Capital Shortfall Research Articles

S-shaped transition trajectory and dynamic development frontier of the financial systemic risk research: a multiple networks analysis

Financial systemic risk has an impact on the real economy and may trigger a chain reaction in the whole economic system leading to the financial crisis. Many scholars focus on financial systemic risk, but few of them are bibliometric analyses. Therefore, this paper explores the status quo, emerging trends, and transition trajectory through the above analysis method in the research field from 1990 to 2020. Based on the above analysis, we find the following conclusions: (1) The basic conclusions of the most productive countries, institutions, journals, authors, status quo, and the change of hotspots in this research field are presented. (2) The emerging trends in this research field are ‘credit risk’, ‘capital shortfall’, ‘spill-over’, ‘spread’, ‘financial market’, ‘interconnectedness’, ‘transmission’ in the last three years. (3) The research field of financial systemic risk presents an S-shaped transition trajectory through the local forward, the local backward, the global standard, and the global key-route main path analysis. (4) We find that the most cited authors are not always at the core of the trajectory of financial systemic risk research. The emerging trend ‘credit risk’ is also recently a core research direction in this research field’s transition trajectory.

Optimal capital allocation principles considering capital shortfall and surplus risks in a hierarchical corporate structure

When allocating a given total capital among main business lines and their sub-business lines, a decision maker will face both capital shortfall risk and capital surplus risk for each business line. There is a trade-off between the two kinds of risks. To balance such two kinds of risks in main business lines and their sub-business lines, we propose a capital allocation model considering both capital shortfall risks and capital surplus risks in a hierarchical corporate structure. We derive optimal allocation principles as solutions that minimize a general loss function that balances the shortfall and surplus risks. As applications of the proposed model, a general proportional allocation principle in the presence of a hierarchical corporate structure is derived. It is illustrated that the general proportional allocation can be viewed as the unique solution minimizing a specified loss function in the proposed model. Connections between this proposed model and some risk factors, such as dependence, extreme events, exogenous risks, and risk measures, are discussed.

Early warning of systemic risk in global banking: eigen-pair R number for financial contagion and market price-based methods

We analyse systemic risk in the core global banking system using a new network-based spectral eigen-pair method, which treats network failure as a dynamical system stability problem. This is compared with market price-based Systemic Risk Indexes (SRIs), viz. Marginal Expected Shortfall (MES), Delta Conditional Value-at-Risk (Delta-CoVaR), and Conditional Capital Shortfall Measure of Systemic Risk (SRISK) in a cross-border setting. Unlike paradoxical market price based risk measures, which underestimate risk during periods of asset price booms, the eigen-pair method based on bilateral balance sheet data gives early-warning of instability in terms of the tipping point that is analogous to the R number in epidemic models. For this regulatory capital thresholds are used. Furthermore, network centrality measures identify systemically important and vulnerable banking systems. Market price-based SRIs are contemporaneous with the crisis and they are found to covary with risk measures like VaR and betas.

Optimal investment policy in a multi-stage problem with bankruptcy and stage-by-stage probability constraints

ABSTRACT The present paper studies a multi-stage portfolio optimization problem with bankruptcy and stage-by-stage value at risk (VaR) constraints that impose boundary for probability of the percentage of the investor's capital shortfall at each stage. The goal function is the mean value of final investor's capital. Making use of the stage-by-stage VaR constraints and a multivariate normal model for rates of return, the method of dynamic programming is applied. Due to peculiarities of this optimal control problem of the Markov chain with a set of absorbing states, an optimal investment policy turns out to be a relatively simple policy. More exactly, at each stage optimal portfolio depends only on the number of stage, but not on the value of current investor's capital. The initial problem is reduced to a sequence of one-stage portfolio optimization problems. Analysis of such one-stage problem is mainly based on known results, providing sufficient and necessary conditions for fulfilment of Slater's constraint qualification, as well as conditions for optimality. In addition, we extend the obtained results to a non-normality situation by use of elliptical distributions.

SRISKv2 – A note

SRISK is a very influential metric of the systemic risk posed by financial firms. However, SRISK suffers from a conceptual flaw in its capital shortfall calculation. This note proposes a modified version of this metric, SRISKv2, which corrects this flaw and provides a more sensible metric of the systemic risk posed by financial firms.

