Systemic Risk in Commercial Bank Lending

Abstract

This paper develops a bank model for financial systemic risk in bank lending. The model analyzes the impact of a financial institution failure on the distribution of losses in the financial system. The fundamental idea is that bank loss rates may be decomposed into a level, momentum, systematic and systemic component. Financial institutions fail when unexpected losses exceed the capital buffer and the release of capital allocated to credits. Failed financial institutions pass these loss exceedances on to creditors, deposit insurance schemes or the general public. The benefits of the presented model framework are (i) the identification of systemically relevant financial institutions, and (ii) the measurement of the size of safety nets in terms of attachment likelihood and expected losses given attachment. The model is generally applicable as it does not rely on financial market data. The empirical evidence presented is based on information collected by US prudential regulators from 1997 to 2012. The parameter estimation is based on a novel maximum likelihood technique to derive the parameters in a non-linear mixed model with multiple random effects.