Effects on Growth and Inflation of the Unraveling of Systemic Risk in the Euro Area Banking Sector: Lessons from the Financial Crisis

Abstract

This study extends the work of Kabundi and Nadal De Simone’s (2019) measurement of systemic risk-taking in the euro area banking sector in two interrelated directions. First, it shows that all but one of the estimated systemic risk measures could have signaled with high accuracy the extreme macro-financial instability in the euro area that followed Lehman Brothers’ collapse. Second, the unravelling of systemic risk following a one-standard deviation shock to systemic risk affects GDP growth and inflation negatively with the latter displaying a more pronounced response than the former. There is heterogeneity in the strength of the responses across diverse forms of systemic risk and their time dimension. Systemic risk associated with banks’ interconnectedness and contagion plays a considerable role in depressing economic activity. Short-term systemic risk measures tend to portray stronger effects on output and inflation than their conditional forward counterparts. The systemic risk measures are potential candidates of a macroprudential-policy toolkit for calibrating policy instruments with thresholds that reflect policymakers’ risk preferences.

Keywords: systemic risk, financial stability, non-linearities, FAVAR, monetary policy

JEL Classification: E44, E52, C30, C38, G1