Using Market Information for Banking System Risk Assessment

Abstract

We propose a new method for the analysis of systemic stability of a banking system relying mostly on market data. We model both asset correlations and interlinkages from interbank borrowing so that our analysis gauges two major sources of systemic risk: Correlated exposures and mutual credit relations that may cause domino effects. We apply our method to a dataset of the 10 major UK banks and analyze insolvency risk over a one year horizon. We also suggest a stress testing procedure by analyzing the conditional asset return distribution that results from the hypothetical failure of individual institutions in this system. Rather than looking at individual bank defaults ceteris paribus, we take the change in the asset return distribution and the resulting change in the risk of all other banks into account. This takes previous stress tests of interlinkages a substantial step further.

Keywords: Systemic Risk, Financial Stability, Risk Management, Interbank Market

JEL Classification: G21, C15, C81, E44