April 21, 2014

May 17-18, 2010 Industrial-Academic Forum on Systemic Stability and Liquidity

Talk Titles and Abstracts

Viral Acharya (NYU Stern)
Measuring Systemic Risk

We present a simple model of systemic risk and show how each nancial institution's contribution to systemic risk can be measured. An institution's contribution, denoted systemic expected shortfall (SES), is its propensity to be undercapitalized when the system as a whole is under-capitalized, which increases in the institution's marginal expected shortfall, MES, i.e., its losses in the tail of the aggregate sector's loss distribution, and in its leverage. Institutions internalize their externality if they are \taxed" based on their SES. We demonstrate empirically the ability of components of SES to predict emerging systemic risk during the nancial crisis of 2007-2009, in particular, (i) the outcome of stress tests performed by regulators; (ii) the decline in equity valuations of large nancial rms in the crisis; and, (iii) the widening of their credit default swap spreads.

Rama Cont (Columbia University IEOR)
Measuring Contagion and Systemic Risk

We propose a quantitative approach for assessing the systemic impact of the failure of a financial institution, based on a simple model of default contagion in a banking system. Our approach takes into account both volatility and correlation of market factors and contagion effects due to counterparty exposures: we argue that neglecting either of these aspects leads to a severe underestimation of systemic risk. By contrast to "backward-looking" indicators of systemic risk, our approach, based on exposures, is a forward-looking approach based on the simulation of future contagion scenarios. We discuss some theoretical properties of our proposed measure of systemic risk and show how it can be estimated in practice using a database of interbank exposures obtained from the Brazilian central bank. The analysis reveals the importance of network properties when modeling contagion and systemic risk and leads to some recommendations for the macro-prudential regulation of systemic risk.

Jon Danielsson (London School of Economics)
Risk Appetite and Endogenous Risk

Risk is endogenous. Equilibrium risk is the fixed point of the mapping that takes perceived risk to actual risk. When risk-neutral traders operate under Value-at-Risk constraints, market conditions exhibit signs of fluctuating risk appetite and amplification of shocks through feedback effects. Correlations in returns emerge even when
underlying fundamental shocks are independent. We derive a closedform solution of equilibrium returns, correlation and volatility by solving the fixed point problem in closed form. We apply our results to stochastic volatility and option pricing.

Erkko Etula (Federal Reserve Bank of New York)
Risk Appetite and Exchange Rates

We present evidence that the funding liquidity of U.S. financial intermediaries forecast U.S. dollar exchange rate growth---at weekly, monthly, and quarterly horizons, both in-sample and out-of-sample, and against a large set of foreign currencies. We provide a theoretical foundation for a funding liquidity channel in a simple asset pricing model where the effective risk aversion of dollar-funded intermediaries fluctuates with the tightness of their risk constraints. We estimate prices of risk using a cross-sectional asset pricing approach and show that U.S. dollar funding liquidity forecasts exchange rates because of its association with time-varying risk premia. Our empirical evidence shows that this channel is separate from the more familiar "carry trade" channel.

Kay Giesecke (Stanford MSE)
Systemic Risk: What Defaults Are Telling Us

This paper defines systemic risk as the conditional probability of failure of a large number of financial institutions, and develops maximum likelihood estimators of the term structure of systemic risk in the U.S. financial sector. The estimators are based on a new dynamic hazard model of failure timing that captures the influence of time-varying macro-economic and sector-specific risk factors on the likelihood of failures, and the impact of spillover effects related to missing/unobserved risk factors or the spread of financial distress in a network of firms. In- and out-of-sample tests demonstrate that the fitted risk measures accurately quantify systemic risk for each of several risk horizons and confidence levels, indicating the usefulness of the risk measure estimates for the macro-prudential regulation of the financial system.

Itay Goldstein (Wharton)
Self-Fulfilling Credit Market Freezes

This paper develops a model of a self-fulfilling credit market freeze and uses it to study alternative governmental responses to such a crisis. We study an economy in which operating firms are interdependent, with their success depending on the ability of other operating firms to obtain financing. In such an economy, inefficient credit market freeze may arise in which banks abstain from lending to operating firms with good projects because of their self-fulfilling expectations that other banks will not be lending. Our model enables us to study the effectiveness of alternative measures for getting an economy out of an inefficient credit market freeze. In particular, we study the effectiveness of interest rate cuts, infusion of capital into financial institutions, direct lending to operating firms by the government, and infusion of capital into financial firms under lending commitment.

Jennifer Huang (University of Texas at Austin)
Optimal Liquidity Policy

This paper presents a simple model of liquidity demand and supply. We show that competitive market forces fail to lead to efficient supply of liquidity. The market provision of liquidity is generally too low when the probability of liquidity event is small and is too high when the probability of liquidity event is large. Moreover, we show that different policy interventions have different efficiency consequences under different market conditions. For example, while subsidizing liquidity providers ex ante (e.g., designated market makers) is generally efficient, the market liquidity might be too high especially when the probability of liquidity event is small; while subsidizing sellers in the spot market (e.g., relaxing capital requirements, subsidizing loan modifications, or purchasing of toxic assets) can reduce the cost of immediate default, it reduces the incentives of other market participants to provide liquidity, both ex ante and ex post, and generally reduces welfare.

Wei Xiong (Princeton University)
Heterogeneous Beliefs and Short-term Credit Booms

We study the financing of speculative asset-market booms in a standard framework with heterogeneous beliefs and short-sales constraints. Cash-constrained optimists use their asset holdings as collateral to raise debt financing from less optimistic creditors. Through state-contingent refinancing, short-term debt allows the optimists to reduce debt payment in upper states which they assign higher probabilities to, but at the expense of greater rollover risk if the asset fundamental deteriorates at the debt maturity. In contrast, long-term debt allows the optimists to hedge their financing cost in downturns. Our model identifies distinctive effects of initial and future belief dispersion in driving a short-term credit boom, and shows that the optimists' debt-maturity and leverage choices can directly affect the asset market equilibrium.

Hao Zhou (Federal Reserve Board)
Assessing the Systemic Risk of a Heterogeneous Portfolio of Banks during the Recent Financial Crisis

This paper measures the systemic risk of a banking sector as a hypothetical distress insurance premium, identifies various sources of financial instability, and allocates systemic risk to individual financial institutions. The systemic risk measure, defined as the insurance cost to protect against distressed losses in a banking system, is a summary indicator of market perceived risk that reflects expected default risk of individual banks, risk premia as well as correlated defaults. An application of our methodology to a portfolio of twenty-two major banks in Asia and the Pacific illustrates the dynamics of the spillover effects of the global financial crisis to the region. The increase in the perceived systemic risk, particularly after the failure of Lehman Brothers, was mainly driven by the heightened risk aversion and the squeezed liquidity. Further analysis, which is based on our proposed approach to quantifying the marginal contribution of individual banks to the systemic risk, suggests that “too-big-to-fail” is a valid concern from a macroprudential perspective of bank regulation.

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