The role of debt valuation factors in systemic risk assessment

TL;DR

This paper enhances systemic risk assessment by incorporating debt valuation factors, especially the dynamic relationship between interest rates and bank credibility, improving failure detection and prevention strategies.

Contribution

It introduces a novel framework that integrates debt valuation factors into systemic risk analysis, capturing dynamic interdependencies often overlooked by traditional models.

Findings

Debt valuation factors significantly impact risk assessment outcomes.

Modeling interest rate and bank credibility dynamics improves failure prediction.

Framework aids regulators and companies in preventing and preparing for financial crises.

Abstract

The fragility of financial systems was starkly demonstrated in early 2023 through a cascade of major bank failures in the United States, including the second, third, and fourth largest collapses in the US history. The highly interdependent financial networks and the associated high systemic risk have been deemed the cause of the crashes. The goal of this paper is to enhance existing systemic risk analysis frameworks by incorporating essential debt valuation factors. Our results demonstrate that these additional elements substantially influence the outcomes of risk assessment. Notably, by modeling the dynamic relationship between interest rates and banks' credibility, our framework can detect potential cascading failures that standard approaches might miss. The proposed risk assessment methodology can help regulatory bodies prevent future failures, while also allowing companies to more accurately predict turmoil periods and strengthen their survivability during such events.