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Predicting & Regulating The Systemic Risks of
Financial Institutions 

Nicolas David Greilsamer

April 2010

 Cass Business School Nicolas David Greilsamer

 City University, London 070013119

BSc Investment & Financial Risk Management (Honours)

Predicting & Regulating The Systemic Risks of
Financial Institutions 


This paper extends on the literature previously written exploring the health, soundness
and vulnerabilities of the financial sector due to systemic risk. The aim of this study is
to: (i) predict the risks of financial contagion and failure; (ii) assess the liability of
individual financial institutions to the financial system; and, (iii) evaluate the tools
needed for effective management of systemic risk by central banks and regulators.

To do this, I test the Systemic Expected Shortfall (SES) methodology on a portfolio of 29

of the largest U.S. financial institutions. This methodology illustrates the predicting
capabilities of widespread market risk, contagion, and effects surrounding the global
financial crisis. The analysis on the individual contribution of individual banks to the
systemic risk of the financial system suggests that “Too-Big-to-Fail” is a legitimate
trepidation from a macro-prudential perspective of bank regulation.

In addition to testing the predictability and measurement of systemic risk, I will explore
the complexities within the recent crisis that led to instances of heightened systemic
risk. Furthermore I evaluate the current themes in regulation, in order to assess the
need for new predictive measures and regulatory reform.

Keywords: Systemic risk, Systemic Expected Shortfall, Contagion effects, Macro-

prudential regulation, Regulatory reform, Capital Adequacy Requirements

Table of Contents
                 1. DATA  16 
                 2. METHODOLOGY  16 
                 1. ROBUSTNESS CHECK  20 
                 1.CREDIT DEFAULT SWAPS  24 
                 2.CREDIT RATING AGENCIES  26 
                 1.FINANCIAL CONTAGION  29 
                 2.LIQUIDITY & LEVERAGE  31 
                 3.FIRM LEVEL CAPITAL BUDGETING  30 

•CCP : Central counterparty •FDIC : Federal Deposit Insurance •SEC : Securities and Exchange
..Corporation ..Commission

•CCA : Contingent Claims Analysis •FVA : Fair value accounting •SES : Systemic Expected Shortfall

•CDO : Collateralized debt obligation •OTC : Over-the-counter •SIV : Structured Investment Vehicle

•CDS : Credit default swap •MES : Marginal Expected Shortfall •VaR : Variance-at-Risk

•ES : Expected Shortfall •PD : Probability of Default

I would like to thank my supervisor, Dr. Sotiris Staikouras, for his ideas, assistance and support
during the course of this project. I am particularly grateful to Dr Staikouras for enlightening me
on the field of Credit Risk Management and Capital Requirements.


“More often than not, episodes of financial distress arise from the exposure of groups of institutions to
common risk factors. Unless the authorities take into account the impact of the collective behavior of
institutions on economic outcomes, they may fail to monitor risks and take remedial action appropriately.”

- Andrew D. Crockett, Former General Manager Bank for International Settlements,

21st September 2000

The aspect under which systemic risk1 in the financial system is perceived has changed
due to the widespread implications of the sub-prime crisis. The dangers of bank
exposures to common risk factors have called for new risk management instruments for
regulators and institutions alike. The recent financial crisis has shown us that
traditional quantitative measures of risk have undermined or ignored systemic risk.

Historically it has been proven that a sustainable banking system is essential for
economic growth2. In contrast, a stressed financial sector has repeatedly caused financial
crises that impact other industries and the economy as a whole. The recent financial
crisis has questioned the effectiveness of regulators’ organised intervention. Quick and
effective backing of financial markets is needed in order to halt the fire sales of assets
and widespread financial contagion. This inevitably creates a “Too-Big-To-Fail” moral
hazard. Due to the difficulties in establishing an ex-ante rule that would out-weight
these moral hazards, market participants can agree that the traditional approach to
assuring the soundness of individual banks needs to be supplemented by a system-wide
macro-prudential approach.

Systemic risk was amplified and harder to measure in recent years due to unprecedented
levels of financial innovation and the rising opacity of financial markets. Detecting
systemic risk early on is of prime importance to regulators in order to mitigate the
severity of a crisis, and maintain liquidity. This was a key vulnerability during the
recent financial crisis, as bank funding proved to evaporate extremely fast due to the
interconnectedness of banks and their over-reliance on short-term funding. One
surprising element is that many institutions that subsequently failed still met minimum
regulatory capital adequacy requirements in the early days of the financial crisis. While


The exact definition of systemic risk is ambiguous; for the purpose of this study, a suitable definition is given by the
Bank for International Settlements (BIS), which provides a definition of systemic risk as "the risk that the failure of a
participant to meet its contractual obligations may in turn cause other participants to default with a chain reaction
leading to broader financial difficulties" (BIS 1994, 177)
See IMF keynote address by Anne O. Krueger on Banking Needs of A Global Economy for a discussion on the
importance of a strong financial sector for fostering sustainable economic growth.

standard risk management indicators are still helpful in assessing individual
vulnerabilities, they could be complemented by other market measures linked to
systemic stress testing. Furthermore standard tools could undoubtedly be broadened to
better capture off-balance sheet exposures and liquidity mismatches.

Systemic risk usually builds up as a consequence of banks taking correlated risks, often
by preferring to lend to similar industries. This can then be intensified by complex
patterns of inter-bank loans, derivatives, and other transactions1. This paper applies the
Systemic Expected Shortfall (SES) methodology, measuring a financial institution’s
volatility and its tail dependence with the financial system to determine levels of
systemic risk. The purpose of SES is not only to measure but also to predict systemic
risk. Developing an ex-ante measure would be beneficial to macro-prudential regulation,
but also to banks and investors trying to avoid the next financial crisis.

To tackle a number of issues mentioned above, this paper is split into three sections:
 Section I explores past literature on the design of predictive indicators of financial
system distress that can assist regulators and policymakers in managing banking

 In Section II, I present the empirical research I have carried out on a sample of 29
US banks. This section’s proposed methodology aims to tackle two important
issues: Firstly, does publicly available information provide adequate data to
predict systemic risk; and secondly, can the framework be a useful tool to
regulators seeking to prevent or mitigate systemic risk.

 Section III elaborates on the banking regulation literature, the complexities of the
financial crisis, the current environment of macro-prudential regulation, as well
as topics in banking. This topical section attempts to examine the need for reform
in order to prevent and limit the existence of systemic risks. In this section I will
use previous findings from Section II as well as current themes in banking, to
examine and recommend solutions that will help regulate, prepare and prevent
financial crises.

See also De Bandt et Al. (2000), Kaufmann (2000) and Summer (2003) for other such analysis of systemic risk. Allen et
Al (2000) and Freixas et al. (2000) also provide empirical research with economic models.

 In Section IV, I present recommendations and discussions framed in a way to
provide solutions to any economy facing financial crises. Although the analysis in
Section II refers to U.S. financial institutions, many of the topics discussed in this
paper refer to concepts with global repercussions.

Section I: Literature Review
There have been numerous papers that explicitly derive measures related to the design
of systemic risk indicators, mostly related to the recent sub-prime crisis. Two widely
used methodologies for predicting and measuring systemic risks are the following:

•A structural approach using an adaptation of Merton’s Model (1974) for credit risk
•A reduced form approach measuring the tail risk of asset performance

Many techniques analyse forward-looking market data for groups of financial

institutions in order to predict when systemic risks may become apparent. This can be
roughly estimated on a reduced form basis using a simple correlation analysis. A more
in-depth analysis may be carried out with market-based measures, which are then used
to calculate joint tail risks (the risk that several financial institutions simultaneously

Some papers have then used micro-macro models, and applied “stress testing”. This
technique tests the impact of individual and system-wide bank performance on the on
the rest of the economy based on adverse market movements. Examples of such exercises
to analyse systemic risks are presented in the empirical studies of Huang et al. (2009),
Basurto et Al. (2006), Avesani et al. (2006).