Capital shortfall: A multicriteria decision support system for the identification of weak banks

Following the 2007–2008 global financial crisis, regulators introduced a series of supervisory tools for the closer monitoring of financial institutions. Among them, stress tests and capital exercises performed by the Federal Reserve System (Fed) and the European Banking Authority/European Central Bank (EBA/ECB) play a critical role in the surveillance of the U.S. and the European banking sector. However, due to their nature, these exercises are time consuming. Therefore, we propose the use of a multicriteria based decision support system (DSS) to model and predict the regulatory decisions and outcomes of the above-mentioned exercises. Thus, the proposed approach can be employed by regulators as an early-warning system (EWS) for the continuous, automated, and timely identification of weak banks in need of capitalization, as well as by bank managers and risk analysts as a tool for capital management and strategic planning.

Conditional capital surplus and shortfall across renewable and non-renewable resource firms

This study examines the conditional capital surplus and shortfall dynamics of renewable and non-renewable resource firms. To this end, this study uses the systemic risk index by Brownlees and Engle (2017) and considers two conditional systemic events, namely, the stock market crash and the commodity price crash. The results indicate that generally, companies in the resource sector tend to have conditional capital shortfall before 2000 and conditional capital surplus after 2000 owing to the boom of the commodity sector stock and the moderate-to-careful capital structure management adopted by these companies. This finding is especially valid for resource firms from developed countries, whose observations dominate the dataset used in this study. Furthermore, the analysis using the panel vector autoregressive model indicates a positive influence of commodity price, geopolitical, and economic policy uncertainties on the conditional capital shortfall. These uncertainties have also been proven to increase the conditional failure probability of firms in the sample. Lastly, the performance analysis shows that potential capital shortfall is positively related to market return, reflecting a high-risk high-return trade-off for this sector.

Climate Stress Testing

Climate change could impose systemic risks upon the financial sector, either via disruptions in economic activity resulting from the physical impacts of climate change or changes in policies as the economy transitions to a less carbon-intensive environment. We develop a stress testing procedure to test the resilience of financial institutions to climate-related risks. Specifically, we introduce a measure called CRISK, systemic climate risk, which is the expected capital shortfall of a financial institution in a climate stress scenario. We use the measure to study the climate-related risk exposure of large global banks in the collapse of fossil-fuel prices in 2020.

Stress-Testing Net Trading Income: The Case of European Banks

Net trading income is an important but volatile source of income for many euro area banks, highly sensitive to changes in financial market conditions. Using a representative sample of European banks, we study the distribution of net trading income (normalized by total assets) conditional to changes in key macro-financial risk factors. To map the linkages of net trading income with financial risk factors and capture non-linear effects, we implement a dynamic fixed effects quantile model using the method of moments approach. We use the model to empirically estimate and forecast the conditional net trading income distribution from which we quantify tail risk measures and expected losses across banks. We find a heterogeneous and asymmetric impact of the risk factors on the distribution of net trading income. Credit and interest rate spreads affect lower quantiles of the net trading income distribution while stock returns are an important determinant of the upper quantiles. We also find that the onset of the Covid-19 pandemic resulted in a significant increase in the 5th and 10th percentile expected capital shortfall. Moreover, adverse scenario forecasts show a wide dispersion of losses and a long-left tail is evident especially in the most severe scenarios. Our findings highlight strong inter-linkages between financial risk factors and trading income and suggest that this tractable methodology is ideal for use as an additional tool in stress test exercises.

Bank regulation and systemic risk: cross country evidence

Using data for banks from 65 countries for the period 2001–2013, we investigate the impact of bank regulation and supervision on individual banks’ systemic risk. Our cross-country empirical findings show that bank activity restriction, initial capital stringency and prompt corrective action are all positively related to systemic risk, measured by Marginal Expected Shortfall. We use the staggered timing of the implementation of Basel II regulation across countries as an exogenous event and use latitude for instrumental variable analysis to alleviate the endogeneity concern. Our results also hold for various robustness tests. We further find that the level of equity banks can alleviate such effect, while bank size is likely to enhance the effect, supporting our conjecture that the impact of bank regulation and supervision on systemic risk is through bank’s capital shortfall. Our results do not argue against bank regulation, but rather focus on the design and implementation of regulation.

