Bank Systemic Risks

The subprime crisis of 2007 brought the worldwide financial system to the brink of breakdown. Famous rating agencies that should have sent early warning signals failed to do so and therefore proved to be poor monitors of financial markets risks. Because of the economic hardship a breakdown of financial markets represents, it is of highest importance that objective measures of risk are constructed and made available to the public at large as to avoid future market breakdowns.

The objective of this project is to present the results of a model developed jointly by HEC Lausanne and the NYU Stern Volatility Institute. The NYU Stern Volatility Lab, created by NYU Stern Professor and Nobel Laureate Robert Engle, provides systemic risk measures for U.S. and global financial firms. It is based at New York University Stern School of Business. A new European model has been built by Prof. Engle and Profs. Eric Jondeau and Michael Rockinger  both from HEC Lausanne. The model is based on publicly available data and anybody who wishes to do so can replicate our methodology, which is discussed in detail in a working paper. Stated differently, we have a completely transparent model, which we update once per week. The results are what they are and if some financial institution does not like the results, we cannot change them. We are willing to adapt our methodology if corrections would be needed. Again we promote open discussions.

Greening (Runnable) Brown Assets with a Liquidity Backstop

Eric Jondeau, Benoit Mojon, and Cyril Monnet
Swiss Finance Institute Research Paper No. 21-22

Abstract: The momentum toward greening the economy implies transition risks that are new threats to financial stability. In particular, the expectation that other investors may exclude high carbon corporate emitters from their portfolio creates a risk of runs on brown assets. We show that runs can be contained by a liquidity backstop with an access fee that depends on the firm’s carbon intensity, while the interest rate on the liquidity lent through this facility is independent from its carbon intensity.

Measuring the Capital Shortfall of Large U.S. Banks
Eric Jondeau and Amir Khalilzadeh
Swiss Finance Institute Research Paper No. 18-11

Abstract: We develop a methodology to measure the capital shortfall of commercial banks in a market downturn, which we call stressed expected loss (SEL). We simulate a market downturn as a negative shock on interest rate and credit market risk factors that reflect the banks’ market-sensitive assets. We measure SEL as the difference between the mark-to-market value of the assets in the downturn and the book value of the liabilities. Based on large U.S. commercial banks, we empirically demonstrate that individual SEL predicts the loss of capital projected by banks in a severely adverse scenario and that aggregate SEL predicts macroeconomic variables.

A General Equilibrium Appraisal of Capital Shortfall
Eric Jondeau and Jean-Guillaume Sahuc
Swiss Finance Institute Research Paper No. 18-12

Abstract: We quantify the capital shortfall that results from a global financial crisis by using a macro-finance dynamic stochastic general equilibrium model that captures the interactions between the financial and real sectors of the economy. We show that a crisis similar to that observed in 2008 generates a capital shortfall (or stressed expected loss, SEL) equal to 2.8% of euro-area GDP, which corresponds to approximately 250 billion euros. We also find that using a cycle-dependent capital ratio that combines concern for both credit growth and SEL has a positive effect on output growth while mitigating the excessive risk taking of the banking system. Finally, our estimates confirm that most of the variability of the macroeconomic and financial variables at business cycle frequencies is due to investment and risk shocks.

Collateralization, Leverage, and Stressed Expected Loss
Eric Jondeau and Amir Khalilzadeh
Journal of Financial Stability (2017) 33, 226-243

Abstract: We describe a general equilibrium model with a banking system in which the deposit bank collects deposits from households and the merchant bank provides funds to firms. The merchant bank borrows collateralized short-term funds from the deposit bank. In an economic downturn, as the value of collateral decreases, the merchant bank must sell assets on short notice, reinforcing the crisis, and defaults if its cash buffer is insufficient. The deposit bank suffers from losses because of the depreciated assets. If the value of the deposit bank’s assets is insufficient to cover deposits, it also defaults. Deposits are insured by the government, with a premium paid by the deposit bank equal to its expected loss on the deposits. We define the bank’s capital shortfall in the crisis as the expected loss on deposits under stress. We calibrate the model on the U.S. economy and show how this measure of stressed expected loss behaves for different calibrations of the model. A 40% decline of the securities market would induce a loss of 12.5% in the ex-ante value of deposits.

Systemic Risk in Europe
Robert F. Engle, Eric Jondeau, and Michael Rockinger
Review of Finance (2015) 19(1), 145-190

Abstract: Systemic risk may be defined as the propensity of a financial institution to be undercapitalized when the financial system as a whole is undercapitalized. In this paper, we investigate the case of non-U.S. institutions, with several factors explaining the dynamics of financial firms returns and with asynchronicity of time zones. We apply this methodology to the 196 largest European financial firms and estimate their systemic risk over the 2000-2012 period. We find that, for certain countries, the cost for the taxpayer to rescue the riskiest domestic banks is so high that some banks might be considered too big to be saved.