Financial Stability and Extreme Market Conditions

Abstract

The paper analyzes the role of systemic risk in normal and extreme market conditions. We provide a definition of financial stability and argue that systemic risk can significantly contribute to the amplification of financial crises. We interpret a constant (or decreasing) impact of systemic risk in extreme market situations as a fundamental condition for financial market stability since common shocks are not amplified.

Empirical results for a number of emerging and developed markets show that the impact of systemic risk varies considerably and is significantly larger in highly volatile regimes for some markets. The findings also display the fact that developed markets exhibit a constant dependence on systemic risk and hence meet an essential condition for financial market stability.

Finally, we compare our results with the outcomes from a small simulation study and show that an increased impact of systemic risk can be interpreted as evidence of contagion. By utilizing the quantile regression framework, we thereby circumvent the ad hoc definition of a crisis origin and a crisis period which is prevalent in the contagion literature.

Keywords: Financial stability, Systemic risk, Contagion, Quantile regression

JEL Classification: C22, C51, G15