Calculating systemic risk capital: A factor model approach

Abstract

We treat the banking system as a traded credit portfolio and calculate systemic risk capital as the amount of capital that insures the portfolio's value against unexpected losses. Using data from the largest global financial institutions, we find evidence of extreme event dependence between banks during the recent financial crisis. Subsequently, we extend the existing Gaussian approach by proposing a model that accounts for the extreme event dependence, and we quantify the level of capital shortfall when this characteristic is ignored. Furthermore, the mark to market valuation approach incorporates the economic loss of credit downgrades into the estimates.