Below, I will go through the main measures of systemic risk, and their related literature.

I- Contingent Claims Analysis

Contingent claims analysis (CCA), or Merton Model when applied to credit risk1, is a
widely used (credit) risk management instrument among financial institutions and
regulators alike. Contingent Claims factors in the uncertainty in the future value of an
asset, by computing the market value of equity, assets, and liabilities in one observable
model. This application of the Merton model relies on three important identifiers of
systemic risk. Firstly, the model takes into account asset correlation of banks, to
estimate the risk of financial contagion. Secondly, the model includes capital adequacy
ratios as an indicator of financial stability. Thirdly, the model factors in the level of

See Merton (1973, 1974, 1977, 1992, 1998). Initially developed for valuation of corporate firms, CCA has been adapted to
financial institutions and countries.

volatility of the assets, as an indicator of its probability of default. In addition to initial
bank capital ratios, the model may also look at interest rate spreads on loans as a key

By modelling the CCA of banks, we can estimate the value of assets and their inherent
risk, and use these to provide an equity market-based assessment of default risk (Gray
and Malone, 2008). After deriving the value of liabilities, CCA may then look at the
seniority of claims on a firm’s debt. CCA assumes that as total assets decline, the value
of risky debt declines and credit spreads on risky debt rise1.

Under CCA, the probability distribution shows asset price uncertainty, with assets prices
either above what is owed (debt servicing attained), or below the critical level owed
(distress). For CCA, a risk-adjusted probability distribution is used to value a underlying
claims (replacing risk-free rate with expected rate of return) as shown below in Figure 1
with risk-adjusted line r being larger than the actual probability of default.

Figure 1

Source: See Merton (1992, pp.334-343; 448-450).

By applying observed prices and volatilities of market-traded securities the CCA

facilitates the process of estimating systemic risk (these market values are then used to
estimate the implied values and volatilities of the underlying assets2). This is beneficial

Also see Gray, Merton, and Bodie (2006,2007a, 2007b, and 2008).

An implied value refers to an estimate derived from other observed set of data. Techniques for using implied values are
widely practiced in options pricing and financial engineering applications. See Bodie and Merton (1995).

as the market values of assets often cannot be observed directly- or simply in infrequent
periods, or not in real time.

Gray et Al. (2008) use information from equity options to analyse inherent risk during
event windows (examining time periods of crisis), evaluating the changes before and
during financial crisis. In their paper they use its application to assess credit risk and
guarantees against the risk of default. Furthermore, they examine the amplification of
risk due to lack of transparency, as mortgages move off balance sheet via structured
products. Moreover, they use a CCA framework which identifies key risk transmission
channels of mortgages during the recent financial crisis. This is done also in a cross-
country and cross-sector analysis, with a large sample.

Similarly, Lehar (2005) evaluates the systemic risk between interconnected financial
institutions’ assets using equity prices and a CCA of bank book values. For different
estimation windows and countries, Lehar measures the central body’s total liability
(assuming that the institution or creditor is bailed out by a central body) and the
contribution of each institution to this liability. Lehar finds that capital requirements
contain systemic risk for under-capitalised financial institutions during this estimation
period. Furthermore, for these undercapitalised financial institutions increasing equity
capital results in a significant reduction of systemic risks. Lehar does not measure this
however for north American banks during a financial crisis. Increasing asset volatilities
and common exposures on bank’s asset portfolios tell us that during a crisis, the
minimum capital requirements may not be able to contain systemic risk. Gray and Jobst
(2009) also use the CCA methodology during the sub-prime crisis, and measure the
largest institutions’ liability on systemic.

Following on from the theory of contingent claims, studies have used put-call parity
relationships to assess the riskiness of financial institutions and the predictability of

Alternative methods of the CCA methodology are presented by Avesani et Al. (2006), and
Chan-Lau et Al. (2005) who model the financial sector as an asset portfolio using
Probability of Defaults (PDs) as a reduced form measure of systemic risk. They then use


See Nawalkha (1996) for an application of the Contingent Claims Analysis to the Interest Rate Risk and Characteristics
of Corporate Liabilities.

equity and CDS prices using CCA style methodology. Equity option information is used
to calculate tail-risk for specific firms as well as intra-firm. These tail risks are then
modelled around stressful conditions and scenarios (see Gray and Jobst, 2009).

The probability of contagion among banks whereby the distress of one bank leads creates
a domino effect is also calculated in a similar approach by Segoviano, 2006 and
Segoviano and Goodhart, 2009. Stress testing scenarios are then used to examine the
different states of the multivariate stability indicators.

The empirical evidence presented in the mentioned literature show that CCA models do
in fact provide practical predictors of systemic risk. In addition the CCA methodology
may be adapted and derived to evaluate wide sets of data.

It has been discussed that the addition of adapted credit risk indicators in monetary
policy frameworks could enhance central banks’ understanding of widespread risk in the
financial system. This would enhance their ability of utilising appropriate rate changes
and funding needs according to macro goals (which are generally categorised as
sustainable GDP growth and maintaining a cap on inflation) and stability in the
financial sector. However as pointed out by Jarrow and Turnbull (1995), CCA is
dependent often on non-observable data, and hence a reduced form model of systemic
risk is often more convenient.

II- Moody’s-KMV Model

Moody’s KMV is designed for risk management of the credit risk, although the model
may also be used to analyse macroeconomic financial sector risk. More specifically, the
MKMV model can be effective for measuring risk transmission, and systemic risk issues
(see Crosbie and Bohn, 2003).
MKMV adjusted the Merton Model for commercial purposed using leverage and
volatility (the Expected Default Frequency credit measure is calculated by implying
asset volatility). Then, asset volatility and implied asset values are estimated to
calculate the distance-to-default measure1. Albeit the MKMV model provides an effective
assessment of credit as well as market risk, its applicability is limited as some of the
variables not observable (including firm value).

1 The MKMV Expected Default Frequency is calculated from the expected drift of the asset, A µ , while Merton’s distance-
to-default uses risk-free rate, r , for asset drift.

Gray, Malone (2008) compute the MKMV outputs for financial institutions and
intermediaries and confirmed the widely known facts that market capitalization declined
from August 2007 to January 2008, whilst market leverage and implied asset volatility
increased indicating that the default point increased faster than assets.

IV Alternative Structural Models

The probability of default (PD) represents the probability that a loan will not be serviced
and will fall into default region. This is used in credit risk management, but also when
deciding minimum capital requirements and regulatory controls under Basel II banking
regulation proposals.

This approach to modelling risk captures the PD using an option-implied methodology

based on equity option prices from market data. PDs infer default probabilities on
individual financial institutions; with the advantage that the institution’s PDs are
predicted under the model partly in function of moving debt levels following market
conditions (see Capuano, 2008). Default probabilities implied from equities are
particularly attractive in modelling credit risk and systemic risk as they predict
supervisory rating changes up to four quarters early (Krainer and
Lopez, 2001).

Segoviano (2006) presents a methodology that follows a Merton Model (1974) to create a
framework to model the conditional probability of default (CoPDs). As opposed to
estimating the probability of system-wide financial instability, Segoviano evaluates the
frequencies of loan default (PDs) of specific types of loans in his study to predict the
likelihood of banking crises. The PDs of the loans are calculated as functions of
identifiable macroeconomic and financial variables (which he determines using a
multivariate OLS).

