantees were suddenly withdrawn.