Jump Risk in the US Financial Sector

In this paper we establish empirical evidence for the relationship between the systematic jump betas of financial institutions and two types of systemic risk index: a capital shortfall index and a interconnectedness index. Using high‐frequency data for US financial sector stocks, we show that equity market jumps are positively related to capital shortfall and negatively related to interconnectedness. Higher potential capital shortfall measures of systemic risk lead to a greater sensitivity to systematic jumps, while increased interconnectedness leads to greater resistance. Our findings, along with indicators such as size and leverage, provide a means to identify the possible trade‐offs that regulators might face when assessing the systemic risks of financial institutions, particularly in the context of the cross‐multiple influences within the sector.

SRISKv2 - A Note

SRISK is a very influential metric of the systemic risk posed by financial firms. However, SRISK suffers from a conceptual flaw in its capital shortfall calculation. This note proposes a modified version of this metric, SRISKv2, which corrects this flaw and provides a more sensible metric of the systemic risk posed by financial firms.

Heterogeneous Risk Behaviour of Bank Holding Companies after the Dodd–Frank Act

We investigate the risk-taking behaviour of Bank Holding Companies (BHCs) that are subject to the Dodd–Frank Act (DFA). Specifically, we employ a difference-in-differences method to assess the effectiveness of the DFA in reducing the riskiness of complex banks and their contribution to systemic risk. Consistent with the Risk Monitoring Hypothesis, our results suggest that the DFA generally reduced the market risk and Distance to Default of complex BHCs and increased their stability. Furthermore, our findings show that the DFA also caused a significant reduction in the BHC contribution to systemic risk, measured both as Expected Capital Shortfall and the Systemic Expected Shortfall. In addition, we identified various economic transmission channels to explain how the DFA has affected the individual risk of complex BHCs. Our findings are robust to a battery of additional analyses and tests.

Systemic Risk of China’s Financial System (2007–2018): A Comparison between CoVaR, MES and SRISK across Banks, Insurance and Securities Firms

China’s stock market crash in 2015 aroused scholarly attention on financial systemic risk in China. Using data on China’s stock market from January 5, 2007 to September 28, 2018, this study calculated three different measures of systemic risk, i.e., temporal fluctuation of financial institutions’ contribution to systemic risk (CoVaR), sensitivity of financial institutions to systemic risk (MES) and long-run expected capital shortfall (SRISK), to assess the formation, occurrence, and consequences of systemic risk in China. The results show that CoVaR and MES exhibited an abnormal rise during the outbreak of the 2008 global financial crisis and the 2015 domestic stock market crash, whereas SRISK showed a steady increase throughout the observation window, indicating China’s ever-growing SRISK despite the CoVaR and MES. More importantly, regardless of temporal fluctuation, (1) the vast majority of systemic risk comes from banks, followed by insurance firms, which is shown by the institutions’ ranking in terms of CoVaR; (2) securities firms followed by insurance firms are exposed to more systemic risk as indicated by short-run expected equity loss (i.e., MES); and (3) banks accumulate more SRISK than any other financial institution. The findings suggest that, in the event of a severe Chinese financial crisis, likely banks will endure the greatest amount of capital shortfall, whereas securities firms will suffer more short-run loss proportionally and thus risk a higher probability of bankruptcy. We conclude with a comparison of systemic risk in financial systems between China and the USA and policy implications.

Policy uncertainty and the capital shortfall of global financial firms

This paper examines how economic policy uncertainty affects financial firms' capital shortages in the event of a new crisis. By employing a global economic policy uncertainty index, we show that an increase in policy uncertainty leads to future capital shortfall increases in the event of a severe market decline. This effect of policy uncertainty is of a similar magnitude for all firms across all regions and sectors, albeit with a few exceptions. As expected, well-capitalized financial firms are less affected. Our findings have important implications for policymakers and politicians, since if their response during a severe market decline is not timely and decisive, the delay will come at a cost. Further, in terms of the implications for firms' managers, we show that during periods of elevated policy uncertainty and a severe market downturn, firms will face additional, unexpected capital requirements.