In a more unorthodox approach towards measuring risk, proxies for “market conditions”
are used as variables to measure investors’ risk appetite and aversion; key factors that
influence the risks facing financial institutions. This is done by González-Hermosillo
(2008) to capture the bigger picture of system-wide stress. The signalling capacity of
these indicators are tested by when and how they move from low, to medium, and to high

volatility periods, with the high state associated with systemic crisis (see González-
Hermosillo and Hesse, 2009).

Applying CCA in reality may be easier said than done, due to the assumptions made
about the balance sheet structure of banks. To counter this, some researchers have used
market data to imply reduced-form measures of systemic risk. In a study by Huang et Al.
(2009), credit default swaps (CDS) of banks, risk-neutral Probability of Defaults (PDs)
and their stock return correlations are used to estimate joint bank credit losses above a
certain limit of total liabilities of the financial industry. In their study, they define a
distress scenario, in which 15% of the financial sector’s total liabilities falls into default.
Their paper provides insight into new measures of measuring and stress-testing
systemic risks. They include several important concepts of systemic risk (bank risk
appetite, multiple default probability and the asset price correlation of banks), where as
most papers concentrate on one factor as a proxy for systemic risk. Even though Huang
et Al. provides a sophisticated model, their results lack strength due to the relatively
small sample (12 Major US banks assessed).

V- Value-At-Risk
Value-at-Risk (VaR) is a standard risk management tool used to measure the marginal
loss distribution of a financial institutions portfolio harmed by adverse market moves.
Here, I present some of the literature behind the use of VaR models as determinants of
market risk and its adaptation for systemic risk. VaR concepts and methodology are
explained in more detail in Section II.

Hancock and Passmore (2008) present a Vector Auto-Regression of VaR ( VAR in VaR)
methodology, that models systemic risk, which consequently using a Merton option
pricing model, are translated into changes in bank performance. This methodology is
particularly useful as the joint VAR method uses variables such as yield spread,
volatility, risk free rates, and market return which are available on daily frequency. On
the other hand, this methodology requires more creative assumptions regarding
macroeconomic outlooks (which are fed into the model) and the health of the financial
Hancock and Passmore design a VaR model to assess capital buffers needed to prevent
bank failures due to systemic risks. Given that consensus financial analysts’ and

economists’ predictions are subject to interpretation, the assumptions in such a model
can be seen as scenarios that may not reflect reality. However, this methodology may be
used more effectively in a stress-testing situation.

Financial institution’s leverage has a strong element of cyclicality, as banks will increase
their risk appetite during economic expansion and sell off risky assets in downturns,
ultimately with peaked leverage when in distress (Adrian and Shin, 2008)1. Adrian and
Shin (2008) also show that banks increase their common asset exposures by taking
positions in the same sectors in order to raise their expected rate of return2.

Similarly, Adrian and Brunnermeier (2009) use quantile regressions to predict the
financial sector’s CoVaR. The CoVar represents the VaR given that a bank has had a VaR
loss. The CoVar measure as calculated by Adrian and Brunnermeier uses market data
and book data of liabilities to construct the underlying asset returns. Adrian and
Brunnermeier’s approach has the advantage of using the standard regulator tool of VaR,
though regulators should also care about expected losses beyond the VaR threshold, as
implied by the Expected Shortfall (ES).

VI- Expected Shortfall and its adaption in measuring Systemic Risk

From a systemic regulation stance it may useful to examine the Expected Shortfall (ES).
The ES refers to the present value of the debt not serviceable (ie. not covered by the
firm’s assets) in case of default. Broadly speaking, ES is the average of the losses that
are above the VaR threshold, (i.e. losses from the worst (1-p)% days). In this study, I will
examine the ES of individual institutions and relate this to that of the overall financial
sector by creating a Systemic Expected Shortfall indicator.

Systemic Expected Shortfall (SES) was first examined by Acharya (2007), and recently
presented by Acharya, Pedersen, Philippon and Richardson (2009). In their paper, they
estimate using their systemic risk measure the SES for 102 financial firms in the US
financial sector with equity market capitalization in excess of USD 5bln. They show that
In their paper, they calculate the MES of each firm using the worst 5% days of the value-
weighted market return (their market in this case being the weighted average returns of

Also see Adrian and Brunnermeier (2008) for an analysis of leverage and the impact of distress.

2 Acharya (2001, 2009) and Acharya and Yorulmazer (2007) discuss how banks have an incentive to take inefficiently high
correlated risks due to the moral hazard that they are more likely to be bailed out when they fail together.

their 102 sample stocks) during a period running up to the financial crisis. They use this
period for cross-section regressions on an event window that captures the losses during
a crisis, to test whether they are able to predict these with their risk measure.

Their empirical findings illustrate that to align incentives, regulators should impose a
tax as a capital adequacy requirement or mandatory insurance purchase on each bank
which is related to the sum of its expected default losses and its expected contribution to
a systemic crisis, denoted by Systemic Expected Shortfall (SES).

Section II: Empirical Research

Systemic risk is concerned with the joint distribution of the losses of all market
participants and requires modelling how losses are transmitted through the financial

Traditional measures have focused on banks’ balance sheet information, such as non-
performing loan ratios, earnings and profitability, liquidity and capital adequacy ratios.
However, given that balance sheet information is only available on a relatively low-
frequency (typically quarterly) basis and contain a significant lag, there have been
efforts to measure the soundness of a financial system based on information from
financial markets, which provide real time data. Furthermore these market-based
measures are advantageous as they can be updated in a more timely fashion and tend to
be forward-looking (as asset price movements reflect changes in market anticipation on
future performance of the underlying entities).

Here I present the Systemic Expected Shortfall methodology, which uses both balance
sheet and market data to predict systemic risk.

I- Standard Risk Measures

In order to compute the Systemic Equity Shortfall model, lets first consider the standard
risk measures used inside financial firms. Value-at-Risk (VaR) and Expected-Shortfall
(ES) attempt to capture the potential loss of a firm if an extreme event were to happen.

Generally speaking, VaR represents an estimate of the probability of losses that could
arise from adverse changes in market prices. VaR is hence the most that the bank loses
with confidence 1-α, with α typically being at the 1% or 5% level. With a 5%VaR (α =
5%), VaR is the most that the bank loses with 95% confidence on one tail. Hence, VaR = -
qα , with qα being the α quantile of the firm’s return R:

qα= sup{z | Pr[R < z] <α}

The expected shortfall (ES) is the conditional expected loss given that an adverse event
has occurred. The loss is conditional on the return being less than the α quantile:

ESα=-E[ R | R < qα]

The ES is the performance of the periods when the portfolio is over the threshold given
by VaR. In this study, I focus on a derivation of ES as VaR is misleading. The VaR may be
misleading due to asymmetric but risky positions do not necessarily yield a large VaR, as
the VaR does not capture negative payoffs below the 1% or 5% threshold. One main
concern to regulators and market participants is directly related to the limitations of
VaR1. During the recent financial crisis VaR has failed to pick up potential tail losses in
the AAA-tranches of CDOs.

ES does not suffer from this since it measures all the losses beyond the α threshold. This
difference is important when considering moral hazard of banks, because the large losses
beyond the VaR threshold are often born by the government bailout. According to
Artzner et al. (1999), VaR is not a consistent risk measure given that VaR of two
portfolios combined may be above the total of their individual VaRs.

