# Systemically important banks: an analysis for the European banking system

- 474 Downloads
- 18 Citations

## Abstract

In this paper we perform an empirical analysis to identify systemically important banks by a few individual bank characteristics that are easy to observe in practice. This analysis builds on a new method to construct measures of systemic relevance of individual institutions that are consistent with a risk analysis at the level of the banking system, taking correlations in bank asset returns into account. We derive asset return correlations for a sample of European publicly traded banks from market data and construct two risk measures: incremental value at risk and conditional expected shortfall. Incremental value at risk quantifies the individual contributions of banks to the system’s Value-at-Risk. Conditional expected shortfall measures the increase in the expected system wide deposit insurance liability that would follow from the default of an institution. The analysis of hypothetical defaults of institutions is performed consistently with the observed distribution of asset returns by using the conditional distribution. Both measures are then analyzed in a panel regression where individual characteristics are used to explain incremental value at risk and conditional expected shortfall.

## JEL Classification

C15 E53 G21## Notes

### Acknowledgements

We would like to thank Nyeong Lee for valuable research assistance. Martin Summer thanks the Bank of England and the London School of Economics for their hospitality during early stages of the work on this paper. The views and findings of this paper are entirely those of the authors and do not necessarily represent the views of Oesterreichische Nationalbank. Helmut Elsinger and Alfred Lehar are grateful for financial support from the Jubiläumsfonds der Oesterreichischen Nationalbank under grant number 10972.

## References

- Allen L, Saunders A (1993) Forbearance and valuation of deposit insurances a callable put. J Bank Financ 17:629–643CrossRefGoogle Scholar
- Angelini P, Maresca G, Russo D (1996) Systemic risk in the netting system. J Bank Financ 20:853–867CrossRefGoogle Scholar
- Black F, Scholes M (1973) The pricing of options and corporate liabilities. J Polit Econ 8:1637–1659Google Scholar
- Duan J-C (1994) Maximum likelihood estimation using the price data of the derivative contract. Math Financ 4:155–167CrossRefGoogle Scholar
- Duan J-C (2000) Correction: maximum likelihood estimation using the price data of the derivative contract. Math Financ 10:461–462CrossRefGoogle Scholar
- Duan J-C, Yu M-T (1999) Capital standard, forbearance and deposit insurance pricing under GARCH. J Bank Financ 23:1691–1706CrossRefGoogle Scholar
- Duan J-C, Simonato J (2002) Maximum likelihood estimation of deposit insurance value with interest rate risk. J Empir Finance 9:109–132CrossRefGoogle Scholar
- Duan J-C, Moreau AF, Sealey C (1992) Fixed-rate deposit insurance and risk-shifting behavior at commercial banks, J Bank Financ 16:715–742CrossRefGoogle Scholar
- Elsinger H, Lehar A, Summer M (2003) Risk assessment for banking systems. Working Paper, University of ViennaGoogle Scholar
- Elsinger H, Lehar A, Summer M (2006) Using market information for banking system risk assessment. International Journal of Central BankingGoogle Scholar
- Ericsson J, Reneby J (2001) The valuation of corporate liabilities: theory and tests. mimeo, McGill UniversityGoogle Scholar
- Furfine C (2003) Interbank exposures: quantifying the risk of contagion. J Money, Credit Bank 35:111–128CrossRefGoogle Scholar
- Giammarino R, Schwartz E, Zechner J (1989) Market valuation of bank assets and deposit insurance in Canada. Can J Econ 22:109–127CrossRefGoogle Scholar
- Gizycki MC, Levonian M (1993) A decade of Australian banking risk: evidence from share prices. Research Discussion Paper 9302, Reserve Bank of Australia Google Scholar
- Hovakimian A, Kane EJ (2000) Effectiveness of capital regulation at U.S. commercial banks, 1985 to 1994. J Finance 55:451–468CrossRefGoogle Scholar
- Humphrey D B (1986) Payments finality and risk of settlement failure. In: Saunders Anthony S, White Lawrence J (eds) Technology and regulation of financial markets: securities, futures and banking. Lexington Books, MAGoogle Scholar
- Jorion P (2000) Value-at-risk, 2nd edn. McGraw-HillGoogle Scholar
- Laeven L (2002) Banking risks around the world—the implicit safety net subsidy approach. working paper, World BankGoogle Scholar
- Lehar A (2005) Measuring systemic risk: a risk management approach, J Bank Financ 29:2577–2603CrossRefGoogle Scholar
- Merton RC (1973) A rational theory of option pricing. Bell J Econ Manage Sci 4:141–183CrossRefGoogle Scholar
- Merton RC (1977) An analytic derivation of the cost of deposit insurance and loan guarantees: an application of modern option pricing theory. J Bank Financ 1:3–11CrossRefGoogle Scholar
- Merton RC (1978) On the cost of deposit insurance when there are surveillance costs. J Bus 51:439–452CrossRefGoogle Scholar
- Ramanathan R (1993) Statistical methods in econometrics. Academic, San DiegoGoogle Scholar
- Ronn EI, Verma AK (1986) Pricing risk-adjusted deposit insurance: an option-based model. J Finance 41:871–895CrossRefGoogle Scholar
- Ronn E, Verma A (1989) Risk-based capital adequacy standards for a sample of 43 banks. J Bank Financ pp 21–29Google Scholar
- Sheldon G, Maurer M (1998) Interbank lending and systemic risk. Swiss Journal of Economics and Statistics 134:685–704Google Scholar
- Upper C, Worms A (2004) Estimating bilateral exposures in the German interbank market: is there a danger of contagion? Eur Econ Rev 48:827–849CrossRefGoogle Scholar
- Vassalou M, Xing Y (2004) Default risk in equity returns. J Finance 59(2):831869Google Scholar
- Wells S (2002) UK interbank exposures: systemic risk implications, Bank of England Financial Stability ReviewGoogle Scholar