Cyclical Behavior of Systemic Risk in the Banking Sector

Abstract

This paper examines cyclical behavior of banks’ systemic risk contribution and exposure. Using an unbalanced panel of 787 banks from countries members of the Organisation for Economic Co-operation and Development and the European Union covering the period 2000:Q1-2017:Q4, we document that both systemic risk contribution and exposure are positively related to business cycle. That is, systemic risk starts to accumulate in the financial sector during periods of boom, i.e., when the output gap is positive. Furthermore, during periods of robust economic growth, the level of credit tends to increase dramatically, going hand in hand with asset and property prices developments. We also find that contribution and exposure to system-wide distress move procyclically during credit and house cycles, meaning that during upturns in credit and house cycles bank interconnectedness increases, but tend to fall during downturns. However, individual risk of the banks, proxied by Value at Risk, evolves countercyclically during business and financial cycles, i.e., decreasing in upturns and raising in downturns. Thus, Value at Risk is not a good proxy for signalling the buit-up of financial imbalances. Dynamic conditional beta, however, is a more appropriate measure to quantify individual risk of the banks in relation with the market, being procyclical during the financial cycle. Additionally, the empirical analysis shows that both bank-specific and macroeconomic factors influence banks’ systemic distress. Particularly, size, credit risk and inflation boost systemic risk contribution and exposure of the banks, whereas capitalization, the share of loans in total assets, the share of non-interest income in total revenue and economic freedom help banks in reducing their systemic importance. The findings remain robust after controlling for nesting, cross-sectional dependence and reverse causality issues.

Keywords: Systemic risk, Business cycle, Financial cycle, Financial regulation, Bank fragility

JEL Classification: G21, G28, E30