To enhance risk management and capital budgeting decisions, banks may break down
the individual areas of the firm (trading divisions) using the sum of their Marginal
Expected Shortfall (MES) to give them an indication of firm-wide losses. First, let us
split-up the firm’s return R into the total of each division’s return ri, R= Σi yi ri, yi being
the portfolio weight of group i. By definition, we know:
ESα = −∑ y i E[ri | R ≤ qα ]

and the overall sensitivity:

€ = −E[ri | R ≤ qα ] = MESαi
∂y i
The MES tells us how group i’s individual risk contributes to that of the bank as a whole.

In measuring Systemic Expected Shortfall, I am not interested in the risk of divisins of
individual firms. But using this concept, I will use the standard risk managemento tool
of ES and MES to find the contribution of individual banks to the banking system.
Similarly to the usual use of MES, in my model, this would represent the risk of
individual banks to the overall system.

Furthermore, as VaR measures only the market risk of an individual firm, regulation measures based on VaR do not
take into account system-wide risks. This has led me to choose an adaptation of Expected Shortfall for the analysis of
Systemic Risks.

II- Systemic Expected Shortfall Model
1. Data
The data used in computing the SES consists of 29 US financial institutions with a
market capitalization in excess of 10 billion USD as of end of June 2007. I essentially
screened firms large enough to be relevant to a systemic risk model. I chose to model
systemic risk on U.S. data, given the origins of the financial crisis, and the high
involvement of these firms in sub-prime losses. Appendix A lists these firms and their
characteristic (Commercial Banks, Brokerage Firms, Insurance).

As a dependent variable, I use daily closing prices of the MSCI US Equity Financial
sector as a proxy for the US financial system. This index developed by MSCI provides an
accurate measure of the financial system market as a whole as it includes all tradable
financial institution securities in the US.

As a robustness check, I also do the same analysis using the S&P 500 index as the
market. The daily closing prices for MSCI US Equity Financial sector index, S&P 500
and stock prices of my 29 financial institutions are obtained from Bloomberg. The results
from each of these should show the predictability of systemic risk ex-ante on the overall
economy and financial sector indices.

For computation of SES, I also need the leverage (LVG), the quasi-market assets
(quarterly data) to market equity ratio. As mentioned below in the methodology this is
derived from market value of equity and the book value of assets. The quarterly book
value of firms was obtained through compilations of balance sheets provided by

2. Methodology
For the sample of 29 banks I have chosen, I compute the Leverage (LVG), Beta,
Volatility (Annualized), Expected Shortfall (ES), Marginal Expected Shortfall (MES),
and Systemic Expected Shortfall (SES) of each firm.

The SES can be measured as a weighted average of its expected loss when the market is
in its left tail (Marginal Expected Shortfall or MES) and its leverage (LVG; measured as
quasi-market value of assets to market value of equity). I calculate the MES of each firm
using the worst 5% days of the value-weighted market return during the period June

2006 to June 2007, which I determine as my pre-crisis event window. The leverage
component used in the SES is measured as of end of June 2007.

To compute the MES, which I choose to compute at 5% worst-case days for the market, I
simply select the 5% worst days of the market during June 2006 to June 2007 and
calculate the average return of each financial firm on those worst days of the market.

To calculate the leverage (LVG) of each firm I will use the ratio of market value of assets
to the market value of equity, l(1/(1-l). Since market value of debt is generally
unavailable, it is standard instead to use the quasi-market value of assets. The quasi-
market value of assets was calculated as [book value of assets – book value of equity +
market value of equity]

To compare with individual firm risk, I compute the Expected Shortfall (ES), Beta (the
standard measure of systematic risk, defined as covariance of stock return with the
market return over the variance of market returns), and the volatility (annualized daily
standard deviation of returns).

To calculate SES, I use formula 2) below, designed by Acharya et Al. (2009)2. The
formula as shown below, takes the MES5% and factors in a 60% drop in market value as
an indicator of the crisis period. However as our MES5% measure pre-crisis is constructed
around average return on days where the market falls roughly by 1.4%, this must be
accounted for, hence the 60/1.4. The 6% figure in the numerator in the formula below, is
based on Tier-1 Basel capital requirements.

e  z 
1) SES% = SES /w 0b = α 0  MESα (R b ) + b
c  1− l 
Where e is externality to the financial system, c is cost of capital, l is leverage, w is a firm’s target capital, and z is the tier-
1 capital requirement. α is the probability of a systemic crises, denoted by: α0 = ( P0(R <
− 1)
1− L

60 0.06
SES% = MES% + −1
2) 1.4 €1− LVG

1 €and its LVG is 15.8. That is, its average loss on 5% worst case days of the market was 3.56% and its
MES of Lehman Brothers is 3.56%
quasi-market assets to market equity ratio was 15.8. Therefore, Lehman Brothers’ SES is calculated as per formula to be 60/1.4 * 0.0356 +
0.06 * 15.8 – 1 = 1.47.
See Acharya, Pedersen, Philippon and Richardson (2009) for a presentation of the economic model of SES, where they present a
methodology for assessing capital requirements based on the SES measure.

I use the SES calculated pre-crisis, to explain the cross-sectional returns during my
crisis event window, established as July 2007 to December 2008. This is also done for all
other risk measures mentioned above, in order to compare their relative of explanatory

As shown above, the SES is directly linked to the MES with a coefficient of leverage.
This implies that the higher aggregate leverage in the financial system leads to higher
levels of externalities on the economy, and a higher leverage for an individual institution
means that it is more likely to contribute to these externalities.

III- Empirical Results

Systemic risk of financial institutions, as implied by SES relies on left tail risk, while
systematic risk given by beta is dependent on covariance with the market. Moreover SES
is computed with the MES and is adjusted for the leverage of the firm, and is implied in
my analysis for financial institutions that could be of systemic importance due to their
size (USD 10 Billion +).

Table 1 presents the summary statistics for the various risk measures. In Panel A, the
average event return is -165.09%, implying a disastrous performance during this period.
The average ES, MES, and SES are respectively 2.61%, 1.85%, and 0.26. The average
volatility and beta are 19% and 1.08, respectively. From Panel B, SES is highly
correlated to MES and LVG with correlation being 0.85 and 0.87 respectively, which is
expected since SES is a weighted average of both of these components. More
importantly, event return is highly negatively correlated to both SES and LVG, which
suggest that the variation in event returns is well explained by SES and LVG.

To test predictability, I check if the SES estimated before the start of the financial crisis
helps predict the returns during the crisis period of July 2007 until December 2008. In
Table 2 I show the results for the cross-sectional regressions of losses during the crisis
(i.e. realized returns during the event window of July 2007-Dec 2008) on the pre-crisis
measures of risk, MES, SES, Beta, Volatility, ES and LVG, respectively. The scatter
plots for each of the indicators are shown subsequently in figures 1a-1d.

First, Table 2 shows that SES has significant effect on the event returns with an

adjusted R2 of 20.06%. This is relatively high when contrasted with standard measures
of institution-level risk such as ES in institutions’ own left tail and Volatility as shown.
The conclusion from these comparisons is that ES and Beta have little predicting ability
with R2 of 11% and 12% respectively, whilst MES had a higher explanatory power with
R2 of 15%. MES is not the only component of SES with consistent explanatory ability.
When looking at how far in advance MES and LVG are able to predict returns, the
explanatory power of MES seems to predict returns several months in return, whereas
that of leverage (LVG) shows significant predictability half a year before the start of the
financial crisis. Column (7) of Table 2 employs MES and LVG as separate regressors in
explaining the realized returns. These variables are both statistically significant,
controlling for the other. Allowing the weights on MES and LVG to vary freely in
explaining returns does not produce that much of an improvement compared to
employing the weights we chose in computing SES.

