Measures of Systemic Risk

TL;DR

This paper introduces a new framework for measuring systemic risk in financial systems, deriving measures from system structure and regulatory objectives, and providing algorithms and case studies for their application.

Contribution

It proposes a novel, rigorous approach to systemic risk measurement based on capital allocations, system structure, and acceptability criteria, advancing beyond existing methods.

Findings

New systemic risk measures derived from system structure and regulator goals

Algorithm for computing systemic risk measures demonstrated in case studies

Operational measures that include both ex post bailout costs and ex ante capital requirements

Abstract

Systemic risk refers to the risk that the financial system is susceptible to failures due to the characteristics of the system itself. The tremendous cost of systemic risk requires the design and implementation of tools for the efficient macroprudential regulation of financial institutions. The current paper proposes a novel approach to measuring systemic risk. Key to our construction is a rigorous derivation of systemic risk measures from the structure of the underlying system and the objectives of a financial regulator. The suggested systemic risk measures express systemic risk in terms of capital endowments of the financial firms. Their definition requires two ingredients: a cash flow or value model that assigns to the capital allocations of the entities in the system a relevant stochastic outcome; and an acceptability criterion, i.e. a set of random outcomes that are acceptable to a regulatory authority. Systemic risk is measured by the set of allocations of additional capital that lead to acceptable outcomes. We explain the conceptual framework and the definition of systemic risk measures, provide an algorithm for their computation, and illustrate their application in numerical case studies. Many systemic risk measures in the literature can be viewed as the minimal amount of capital that is needed to make the system acceptable after aggregating individual risks, hence quantify the costs of a bail-out. In contrast, our approach emphasizes operational systemic risk measures that include both ex post bailout costs as well as ex ante capital requirements and may be used to prevent systemic crises.