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How secure are Europe’s financial institutions? What are the chances of another crisis? Eric Jondeau and Michael Rockinger create a model for assessing the ability of European financial institutions, industry sectors, and countries, to withstand market shocks.
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Systemic risk measures are updated every week and available on www.crml.ch. Policymakers, regulators, and financial services executives should take note.
After the collapse of Lehman Brothers investment bank in 2008, and the financial chaos that ensued, attention focused on how to prevent a similar crisis occurring in the future. Risk assessment and management was one area of interest.
Globalization has made nations more prosperous but, at the same time, increased the risks inherent in the banking system. Financial institutions are more interconnected, operating in a more densely populated financial ecosystem than previously, increasing the risk of contagion. Tighter interdependence creates a more efficient global financial system, yet also increases the risk of disruption spreading across markets, countries, and continents.
Systemic risk has been defined by the International Monetary Fund as “a risk of disruption to financial services that is caused by an impairment of all or parts of the financial system and that has the potential to cause serious negative consequences for the real economy.”
In their paper “Systemic Risk in Europe”, Eric Jondeau and Michael Rockinger from HEC Lausanne, together with Robert Engle from the Stern School of Business, New York University, investigated systemic risk in Europe, both at a firm and country level. In particular, they looked at the tendency of a financial institution to be undercapitalized at a time when the financial system as a whole is undercapitalized.
Assessing the vulnerability of the financial system overall
In such a situation should financial firms fail, the other firms in the system, stressed and short of capital, may be unwilling to step in absorb the liabilities and acquire the failing firm. Thus the contagion spreads. Being able to assess the weakness of firms in the light of this network effect is key to assessing the vulnerability of the financial system overall.
The academics built on previous work by Viral Acharya, an economist at NYU Stern, and his co-authors to construct a multi-factor model which looks at the sensitivity of a firm’s returns to extreme downturns in the equity market, using measures of market capitalization, financial leverage, and risk exposure. It also factors in the time lag between Europe and other financial markets around the world.
The authors provide an evaluation of systemic risk for industry sectors, European countries, and nearly 200 individual financial institutions in Europe for the period 2000 to 2012, with respect to financial shocks at the world or European level.
The exposure of banks in Europe multiplied by 5.8 during the period 2008-2012
Compared with the 2000-2007 period, the exposure of banks in Europe is up considerably – multiplied by 5.8 – during the period 2008-2012. Total exposure of the 196 largest financial institutions in Europe, note the authors, increased from an average of 217bn euros between 2000 and 2007 to 1,018bn euros between 2008 and 2012.
Taking the figures at the end of the data period, in August 2012, systemic risk values suggest a significant shortfall of capital in several countries in the event of a market crash. Systemic risks for France and the UK, for example, accounted for some 52% of the total exposure of European financial firms. As for the individual firms, a risk ranking for the European banks studied on the last day of the data period, shows the five riskiest institutions as Deutsche Bank, Crédit Agricole, Barclays, Royal Bank of Scotland and BNP Paribas.
As at December 2014, that ranking produced similar results with BNP Paribas, Deutsche Bank, Crédit Agricole, Barclays, taking the top four positions, and Royal Bank of Scotland dropping down to sixth, replaced by Société Generale.
Too big to fail,
too big to be bailed out
Overall the research suggests that the European banking system is more fragile, and less able to withstand a significant shock, than the US system. Furthermore, in the event of a major shock to the markets – a 40% semiannual decline of the world market return – the size of some individual banks relative to their country’s GDP (in the Netherlands, Switzerland, Sweden, and Denmark, for example) shows that they are not only too big to fail, but possibly too big to be bailed out by that country acting alone.
In addition, the UK and France both had two banks ranked in the top ten institutions in terms of systemic risk as a percentage of GDP. The combined capital shortfalls of these banks potentially presenting a sizeable bail out challenge for their governments, in the event of a new crash.
As of December 2014, France and the UK still had the highest systemic risk (in bn euros), although reduced from the levels in August 2012. Interestingly, the SRISK tool showed the dramatic increase in systemic risk for the Russian Federation in 2014, rising from a little over 1.258bn euros to 13.2bn euros in the space of six months, reflecting events in the global economy.
The methodology offers an alternative approach to the ECB’s stress testing
Perhaps one of the most significant aspects of the research is the methodology itself. It offers an alternative approach to the ECB’s stress testing – an approach founded on the sobering business reality of market value. The ability to provide a snapshot of systemic risk of financial institutions in Europe at any given moment has to be an invaluable tool for policymakers and practitioners; especially given ongoing challenges in the global financial system.
More details and up to date risk rankings: www.crml.ch
Read the original research paper: Systemic Risk in Europe by Robert Engle, Eric Jondeau, and Michael Rockinger.