The effectiveness of MES at explaining the returns during the event window are further
shown in the scatter plot in Figure 1b. In the figure, the R2 of 15%, shows that naturally
a higher MES is associated with a more negative return during the crisis, and this is
further advocated in the losses incurred by Bear Stearns, Lehman Brothers and Merrill

The insurance firms such as Metlife (0.04) and Berkshire Hathaway (0.21) have
relatively low MES. From a systemic risk standpoint however, these two institutions
vary greatly in importance, and this is shown by the SES adjustment for leverage. The
difference in systemic importance in this case is that Metlife’s LVG is relatively high
compared to the mean at 10 while that of Berkshire is considerably lower at 1.03. The
SES shows their inherent risk well.

Relative to Figures 1a-1c, Figure 1d shows that SES has the best fit, with a
Realized return = – 1.67 – 1.22 SES and with an R2=22.59%. This proves that adjusting
MES for leverage of financial institutions helps explaining their systemic risk
importance. This contrasts with the ES (Figure 1a, R2= 11.47%) and with Beta (Figure
1d R2= 12.26%).

The results described tell us several things. Firstly we can infer that ES and Beta as
individual institution risk measures do not have significant predictive powers. Secondly,

the tail-dependence concept that I tested called MES has some ability in explaining the
cross-section of realized returns during a crisis. Finally the leverage-adjusted tail-
dependence measure of systemic expected shortfall (SES) has the most predictive power.

The SES methodology, as shown with the empirical results, provides a framework with
significant predictive ability. Due to its practicality, as it uses publicly available
information and its use of real time data, this can be a useful tool to regulators and
market participants. The model does however have some shortcomings when put in
context with alternative methods. As mentioned in Section I, in the literature review,
Segoviano (2006) presents a model for predicting banking crises, based on a Conditional
Probability of Default (CoPoDs) of specific loans of banks in function of macroeconomic
variables. Segoviano’s paper shows significant differences with my empirical research, as
his structural model does not try to assess the probability of bank failures based on
banks’ information at the balance sheet and market price level. Although our theoretical
results may converge, Segoviano’s model shows several factors which are ignored under
my Systemic Risk Model. Firstly, I rely on data referring to only a short time period.
Secondly, I do not incorporate general macroeconomic and financial system variables.
Together these two points mean that although my indicator is able to predict an
imminent crisis, it does not measure the evolution of risk through time. Moreover, since I
look at aggregate data of individual bank balance sheets, I cannot identify the specific
types of assets in a banks’ portfolios that could alter the likelihood of bank failure. This
also means that the benefits of diversification among different types of assets are not
measured. However as my model takes into account asset correlations, these may be
taken into account to a certain degree.

The benefits of my reduced-form model however are that I do not make assumptions
about which macroeconomic variables to include, and which loans to examine. Due to the
consiberable number of variables in Segoviano’s model, simplicity may prevail.

1. Robustness Check
As a robustness check, I use the S&P 500 index as the proxy for the market and examine
the robustness of our previous findings. I also conduct another robustness check by
changing the event period to July 2008 to August 2009 and the estimation period to June
2006 to June 2008. Results for these two robustness checks are reported in Table 4 and
5, respectively.

From Table 4, I find that SES has the largest power in explaining the cross-section of the
event returns during the period July 2007 to December 2008. As can be seen there, it has
the highest adjusted R2 of 22.73%. The coefficient estimate for SES is -1.99, statistically
significant at the significance level of 5%, which is consistent with my findings obtained
when MSCI Financial Index is used as the market. In addition, as before, LVG has the
second highest adjusted R2 of 20.21%. In contrast, other risk measures, such as ES, have
no significant effect on the event returns.

However, when I change the event period to July 2008-August 2009, I find that none of
the risk measures can explain the loss over this period very well. This is due to the
severe suffering followed by a recovery in equity markets during the period. For
example, SES has an adjusted R2 of 2.80%. More importantly, it has no significant effect
on the event return.

To sum up, the proposed systemic risk measure performs very well during the onset of
the financial crisis regardless of the used market index. However, it has little power in
explaining the losses from the period July 2008 to August 2009.

The results as shown are consistent with the findings of Acharya, Pedersen, Philippon
and Richardson (2009), who first developed the SES as a systemic risk indicator. This is
particularly important for the purpose of this paper, as it validates further the
usefulness of SES as a needed risk measure in regulators’ toolbox.

Section III: Macro-Prudential Regulation and Topics in Banking
Having presented an effective tool for predicting systemic risk through my empirical
findings in Section II, in this Section I examine the regulation in place for financial
stability, and the importance of systemic risks to regulators. I will do so by briefly
reviewing the literature of bank regulation, before discussing the current concerns for
regulators, focusing on several complexities that have had an amplification effect of
systemic risk within the global financial crisis.

I- Bank Regulation & Intervention Literature

Previous literature has been divided regarding the effectiveness of capital requirements
on individual bank risk and system-wide risk. It has been shown in some studies that
capital adequacy requirements explicitly contribute to bank stability, whilst other papers
have noted that bank capital requirements may make banks riskier.

Bank regulation is comprehensively discussed in papers by Freixas et Al. (1997) and

Dewatripont and Tirole (1993), in which they evaluate the soundness of the Basel
committee’s proposals for minimum capital requirements.

In order to mitigate individual bank risk, in 1989, U.S. regulators and other nations
adopted the Basel Agreement requiring a capital-asset ratio and a firm risk-based ratio
(with bank capital requirements based on a ‘risk-weighted’ ratio of assets). In 1999, an
initial reform proposal by the Bank for International Settlements (BIS) recommended
reviewing the 8% capital rule for credit assets of banks1. The BIS’ suggestions were
reviewed by Altman and Saunders (2000, 2001). In their paper, Altman and Saunders
showed that the inherently lagging nature of agency ratings (which were initially
proposed as a variable in measuring bank risk and capital requirements) means that
minimum capital requirements tend to lag in cyclical downturns, with ratios increasing
after loan defaults have occurred. Effectively preparing for periods of financial crises
means that capital requirements must be forward looking, to overcome in short-term
crunches in liquidity.

Regulators found short after the introduction of the initial Basel Agreement that financial institutions had found ways
to cheat the system, and this called for the design of Basel II. The Basel II system, was hence proposed, and aimed at
putting in place a reform built around the three following ‘pillars’: “Risk-based capital requirements, discretionary
supervisory discipline, and market discipline”.

Bliss and Kaufman (2003) explore the widely understood pro-cyclical nature of risk-
based capital regulation. The study highlights that under Basel II capital requirements,
minimum capital would move in line with a bank assets’ perceived risk, as capital
requirements require significant increase in periods surrounding cyclical downturns due
to the reduction in Tier 1 capital (made up essentially of Equity). The consequence is
increasingly tougher capital requirements adding to the decrease in funding associated
with a recession. Another consequence would be a direct rise in the interbank loan rate,
which subsequently reinforces the economic downturn. Berger and Bouwman (2006,
2008) explore these concerns and finds that capital requirements, as proposed by Basel
II, are often not efficient enough to combat liquidity concerns. To counter this, Marotta,
Pederzoli and Torricelli (2005) (in a study on default probabilities of Italian data for
reducing the pro-cyclical trends of bank capital ratios) propose minimum capital
requirements that may be adjusted according to ex-ante predictions of transmissions of a
bank’s assets.

