Systemic Risk, Stress Testing, and Financial Contagion

Abstract

Despite the acknowledgment of the relevance of Systemic Risk, there is a lack of consensus on its definition and, more importantly, on the way it should be measured. Fortunately, there is a growing research agenda and more financial regulators, central bankers, and academics have recently been focusing on this field. In this chapter, the authors obtain a distribution of losses for the banking system as a whole. They are convinced that such distribution of losses is the key element that could be used to develop relevant measures for systemic risk. Their model contemplates several aspects, which they consider important regarding the concept of systemic risk: an initial macroeconomic shock, which weakens some institutions (some of them to the point of failure), a contagion process by means of the interbank market, and the resulting losses to the financial system as a whole. Finally, once the distribution is estimated, the authors derive standard risk measures for the system as a whole, focusing on the tail of the distribution (where the catastrophic or systemic events are located). By using the proposed framework, it is also possible to perform stress testing in a coherent way, including second round effects like contagion through the interbank market. Additionally, it is possible to follow the evolution of certain coherent risk measures, like the CVaR, in order to evaluate if the system is becoming more or less risky, in fact, more or less fragile. Additionally, the authors decompose the distribution of losses of the whole banking system into the systemic and the contagion elements and determine if the system is more prone to experience contagious difficulties during a certain period of time.