The Accounting and Legal Issues of Capital Reserve, with Particular Emphasis on Capital Increase by Share Premium

The type of capital market transaction in which external investors become the members of an undertaking through capital increase by share premium is frequent in everyday business life. We confirmed the significance of the use of the capital reserve for the purposes of maintaining the solvency of an undertaking by using a descriptive statistical analysis. Based on the interpretation of the legal regulation, and the analysis of the accounting and legal practice we found that the Hungarian accounting and legal regulation on capital reserve in force does not ensure sufficient protection and transparency, which weakens social and business trust in business associations. For this reason we would consider it useful from an accounting perspective if capital reserve, similarly to subscribed capital called but not paid, could be paid subsequently, and if it was shown in a separate line of the balance sheet as long as the payment is not made, and if the supplementary notes also contained an obligation to provide information in that regard. Legal risks can be reduced if the arbitral tribunal’s clause is included in the memorandum of association or syndicate contract in the case of capital increase by share premium. The excessive length of proceedings and capital shortfalls may jeopardise the success of the undertaking as a whole. It would strengthen the operation of the economy and legal certainty if the Court of Registration registered capital increase by share premium only when the capital reserve has already been paid in a verified manner in addition to the subscribed capital.

Objectives and Challenges for Stress Testing

Stress testing proved to be an effective crisis fighting tool in the Great Financial Crisis and has since become widely used by regulators and financial institutions to test resilience to financial and economic shocks. This served two objectives: (1) to identify and remediate banks with a capital shortfall, and (2) to restore confidence in the core of the banking system by requiring that banks eliminate any regulatory capital shortfall promptly either by raising capital in private markets or, if unable, from a government backstop fund. The objectives of a stress test will determine six fundamental choices in structuring the exercise: (1) the design of stress scenarios; (2) the risk exposures to be stressed; (3) the range of institutions to be tested, the length of the scenario and the intervals over which shocks are measured; (4) the development of models to map shocks into outcomes and impact on individual bank financials and on the banking system; (5) the choice of criteria to determine whether banks pass or fail the stress test; (6) the decision about what to disclose to the public. But stress tests are no panacea. We discuss a range of challenges to improving the effectiveness of stress tests, such as incorporating nonfinancial risks like cyber, taking into account second-round effects of shocks, broadening the scope beyond just banks, and resisting a tendency to disaster myopia as memories of the financial crisis recede into the past.

Debtholder Monitoring Incentives and Bank Earnings Opacity

We exploit exogenous legislative changes that alter the priority structure of different classes of debt to study how debtholder monitoring incentives affect bank earnings opacity. We present novel evidence that exposing nondepositors to greater losses in bankruptcy reduces bank earnings opacity, especially for banks with larger shares of nondeposit funding, listed banks, and independent banks. The reduction in earnings opacity is driven by a lower propensity to overstate earnings and becomes larger during crises, when the incentive to conceal capital shortfalls is stronger. Our findings highlight the importance of creditors’ monitoring incentives in improving the quality of information disclosure.

Bank response to policy-related changes in capital requirements

We estimate how banks respond to regulatory capital requirements. We use a novel measure called capital surplus/shortfall, which we construct from notifications on regulatory capital requirements sent to Slovenian banks over the period 2009–2015. Capital surplus/shortfall is more relevant than capital adequacy ratio (CAR). It conveys more information about future lending because it is a forward-looking measure of bank capitalization. Our paper carries policy implications for supervisors in countries with a distressed banking sector. Using this measure we show that the same firm has on average a 3.54 p.p. lower loan growth when the loan is obtained through a bank with 1 p.p. higher capital shortfall. Finally, we show that in response to an increase in capital requirements banks engage in risk-taking behaviour.

Measuring Systemic Risk: Capital Shortfall and CSRISK*

AbstractThis study proposes a new measure of systemic risk named CSRISK, which identifies a financial institution's capital shortfall under the worst scenario conditional on a substantial market decline. The CSRISK index requires only public financial data, including accounting and market trading information, which is time and cost effective. The empirical sample consists of 238 US banks over the time period 2003–2013. Overall, we find that it is increasing from 2004 to 2009 and then starts to slightly decrease. This systemic risk measure has the potential to be widely applied in the practical aspects of risk management and macroprudential policy making.