Recent literature has criticised the framework of Basel II, as banks exploited the
reduced capital charges for off-balance sheet exposures (Lall 2009), removing
transparency from the system, and therefore amplifying the need for fire sales during
the crisis. Lall shows that large banks manipulated Basel II’s regulatory process to their
advantage, at the cost of their smaller competitors and of systemic financial stability.

Another theme in the topic of bank regulation during financial crises, is what happens
when all else fails? Central banking behaviour is a huge factor in the stability of the
financial sector, and intervention has become once again a great debate in the lessons
learned from the financial crisis.
The theory behind failure is simple. Essentially, a bank is not able to cover a crunch in
liquidity as the asset side of the balance sheet deteriorates, and without a bailout, it
fails. Central banks may be opposed to provide a bailout due to the message it is sending
out to the system. However, in the face of systemic risk, central bank intervention is
inevitable (Rochet and Tirole, 1996).

Prime examples of liquidity crises are explored in previous literature. In a paper by

Gatev and Strathan (2003), it is shown that some U.S. banks did not have enough
liquidity needed in order to face the 1998 crisis. Further empirical evidence is given by
Gonzalez-Eiras (2000) who shows that Argentinean financial institutions lowered their

liquid assets before the 2001 crisis as they forecasted central bank intervention as a
lender of last resort.

There is an agency problem with the fact that central banks step in as a lender of last
resort. As we will explore further on, larger banks that take on more risk, may be
disproportionately rewarded with capital guarantees or bailouts. This is further explored
in academic papers by O’Hara and Shaw, (1990) and Archarya and Yorulmazer (2008).

Systemic financial crises are of prime concern due to the impact on the real economy, as
presented by Borio (2003, 2006). The regulation in place has focused on maintaining
individual bank health, with minimum capital requirements based on individual bank
risk. The complexity of the recent financial crisis requires that a number of elements be
taken into account to ensure strong macro-prudential regulation1. Supervising areas that
have emerged due to the increased financial innovation of the industry is key. But so is
adding new tools to predict multiple failures.

II- Complexities surrounding the financial crisis

Through much of 2008 and 2009, governments, central banks and regulators globally
stepped-in in a co-ordinated effort to fight the “financial meltdown” from a repeat of the
great depression. Today however, with the financial system stabilised and banks back to
profitability, regulatory reform does not seem to have a globally synced direction.
Although the UK’s bankers’ bonus tax (restricting on compensation encouraging
riskiness over prudence) and the U.S.’ “Volcker Rule” are steps towards in avoiding bank
risk mismanagement, the ultimate focus should be on avoiding extreme losses due to
interconnectedness, and establishing long term mediums to avoid the next systemic
crisis, rather than focusing on short term fixes. Let us now focus on the complexities of
the recent financial crisis, that led to the amplification of systemic risk.

1. Credit Default Swaps2 
Credit Default Swaps (CDS) contracts involve a swap in which the issuer receives a
series of cash flows from the buyer in exchange for a predetermined lump payout should
a credit instrument undergo an “event”, such as default. CDS are often described as a

The term macro-prudential remains somewhat ambiguous. In this paper it is seen as a system-wide orientation of
banking regulatory and supervisory frameworks linked to the macro economy (See Borio 2009).
To see a summary of the risks of CDS, see Appendix B.

form of insurance, whereby the buyer pays a premium, albeit on an underlying asset he
does not need to own, in exchange for a payment if the contractual event materialises.
The fact that the underlying asset does not need to be owned for a buyer to have a CDS
leads to the creation of “Naked CDS”, instruments heavily criticised during the crisis for
their speculative nature.

The three uses of CDS are the same as most derivatives: Hedging, Speculation and
Arbitrage. Although these instruments may pose little threat if used for Hedging,
Speculation using CDS has been described as a threat to financial market stability.

In the run up to the financial crisis, those who wanted to bear the default risk of various
bonds and loans without actually owning the assets could speculate on these through
derivatives. The “naked” short on debt of companies, represents roughly 80% of credit
default swap positions. This is often blamed on the fact that the derivatives market is
unregulated by the SEC, and so there are no rules or oversights to help instil trust in the
market participants. The SEC’s response to the financial crisis has been to ask Congress
for explicit authority over regulation of the CDS market.

Regulators have suggested that OTC derivatives be placed on exchanges and processed
through clearing houses. US regulators and the European Commission have argued that
this is needed to maintain a hold over counterparty risk since clearing houses ensure
transactions are completed even if one party defaults. However, this could be at a cost,
as OTC markets tend to be cheaper than exchange based markets. Homogeneity will
lead to products which are not tailored to firms’ specific needs. For instance, reducing
the scope for bespoke products would make hedging more difficult for airlines,
manufacturers and oil producers.

CDS may change market sentiment regarding a firm. In the run up to the failure of Bear
Stearns, as well as other failed banks, the CDS heightened risk aversion and perception
of risk of the institution in question.

One proposed solution is to replace bilateral CDS trades between counterparties by two
symmetric trades between Central Counterparties (CPP) and counterparties. This
insulates counterparties from each other’s default: mitigation of counterparty risk, a
major concern since 2008. By centralizing information and supervision can facilitate

supervision and transparency. Additionally this mitigates moral hazard: intervention for
“bailing out” a CPP is less problematic than bailing out individual banks.

For a summary of the risks of CDS see Appendix B.

2. Credit Rating Agencies 
Credit Rating Agencies (CRA) have traditionally provided the market with a long-term
analysis of the worthiness of an issuer’s credit. The view of CRAs in theory should reflect
an independent view of the markets, in order to add value. Furthermore, in theory their
value is significant, as they bring market efficiency by improving transparency and
information between an issuer and lender. CRAs play an important role in structured
finance, as Collateralised Debt Obligations (CDOs) for example are assessed in
“tranches” by the CRA, which determines their required rate of interest or pricing.
During the financial crisis however, CRAs were blamed with seriously overpricing CDOs,
by misinterpreting the quality of loans contained within a tranche1.

The agency problem here is that CRAs are contracted by the issuers of securities and not
by the purchasers of the instruments. The conflict of interest contradicts the theory of
independence mentioned above, leading to less value being brought to market. During
times of financial “greed” in the run-up to the financial crisis, banks and the CRAs
developed detrimental relationships, where banks would “shop” among CRAs until they
encountered the highest ratings for their CDOs. This involved removing various
qualities of loans in order to meet minimum requirements for AAA rating.

CRAs have held a quasi-regulatory position in the financial system, even though they
are run as “for-profit entities”. These two points have led to many investors no longer
relying on the ratings they provide, and instead using standard spreads over risk free
benchmarks. The existence of CRAs is still mandatory due the U.S. Federal Reserve
requiring that entities be rated by at least two CRAs. The reform of CRAs should help
loosen the market’s reliance on their ratings and avoid conflicts of interest by making
them dependent on fees stemming from buyers rather than sellers of securities. Having
impartial and independent CRAs may not prevent the next financial crisis, but it will
surely not add to the long list of complexities that helps spur a credit bubble.

CDOs worth $340.7 million issued by Credit Suisse led to losses of $125 million in the run up to the crisis, even though
these were rated AAA /Aaa respectively by S&P's, Moody's and Fitch Group. See Tomlinson, Richard; Evans, David (1
June 2007): "CDOs mask huge subprime losses, abetted by credit rating agencies", International Herald Tribune.

3. Off­Balance Sheet Items, Accounting Reforms and Auditing 
The sub-prime crisis was exacerbated by financial engineering and the use of complex
derivatives. These off-balance sheet items gave false hope to bank managers, who were
overly-confident about such instruments risks, and led them to rely on leverage to
enhance profits. Transparency of complex products, and risks taken on by individual
institutions led to severe liquidity crunches once sub-prime assets started deteriorating.
To avoid repeats, reforms must factor in the lessons of the current crisis.

