Measuring Systemic Risk: A Financial Statement-Based Approach for Insurance Firms and Banks

Abstract

One of the important limitations of the SRISK measure of systemic risk, proposed by Brownlees and Engle and Acharya, Engle and Richardson, is its reliance on stock market data without much validation against the institutions’ fundamentals based on its financial statements. We propose a financial statement based approach to estimating the vulnerability of an institution to a systemic event (labeled CRISK). We illustrate our approach for three business models: a life insurer (Prudential), a property and casualty insurer (Chubb) and an investment bank (J.P. Morgan Chase). We also validate CRISK using AIG’s capital shortfall during the 2008 financial crisis. Our approach reveals that SRISK is likely to (i) overstate (misstate) capital requirements for life insurers (PC and (ii) to overstate capital requirements for banks heavily reliant on FDIC insured deposits. We recommend using the market based SRISK measure as a first cut filter to identify systemically important institutions. The analyst can refine the list and validate the expected capital shortfall number using CRISK or a detailed financial statement analysis of the kind we advocate in this paper.