Measuring Systemic Risk

Author(s): Viral V Acharya, Lasse H Pedersen, Thomas Philippon, Matthew P Richardson

CEPR Discussion Paper Number 8824
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Programme Area(s): Financial Economics (FE), International Macroeconomics (IM)

Date of Publication: 01/02/2012

Keyword(s): bailout, financial regulation, systemic risk, value at risk

JEL(s): G01, G18

Abstract: We present a simple model of systemic risk and we show that each financial institution's contribution to systemic risk can be measured as its systemic expected shortfall (SES), i.e., its propensity to be undercapitalized when the system as a whole is undercapitalized. SES increases with the institution's leverage and with its expected loss in the tail of the system's loss distribution. Institutions internalize their externality if they are ‘taxed’ based on their SES. We demonstrate empirically the ability of SES to predict emerging risks during the financial crisis of 2007-2009, in particular, (i) the outcome of stress tests performed by regulators; (ii) the decline in equity valuations of large financial firms in the crisis; and, (iii) the widening of their credit default swap spreads.

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