One noted characteristic of bank failures across past crises is the heavy reliance on short
term funding. With mismatching of balance sheet maturities (i.e. Not managing
effectively their “GAP”), banks rely often on money markets and repos as a source of
financing. A repo agreement requires one party to borrow and receive cash in exchange
for securities as collateral during a set amount of time before the contract is unwound.
These contracts are accounted for as financings and the cash is placed on the books as an
asset for the bank borrowing, whilst the equivalent amount is placed as a liability in the
form of a promise to re-purchase the collateral.1

Lehman’s Repo 105

In recent times, Lehman Brothers has been accused of misleading
the public to its state of finances, as they used accounting tools to
lower their leverage. By using a “Repo 105”, Lehman was taking
part in repos’ that gave a larger amount of securities than what
was received as cash. The name comes from the concept whereby
under the repo agreement, one party borrows 100 in cash, in
exchange for 105 in securities.

The “Repo 105” would take advantage of loophole in international

accounting standards, which records the over-collateralized
contract as a true sale rather than an obligation to repurchase.
Lehman would then report this obligation as a fraction of full cost
and use cash received to pay off liabilities, in effect shrinking the
balance sheet. Furthermore, this was done on a quarterly basis in
order to hide losses right before balance sheets were disclosed.
Lehman Brothers in this case took part in what can be considered
as fraudulent accounting activity, undetected by regulators (who
trusted auditors) until post-failure.

See Lehman Brother’s Chapter 11 report, by the examiner Anton Valukas, released March 11th 2010. Volume 3, Section
III contains a full report on Repo 105, Lehman’s regulatory failures, and their auditor’s involvement (Ernst & Young).
Made public by Jenner & Block LLP and the United States Bankruptcy Court, Southern District of New York.

Accounting rules under the FASB’ SFAS 140, introduced in 2001 have obviously not kept
up with financial innovation, OTC activity, or products that lie off-balance sheet such as
contingent claim liabilities and credit commitments. Increasingly long and complex
accounting standards for off-balance sheet items are therefore necessary in order to
avoid loopholes as used by Lehman Brothers. Alternatively, simple rules requiring using
accounting standards with the best intentions for stakeholders, and well reinforced by
auditors could also tackle unethical usage of off-balance sheet items. In order to avoid
loopholes, the US (as suggested by the G-20) should consider switching over to a set of
global rules- possibly an updated version of the IASB’s.

Moreover, increased transparency should be induced by these reformed accounting

standards. A prime example during the recent crisis is the lack of transparency induced
by off-balance sheet vehicles. Risk models established by lenders, investors and
regulators alike usually ignored exposures to Structured Investment Vehicles, which
represent large sources of funding for numerous banks. An additional aim of reformed
regulation should be to prevent “toxic assets” to contaminate the financial system and
damage system-wide transparency through off-balance sheet vehicles. This regulation
should help monitor off-balance sheet items, without hindering the availability of trade
credit or stall sound economic growth. This regulation can be adapted in a new Basel
framework. The International Swaps and Derivatives Association (ISDA) have had an
active involvement (although detrimental in previous recommendations to loosen
regulation on off-balance sheet items, see Lall 2009) in the Basel committee’s regulation
of derivative products. As the committee’s standard risk models do not capture trading
book risks1 and default risk, the ISDA could propose a new framework to calibrate credit
risk models used in establishing capital requirements.

Fair value accounting requires firms to value assets on their balance sheets based on the
most up-to-date market prices for that asset. These are based on the principle of efficient
pricing, and hence what price the assets could be sold off for immediately. In the run up
to the crisis, marking-to market asset prices stemming from declining housing prices, led
to drops in value of bank collateral. Assets are then sold off to raise capital to meet
regulatory requirements. This leads to prices readjusting to inexistent demand or

By trading risk, I refer to risks of default, credit migration, credit spreads and equity pricing for example

illiquid assets, propagating a fire sale spiral.

Accounting standards should hence be reviewed in order to develop more pragmatic

guidelines in stressed markets for dealing with illiquidity. The macro-prudential
approach should however subject the most systemically important institutions to the
highest supervisory standards, and hence reorganize their exposures promptly when
losses first come in and value positions suitably, and with larger margins for error.
Regulators could enforce this by verifying pricing techniques discrepancies between each
systemically important financial institution. Of course if discrepancies arise, a source of
risk could quickly be identified and mitigated. This being said, maintaining the health of
the financial system is contingent on staying away from accounting and supervisory
rules that could unintentionally promote excessive risk taking.

III- Discussion of Aspects of Systemic Risks

1. Financial Contagion 

As shown during the sub-prime crisis, the financial system may be harmed by asset price
contagion due to financial constrains by using for collateral assets that experience price
variations because of the externalities of other areas of the economy (see Adrian and
Brunnermeier, 2008). Diamond and Rajan (2005) assess the trade-off, whereby a bank
having had a liquidity shock offsets these by selling off assets, but in doing so, reduces
aggregate liquidity in the financial system, subsequently causing a rise in the bank’s
funding and a reduction in value of assets, leading to contagion in banks capital base.
During a downturn, banks and other large market participants could be forced to sell off
assets at depressed prices in order to generate liquidity. The concepts of “fire sales” and
“toxic assets” create huge risks for markets, as even a small number of institutions can
spark fears by liquidating large positions1.

This contagion becomes systemically important if multiple banks fail simultaneously due
to balance sheet deterioration, or if one bank’s failure causes a failure spiral of other
interconnected banks. Due to the increasingly large social and economic costs of such
failures, the priority for regulators is to guarantee stability of the system.

Market sentiment is vital in assessing bank losses. This is due to the banking sector’s

To measure these risks, we can look at put options, which are used as a hedge and hence equity put option “skews” may
capture fire sale risk and counterparty risk between institutions.

dependence on trust. As banks are trusted by depositors (as well as shareholders), bank
runs on deposits (and on market price by the latter) are still a threat. Once solvency is
tested, it can lead to bank runs not only on the bank in question but on other banks as
risk aversion becomes contagious. This also proves that the liability side of the balance
sheet may also suffer from contagion, as bank runs and market sentiment may lead to
the disappearance of short-term funding. In order to counter these risks, as maintain
financial stability, a central bank must intervene as the “lender of last resort”.

2. Firm Level Capital Budgeting 
The importance for firms as well as regulators of taking into account co-variances or
correlation of assets of banks, in addition to the standard risk measures, have been
highlighted by Froot and Stein (1998). In their paper, they suggest a centralized capital
allocation method sitting within a bank. Their research criticizes the risk-adjusted
return on capital (RAROC) method, for only considering the individual risk of each
division. Standard measures such as VaR have inherent flaws, as exposed during the
crisis, as they assume normal distribution of asset returns and do not factor in trading
book risks. In Froot and Stein’s capital budgeting setup, the decisions are dependent on
a “central planner” linking allocation decisions from different divisions within a bank.
Empirical evidence supporting such capital budgeting is provided additionally by James
(1996) in the case study of Bank of America. The conclusion here is that not only should
the regulation of banks be collective, but that firm level capital budgeting decisions
should take into account interbank correlations.

