Aggregate and Firm-Level Measures of Systemic Risk from a Structural Model of Default

Abstract

The breadth and dynamics of the recent financial crisis have led to efforts to develop forward-looking tools to monitor systemic risk. In this article, the authors propose a new measure that is an extension of the absorption ratio (AR) introduced in 2010 by Kritzman, Li, Page, and Rigobon. Using principal component analysis (as in the original AR methodology) in conjunction with a structural model of default, the authors develop a measure of systemic risk that may be calculated using only publicly available data. They call the new measure the credit absorption ratio (CAR) and find that increases in the CAR preceded periods of financial distress during the recent crisis. The CAR may be interpreted economically: it highlights states of the financial system during which the credit fundamentals of institutions and markets exhibit heightened coupling and higher potential for cascading distress. The authors also demonstrate that a byproduct of CAR analysis provides a measure of the degree to which specific financial institutions are exposed to systemic risk factors at any point in time. They find that a number of the institutions that exhibited, under the CAR measure, high potential exposure during the lead-up to the recent crisis subsequently experienced higher levels of distress or required external assistance.

Keywords: systemic risk, structural model of default, credit models