Early Warning of Systemic Risk In Global Banking: Eigen-Pair R Number for Financial Contagion and Market Price-based Methods

Abstract

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. MES (Marginal Expected Shortfall), Delta Conditional Value-at-Risk (∆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.

Keywords: Global Financial Networks, Systemic Risk, Early Warning Signals, Eigen-Pair Analysis, Statistical Market Price-Based Risk Measures, Paradoxical Risk Measures.

JEL Classification: G21, G15, G28, E44, C63.