Measuring Systemic Risk and Assessing Systemic Importance in Global and Regional Financial Markets using the ESS-Indicator

Abstract

In this paper we propose a measure of systemic risk in the financial sector, the Expected Systemic Shortfall (ESS) indicator. The ESS-indicator is the product of the probability of a systemic default event and the expected tail loss in case this systemic event occurs. We compute the ESS-indicator using a credit portfolio simulation whose input parameters we estimate from market CDS spreads and equity return correlations. Also, a methodology for computing the relative systemic risk contributions of individual banks using the ESS-indicator is provided. We apply the ESS methodology to a global sample of 83 international bank holding companies as well as to four regional bank sub-samples. Our empirical results show that the ESS-indicator responds adequately to both the financial crisis events with global importance and to the specific events in the regional sub-samples. The ESS-indicator reaches its peak in September 2008 and remains at an elevated level at the end of the sample period for all samples and particularly for the European sub-sample. The relative systemic risk contribution of individual banking groups is mainly driven by their size, corroborating the common ‘too big to fail’ statement. We contribute to the ongoing discourse concerning the regulation of systemically important financial institutions by suggesting the use of the relative systemic risk contributions to the ESS-indicator as a measure for a bank’s systemic importance. By applying a systemic risk contribution threshold of one percent, our empirical results show that there are 23 globally systemically important banks.