Monitoring Transmission of Systemic Risk: Application of Partial Least Squares Structural Equation Modeling in Financial Stress Testing

33 Pages Posted: 19 Apr 2018

See all articles by Necmi K. Avkiran

Necmi K. Avkiran

University of Queensland - Business School; Financial Research Network (FIRN)

Christian Ringle

University of Hamburg

Rand Kwong Yew Low

University of Queensland Business School

Multiple version iconThere are 2 versions of this paper

Date Written: April 18, 2018

Abstract

Regulators need a method that is versatile, is easy to use and can handle complex path models with latent (not directly observable) variables. In a first application of partial least squares structural equation modeling (PLS-SEM) in financial stress testing, we demonstrate how PLS-SEM can be used to explain the transmission of systemic risk. We model this transmission of systemic risk from shadow banking to the regulated banking sector (RBS) using a set of indicators (directly observable variables) that are sources of systemic risk in shadow banking and consequences of systemic risk measured in the RBS. Procedures for predictive model assessment using PLS-SEM are outlined in clear steps. Statistically significant results based on predictive modeling indicate that around 75% of the variation in systemic risk in the RBS can be explained by microlevel and macrolevel linkages that can be traced to shadow banking (we use partially simulated data). The finding that microlevel linkages have a greater impact on the contagion of systemic risk highlights the type of significant insight that can be generated through PLS-SEM. Regulators can use PLS-SEM to monitor the transmission of systemic risk, and the demonstrated skills can be transferred to any topic with latent constructs.

Keywords: structural equation modeling, partial least squares, path model, contagion of systemic risk, shadow banking, bank holding companies.

Suggested Citation

Avkiran, Necmi K. and Ringle, Christian and Low, Rand Kwong Yew, Monitoring Transmission of Systemic Risk: Application of Partial Least Squares Structural Equation Modeling in Financial Stress Testing (April 18, 2018). Journal of Risk, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3164861

Necmi K. Avkiran (Contact Author)

University of Queensland - Business School ( email )

Brisbane, Queensland 4072
Australia

Financial Research Network (FIRN) ( email )

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

Christian Ringle

University of Hamburg ( email )

Allende-Platz 1
Hamburg, 20146
Germany

Rand Kwong Yew Low

University of Queensland Business School ( email )

Building 37-411, Joyce Ackroyd
St Lucia
Brisbane, QLD 4122
Australia
+61 7 3346 8124 (Phone)
+61 7 3346 8166 (Fax)

HOME PAGE: http://www.business.uq.edu.au/staff/details/rand-low

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