A State Space Approach to Estimate Systemic Risk

Abstract

The recent global financial crisis has given one important lesson that, the traditional approach of managing the soundness of the banks needs to be supplemented by a system-wide macro-prudential approach. Hence, there is a pressing need for containing this system wide risk. However, prior to containing the systemic risk and form the regulations we need to measure this risk properly and study its sources. I in this paper propose a state space modelling framework to estimate a systemic risk measure "Systemic Expected Shortfall" (SES). This measure was introduced by Acharya et al. (2010) on the basis of a two period model of the economy having N banks but the authors did not present any estimation methodology to estimate this unobserved ex-ante measure of risk over a period of time. I apply the proposed state space estimation approach to estimate the time varying daily SES to evaluate the riskiness of Indian banks and the evolution of systemic risk over the period of time. And evaluate the forecasting performance of the estimated measure.

Keywords: Systemic Risk, Systemic Expected Shortfall (SES), State Space Estimation, Financial System

JEL Classification: G21, C51, C53