introduction to the systemic risk of banks

8/8/2019 Introduction to the Systemic Risk of Banks

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Introduction to the systemic risk of banksS. Kourdoupalos 12/11/2007

Banks, as every other company, face uncertainty and risk about future

states of the world. Uncertainty means that a bank has ignorance aboutthe possible future states and the probabilities to occur. Whereas risk canbe perceived as measurable uncertainty, that is, the future states and theirlikelihood are known.

The basic risks a bank faces are credit, market and interest rate risk.These risks stem form the core operations of a bank and since banks arehighly interrelated, systemic risk is also created. The systemic risk of banks refers to the probability of having a banking crisis. A banking crisiscan be defined as the case when a significant number of banks realise

severe capital losses, which have been caused by contagion from anotherbank or an aggregate shock, leading to default. However, there is no exactand common definition of the banking crisis term in the literature.

Banking crises have reasons to happen, that is to say they do not occurbecause of unexpected self-fulfilling bank runs. The fundamental cause of banking crises is the macro environment of the global or a local economy.The crisis is triggered when an unfavourable macroeconomic state occursthat reduces the value of banks’ assets. This unfavourable state mightmainly affect one bank and then through contagion affect more banks, orit can be in the form of aggregate shock that affect many banks. The final

stage of a crisis can be either a bank run, because of the depositors areconcerned about the banks’ assets devaluation, or a bankruptcy incurredfrom such assets devaluation that the banks’ capital is wiped out.

The macroeconomic variables that are related significantly withbanking crises, according to the econometric analysis of Demirguc-Kuntand Detragiache (1998), are the economy’s growth rate, the real interestrate and inflation. This analysis does not tell us something new, as theseare the key macroeconomic variable that signs different states of theeconomic outlook. The difficult issue that needs to be tackled is

measuring the systemic risk.Arising from its very definition, the problem of measuring systemic

risk can be transform into measuring default probabilities. There are twokinds of models to calculate these probabilities, structural models andreduced-form models. In a few words, structural models examine defaultin an option theory context applying the Black and Scholes valuationmodel. The important assumption behind Black and Scholes valuationformula is normality of the equity returns’ distribution. In practice,however, it has been observed that returns under extreme events have

fatter tails than normal distribution implies. Defaults are directly relatedto extreme return movements and thus cannot be modeled properly by

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structural models. On the other hand, reduced-form models employprobability theory that allows them to model fat tails. Below we brieflyexamine the two approaches as they are applied in a small part of theliterature.

Bartram et al. (2007) develop a structural model to assess systemicrisk within a global bank sample of 334 banks, across 28 countries, in thecrises of Mexico (1994), Asia (1997), Russia and Long-Term CapitalManagement (1998), and Brazil (1999). Their approach measures onlythe contagious systemic risk. In particular, systemic risk is proximated bythe difference in pre-crisis and post-crisis default probabilities of banksunexposed to the crises examined. Their results appear in table 1. Theresults are not very informative as they are presented on average basis.However, the overall conclusion is that systemic risk, measured as the

change of default probabilities during crises, is small.

Table 1: Default probabilities rise after a crisiscrisis Banks

All Asian European AmericanMexico 0.485% 1.986% -0.620% 0.134%Asia 0.655% 0.092% 1.217% 0.785%Russia-LTCM 0.425% -0.358% 1.214% 0.560%Brazil -0.069% -0.656% 0.941% -0.441%Source: Bartram et al. (2007)

The negative sign in some cases indicates smaller default probabilities of the unexposed to the crisis banks after the crises have occurred. Theauthors, for the case of Brazil, attribute this positive effect to theresolution of uncertainty and the government’s handling of devaluation.As far as contagion caused by bank runs is concerned, Bordo et al. (1995)mention that runs on exposed to a crisis banks, shift deposits to otherunexposed and solvent banks. Hence, in crises of table 1 where bank runsare present, we would naturally expect to see a negative sign in the

default probabilities rise of these unexposed banks.Coming to the reduced-form models, De Vries (2005) examines

contagious banking systemic risk in a framework of negativecomovements of equity returns under extreme value theory. Using asimple setting of two banks sharing two syndicated loans, the paperassess the systemic risk in the form of “given there is at least one bank failure, what is the expected rate of bank failures?”. The papers setsmainly a theoretical framework and concludes that under fat tailssyndicated loans, which are used as a way of risk sharing, rises systemic

risk for banks.

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Hartmann et al. (2005) assess the systemic risk caused by contagionand aggregate shocks across 25 European and 25 American banks from1992 to 2004. The quantification of contagious systemic risk is made as“what is the probability that a number of banks face extremely negative

returns, given that part of these banks has already crashed?”. Thesystemic risk is defined as the probability of a bank’s extremely negativereturns given that the market has crashed. Their analysis is formed insuch a way distinguishing cross-border and domestic contagion. Theevolution of contagious systemic risk is presented in figure 1 and showsthe overall contagious systemic risk in Europe is lower than the USbecause of the smaller integration of peripheral European economies withthe rest.

Figure 1: Proximated course of contagious systemic risk

Source: Hartmann et al. (2005)

Interestingly, on average during 1992-1997, the European sample bankshave a total of $791 billion interbank loans, whereas American bankshave $28 billion. Moreover, the tails of the European bank equity returnsare fatter compare to the American ones. The paper does not give anexplanation for these two findings in comparison with the lowerEuropean contagious systemic risk. Hartmann et al. (2005) alsocalculated the sample aggregate systemic risk and find it the same in

Europe and the US. Lastly, both contagious and aggregate systemic riskshave risen during the sample period in Europe and the US.

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References

Bartram, S.M., Brown, G.W., Hund, G.E., 2007. Estimating systemic risk

in the international financial system. Journal of Financial Economics,doi:10.1016/j.jfineco.2006.10.001

Bordo, M.D., Mizrach, B., Schwartz, A.J, 1995. Real versus pseudo-international systemic risk: Some lessons from history. NBER workingpaper series, No 5371, 4

De Vries, C.G., 2005. The simple economics of bank fragility. Journal of Banking & Finance 29 (4), 803-825

Demirguc-Kunt, A., Detragiache, E., 1998. The determinants of bankingcrises in developing and developed countries. IMF staff papers, Vol. 45,No 1

Hartmann, P., Straetmans, S., de Vries, C.G., 2005. Banking systemstability a cross-Atlantic perspective. European Central Bank workingpaper series, No 527

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introduction to the systemic risk of banks

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