Systemic Risk Modeling Documentation
Understanding Systemic Risk
Systemic risk is the risk that distress at one or more financial institutions triggers a broad breakdown in the functioning of the financial system, with significant adverse effects on the real economy. Unlike risks that can be managed through diversification, systemic risk emerges from two primary channels: (1) correlated leveraged exposures, where institutions holding similar positions fail together when those positions decline, and (2) interconnectedness, where direct linkages between institutions transmit distress from one to many.
The defining characteristic of systemic risk is endogeneity: the financial system's collective response to stress can amplify rather than absorb shocks. When many institutions simultaneously sell assets to reduce risk, prices fall further, creating additional losses and triggering more sales. This feedback loop is what makes systemic crises qualitatively different from ordinary market corrections.
Systemic vs. Systematic Risk
Systematic risk (also called market risk) refers to economy-wide factors that affect all assets: interest rates, inflation, recessions. It is the non-diversifiable risk compensated by expected returns. Investors knowingly accept systematic risk in exchange for risk premium.
Systemic risk concerns the stability of the financial system as a whole. It arises from externalities that individual institutions do not internalize: the costs their potential failure would impose on counterparties, markets, and the broader economy.
The key distinction: systematic risk is a feature of normal markets; systemic risk represents a threat to the functioning of markets themselves.
| Aspect | Systemic Risk | Systematic Risk |
|---|---|---|
| Definition | Risk of financial system collapse from correlated exposures or cascading failures | Market-wide risk affecting all securities |
| Scope | Financial system stability | Individual portfolio returns |
| Diversifiable? | No (affects the entire system) | No (cannot be diversified away) |
| Compensation | Not priced; creates externalities | Compensated via risk premium |
| Examples | Bank runs, credit freezes, contagion | Recessions, interest rate changes, inflation |
| Measurement | SRISK, CoVaR, network analysis | Beta, market variance, CAPM |
Why Systemic Risk Matters
The 2008 financial crisis revealed a sobering truth: the failure of institutions that seemed isolated (e.g., Lehman Brothers, AIG) could trigger a global economic collapse within weeks. The crisis demonstrated that financial stability is a public good: when the system fails, the costs fall on everyone.
Unlike individual firm risk (which primarily affects shareholders and creditors), systemic risk creates negative externalities: costs imposed on parties not involved in the original transactions. Taxpayers may fund bailouts; workers lose jobs when credit tightens; pension funds suffer losses; small businesses cannot access financing.
Regulators
Identify systemically important institutions (SIFIs) and impose enhanced prudential standards to internalize externalities
Policymakers
Design macroprudential frameworks including countercyclical capital buffers, stress testing, and resolution planning
Investors
Assess portfolio exposure to tail risks that materialize precisely when diversification fails
Institutions
Manage their contribution to system-wide risk, in addition to their own risk, through capital surcharges
Key Concepts: The Building Blocks
Size and Leverage
Larger institutions have greater capacity to destabilize the system. Leverage amplifies this effect: a highly leveraged firm converts modest asset losses into existential equity crises. SRISK captures both dimensions.
Correlated Leveraged Exposures
Institutions with similar leveraged positions can fail simultaneously when those assets decline. No direct connection is required. Common exposures create correlated fragility.
Interconnectedness
Financial institutions are linked through lending relationships, derivatives contracts, and payment systems. When one institution fails, its counterparties may suffer losses, potentially triggering cascading failures.
Contagion Channels
Distress spreads through multiple channels: direct credit exposures, fire sales that depress asset prices, funding market freezes, and information cascades where uncertainty about one firm triggers runs on others.
Procyclicality
Risk measures, capital requirements, and margin calls can amplify rather than dampen cycles. During booms, low measured volatility encourages leverage; during busts, deleveraging forces asset sales that create additional losses.
The Measurement Challenge
Systemic risk is inherently difficult to quantify because the most dangerous events are precisely those that have not yet occurred. V-Lab addresses this by using forward-looking market-based measures that update continuously.
Moral Hazard & Too-Big-To-Fail
Expectations of government bailouts distort incentives: institutions deemed 'too big to fail' may take excessive risks, knowing losses will be socialized while profits remain private. This creates a feedback loop where implicit guarantees encourage the very behaviors that make bailouts necessary.
Historical Evolution
Understanding of systemic risk has evolved through a series of crises, each revealing new dimensions of interconnection and fragility. Before 2008, regulation focused primarily on individual institution solvency (microprudential supervision). The crisis revealed that a system of individually sound banks could nonetheless collapse collectively.
1998: LTCM Collapse
Extreme leverage (25:1) on concentrated convergence trades; correlated positions unwound simultaneously during flight to quality
2008: Global Financial Crisis
Lehman's bankruptcy proved large complex institutions could fail chaotically, freezing credit markets globally
2010–2012: European Sovereign Debt Crisis
Bank-sovereign doom loop; geographic contagion across the eurozone
2020: COVID-19 Market Stress
Fastest market decline in history; Treasury market disruption required Fed intervention
2023: SVB & Credit Suisse
Bank runs in the social media age; rapid contagion fears across the banking sector
V-Lab's Approach
V-Lab updates its systemic risk measures weekly for major global financial firms, analyzing multiple dimensions: market correlation, volatility, leverage, and capital adequacy under stress. This comprehensive approach reveals not just which firms are risky, but why they pose systemic threats.
Unlike regulatory stress tests that occur annually with proprietary data, V-Lab provides continuous monitoring using only public information, serving as a 'market-implied stress test' available to all stakeholders.
Foundation for Deeper Understanding
This conceptual overview prepares you for the detailed content that follows. V-Lab's documentation progressively introduces the components of systemic risk measurement: how MES captures tail sensitivity, how LRMES extends this to crisis horizons, how leverage transforms market losses into capital shortfalls, and how the SRISK formula synthesizes these elements.
Where to Go Next:
- Explore the Capital Shortfall Approach to understand how SRISK reframes 'too big to fail'
- Learn about Marginal Expected Shortfall (MES) as the core building block
- Compare V-Lab's Model Variants for different applications and markets
Systemic Risk Models
SRISK Models
Systemic risk models measuring capital shortfall under market stress using various market factors and estimation approaches
Use Cases: Systemic risk measurement, capital shortfall estimation, regulatory stress testing, and identification of systemically important financial institutions