Our grant financed by National Science Centre 

Exogenous and endogenous determinants of systemic risk in the financial system

Grant NCN „Egzogeniczne i endogeniczne determinanty ryzyka systemowego w systemie finansowym”  (UMO-2020/37/B/HS4/01893)

 

Keywords in Polish: Stabilność finansowa, ryzyko systemowe, płynność, wypłacalność, COVID-19

Keywords in English: Financial stability, systemic risk, liquidity, solvency, COVID-19

Start: February 5, 2021

Duration: 36 months

 

The onset of the global financial crisis brought about an increased concern about systemic risk. Systemic risk is the risk of widespread disruption of the financial system implying a potential material damage to the economy (Bats & Houben, 2020). The event of systemic risk could emerge from within the financial system when the original shock is endogenously amplified by the fragilities and frictions within the system such as excessive leverage, maturity mismatches or interconnectedness (Danielsson et al., 2011). In this sense, the global financial crisis in 2008 was a typical endogenous event as the crisis preyed on the weaknesses of the financial system and misbehavior of market agents and failure of regulatory institutions. Alternatively, the trigger of the systemic event could be an exogenous shock, which means from outside the financial sector. Unlike the 2008 crisis, the current COVID-19 crisis, for example, did not originate in the banking sector but it was rather caused by an unprecedent administrative lockdown of the economies, which significantly affected demand and supply, public and private sectors as well as financial markets. However, these two dimensions of risk are not mutually exclusive and may materialize independently or in conjunction with each other (ECB, 2009; 2019). In light of the most recent developments, the spread of the coronavirus across the globe triggered abrupt and disorderly asset price developments which led, in turn, to an acute increase in financial system stress (IMF, 2020). The further systemic risk implications of the pandemic will depend on how the vulnerabilities built up in recent years amplify the shock. The paramount distinctions between exogenous or endogenous triggers and sequential or simultaneous impacts reveal the complexity of this phenomenon.

Against this background, the project explores different determinants of systemic risk by distinguishing between an endogenous perspective of systemic risk, where attention is confined to the financial system, and an exogenous perspective of systemic risk in which the two-sided interdependence between the financial system and the economy at large is considered. We reduce the dimensionality problem resulting from the interaction of these elements by limiting attention to two main forms of systemic risk: the risk resulting from the interlinkages between different risks and intermediaries, and the risk of widespread shock causing simultaneous problems across countries, sectors and/or financial institutions.

Accordingly, we first focus on an endogenously self-reinforcing feedback loop between liquidity, solvency and interconnectedness that can have serious consequences for the stability of the financial sector. Our main objective is to identify the direction and evaluate the magnitude of the feedback effects between solvency and liquidity risks, and their mutually reinforcing impact on systemic risk in a banking sector. We test the hypothesis that this channel is material as solvency and liquidity are determined simultaneously and amplify each other, which results in an increase of systemic risk. We also conjecture that financial vulnerabilities such as excessive leverage, maturity mismatches or interconnectedness that may play an important role in the amplification of the initial shock effect.

 Next, we take a system-wide perspective in which systemic risk is triggered by the exogenous shock that hits the world economy. We aim at investigating the role of capital and liquidity buffers in mitigating the risk of negative feedback loop and resulting contagion effect that affect the real economy and the financial system as whole. We are going to compare and contrast the coronavirus crisis with 2008 crisis, and in the process, gain some intelligence on the role of certain banks’ features that determine whether banks can serve us shocks absorbers or amplifiers of stress.

Basic literature

Acharya V. V., Pedersen L. H., Philippon T., Richardson M. (2017), Measuring Systemic Risk, The Review of Financial Studies 30, Pages 2–47.

Adrian T., Brunnermeier M. K., (2016), CoVaR, American Economic Review, 106(7), pages 1705-1741, July.

Adrian, T., Boyarchenko, N., Giannone, D. (2019), Vulnerable growth, American Economic Review, 109(4), 1263-89.

Bennett, R. L., Hwa, V., Kwast, M. L. (2015), Market discipline by bank creditors during the 2008–2010 crisis, Journal of Financial Stability, 20, 51-69.

Brownlees Ch., Engle R. F. (2017), SRISK: A Conditional Capital Shortfall Measure of Systemic Risk, Review of Financial Studies, Society for Financial Studies, vol. 30(1), pages 48-79.

Cai J., Eidam F., Saunders A., Steffen S. (2018), Syndication, interconnectedness, and systemic risk, Journal of Financial Stability, Elsevier, vol. 34(C), pp. 105-120.

Danielsson J, Macrae R., Vayanos D., Zigrand J. (2020), The coronavirus crisis is no 2008, VOX, 26 March 2020.

Espinosa-Vega M., Russell S. (2015), Interconnectedness, Systemic Crises and Recessions, IMF Working Paper No. 15/46.

Holló D. Kremer M., Lo Duca M., (2012), CISS - a composite indicator of systemic stress in the financial system, Working Paper Series 1426, ECB.

Pierret D. (2014), Systemic risk and the solvency-liquidity nexus of banks, CORE Discussion Papers 2014038, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).

Schmitz S., Sigmund M., Valderrama L. (2017), Bank Solvency and Funding Cost: New Data and New Results, IMF Working Paper, WP/17/116.

Towbin P., Weber S. (2013), Limits of floating exchange rates: The role of foreign currency debt and import structure, Journal of Development Economics, Elsevier, vol. 101(C), pages 179-194.