Working Paper: CEPR ID: DP8824
Authors: Viral V. Acharya; Lasse H. Pedersen; Thomas Philippon; Matthew P. Richardson
Abstract: We present a simple model of systemic risk and we show that each financial institution's contribution to systemic risk can be measured as its systemic expected shortfall (SES), i.e., its propensity to be undercapitalized when the system as a whole is undercapitalized. SES increases with the institution's leverage and with its expected loss in the tail of the system's loss distribution. Institutions internalize their externality if they are ?taxed? based on their SES. We demonstrate empirically the ability of SES to predict emerging risks during the financial crisis of 2007-2009, in particular, (i) the outcome of stress tests performed by regulators; (ii) the decline in equity valuations of large financial firms in the crisis; and, (iii) the widening of their credit default swap spreads.
Keywords: bailout; financial regulation; systemic risk; value at risk
JEL Codes: G01; G18
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| bank's leverage (G21) | SES (I20) |
| expected loss in the tail of the loss distribution (D39) | SES (I20) |
| tax based on SES (H29) | internalize externality associated with systemic risk (F65) |
| SES (I20) | emerging risks during the financial crisis (F65) |
| SES (I20) | stress test outcomes (C52) |
| SES (I20) | declines in equity valuations (G12) |
| SES (I20) | widening credit default swap spreads (G19) |