Working Paper: NBER ID: w18043
Authors: Armen Hovakimian; Edward J. Kane; Luc Laeven
Abstract: This paper proposes a theoretically based and easy-to-implement way to measure the systemic risk of financial institutions using publicly available accounting and stock market data. The measure models the credit enhancement taxpayers provide to individual banks in the Merton tradition (1974) as a combination put option for the deep tail of bank losses and a knock-in stop-loss call on bank assets. This model expresses the value of taxpayer loss exposure from a string of defaults as the value of this combination option written on the portfolio of industry assets. The exercise price of the call is the face value of the debt of the entire sector. We conceive of an individual bank’s systemic risk as its contribution to the value of this sector-wide option on the financial safety net. To the extent that authorities are slow to see bank losses or reluctant to exercise the call, the government itself becomes a secondary source of systemic risk. We apply our model to quarterly data over the period 1974-2013. The model indicates that systemic risk reached unprecedented highs during the financial crisis years 2008-2009, and that bank size, leverage, and asset risk are key drivers of systemic risk.
Keywords: systemic risk; financial institutions; banking sector
JEL Codes: G01; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| bank size (G21) | systemic risk (E44) |
| leverage (G24) | systemic risk (E44) |
| asset risk (G32) | systemic risk (E44) |
| systemic risk (E44) | bank size (G21) |
| correlation of credit risk (C10) | systemic risk (E44) |