Proprietary Trading 
The high levels of losses incurred during the crisis by “proprietary trading
desks” (i.e. where a trader takes positions with the firm’s own account, for the
firm’s own benefit) have led to heavy criticism of financial institution’s risk
management. Furthermore, by awarding compensation based on individual
risk taking by employees has led to incentivising excessive exuberance with
the firm’s own capital. Proposals by bank supervision to limit bonuses with
sustainability criteria’s could limit the risk taken by the majority of firms,
however this would not remove the complexity and perhaps lack of
understanding by management of the real risks taken on by such divisions.
Furthermore, the high level of confidentiality of “Prop Desks” positions and
lack of regulation lead to limited transparency of the markets (including
counterparties, creditors and shareholders). It would therefore be beneficial
from a macro-prudential stance to attach higher levels of supervision to
proprietary trading, and to leverage as a determinant of capital regulation.

3. Liquidity & Leverage 
Capital budgeting is an important issue when analysing the systemic risks ex-ante. The
reliance on mandatory capital adequacy ratios led to misestimating of liquidity needs in
the run-up to the financial crisis. In this sense, minimum capital adequacy ratios may in
certain cases lower the internal risk management framework. In contrast, this move
could have been deliberate, as failed banks could believe that some liquidity risk was a
source of revenue for bank operations, as their liquidity choices and funding choices
contained a high level of risk (i.e. Lehman Brothers). The empirical findings of liquidity
choices are explored in a past literature by Diamond and Rajan (2001). Following on
from Diamond and Rajan’s findings, the recent financial crisis has demonstrated how
crucial it is to closely monitor the liquidity of funding markets to financial institutions
and hence taking into account liquidity crunches within systemic risk modelling or

Furthermore, the excess use of leverage as seen in Section II, contributes significantly to
systemic risks. It would hence make sense for policy makers to use countercyclical
requirements that aim to avoid such excesses with a build-up in buffers. As with
derivatives and counterparty margin-calls, policy makers could establish initial and
maintenance margin call requirements for banks that are highly levered. This would
lead to substantial amounts of profits foregone for the banks, but once again this is a
trade-off for sustainability. These buffers, could be set-aside in the form of an
independent “systemic insurance fund”, or simply may lie within a bank’s tier 1 capital
as part of its capital requirements (which would hence be variable according to
cyclicality). The latter would allow banks to make better usage of their balance sheets to
meet requirements, although regulatory arbitrage such as “Repo’s 105” could be
recreated to cheat the system.

IV-The Macro-Prudential Approach to Preventing Systemic Risks
Capital adequacy requirements evaluate soundness of a financial institution by looking
at directly observable accounting value. The rationale behind these capital adequacy
ratios is that well-capitalized banks may withstand stronger shocks. Regulatory controls,
in the form of capital adequacy ratio consider only a bank’s idiosyncratic risk and hence
fail to prevent sector wide risk-taking. This may lead to accentuated systemic risk as
firms act together in order to benefit from lower but more extreme probability of failure,
with enhanced guarantees from regulators and lenders of last resort1. Macro prudential
regulation is shown to function collectively and can be foreseen with models as
illustrated in Section I and II. These would regulate banks as a function of both their
systematic risk with other banks as well as their idiosyncratic risk.

The Bank of International Settlements (Basel Committee,1996) has imposed capital

adequacy requirements on financial institutions that are based on standard
measurements of market risk such as VaR. The lagging nature of moving capital ratios,
as proposed, is that these ratios move too slowly in cyclical downturns.

Basel II has been criticized for not adjusting capital requirements to the excess credit
spurred growth leading up to the financial crisis. Even the former chairman of the
Federal Reserve, Alan Greenspan (a so-called contributor to the financial crisis and a
previous believer of deregulation of financial markets) stated: “ The Basel Committee on
Banking Supervision, representing regulatory authorities from the world’s major
financial systems, promulgated a set of capital rules that failed to foresee the need that
arose in August 2007 for large capital buffers.” With minimum capital requirements not
being able to capture tail losses with liquidity buffers, there have now been proposals for
new measures of capital adequacy2.

In a downturn, a central bank acting as a lender of last resort will bail out institutions in

Archaya (2009)’s paper on bank regulation shows that banks may take a “too-big-to-fail” approach, where bank owners
may predict greater tolerance upon joint failure and therefore increase their systemic risk by making correlated
investments with other banks.

On January 10th 2010, in the consultative document: “Strengthening the Resilience of the Banking Sector”, revised
proposals of Basel II (dubbed Basel III) were presented by the Basel Committee on Banking Supervision to the Committee
of Governors of Central Banks and Heads of Supervision of the Bank for International Settlements. In order to prevent
instances of systemic risk, the early proposals of “Basel III” wish to supplement individual risk-based capital
requirements with a leverage ratio. The intention of reducing leverage incentives follows the same rationale behind the
systemic risk measure developed in Section II.

order to cover the shortfall to the depositors and avoid ex-post costs (which include the
what-if-it-failed implications). A central bank should only step-in if the cost of the
shortfall is below that implied by a bank’s failure. Due to high levels of systemic risk due
higher interconnectedness of institutions and higher leverage, it is ex-post optimal (i.e.
optimal in terms of predicting the costs in hindsight) to bail out the failed bank. With
this in mind the goal of central banks and bank regulators is to limit the ex-ante choice
of risks taken on by banks. Limiting this moral hazard, which leads to systemic risks,
must be done in a way that ex-ante measures outweigh ex-post costs of bailouts.

The return of the too-big-to-fail dilemma1 concerning bank rescues has serious
consequences for longer-term stability. If the banking sector is to be sound and
sustainable, individual banks must be given incentives to make themselves financially
strong. Moral hazard and joint-tail capital budgeting decisions may encourage excessive
risk taking by financial system agents, which makes them weaker and financial markets
more fragile in the long-run. As shown during the recent crisis, “Too-Big-To-Fail” is a
valid concern, due to the system being “Too-Interconnected-To-Fail”. According to this
policy, central banks are unable to allow institutions to fail, out of fear for the
consequence of linked failures within the financial system. This leads to banks becoming
more complacent with their risk taking, even though for a stable financial system banks
in fact need to attribute great importance to risk management. Although the Federal
Reserve has clear incentives to rescue banks at risk, for the greater good of the financial
system, they then must prevent these risks with ex-ante restrictions. One method is
highlighted below, with the introduction of a “Systemic Risk Insurance Fund”.

Systemic Risk Insurance Fund or “Global Bank Tax”

In the academic literature of Doherty and Harrington (1997) and Flannery (2005), they
suggest that banks purchase insurance against systemic crisis. In order to go forward
with this concept, it could be wise to tax each bank on its crisis losses and direct these to
a systemic loss fund, run by an independent regulator (preferably of global nature due to
the global repercussions of systemic risk.

One mentionable point here is that bank bailouts are largely funded by taxpayers (particularly in the last recession due
to poor government finances). The financial crisis has cast criticism on the banking industry due to resentment by the
public for taxes being used to keep risky firms out of bankruptcy. Furthermore compensation packages within the banking
industry, based on individual risk taking have not proved popular in light of such a heavy recession induced by the
banking industry.

Recently, as a consequence of government pressure to raise new taxes, several bankers
have advocated a systemic risk fund1. The capital for this fund would be sourced from
banks, in the hope of avoiding using taxpayers’ money in future crises, and in order to be
more prepared to intervene and liquidate large institutions. This however will continue
to place a guarantee on banks, which would subsequently reduce their cost of capital, as
investors view these institutions at Too-Big-to-Fail. Moreover, the systemic risk fund
would entail that retained earnings which bank managers would argue could be lent to
prospective borrowers to increase the bank’s asset base or used to finance new projects,
or could belong to the shareholders in the form of dividends would be lost lying dormant.
The increased profitability would be foregone in a trade-off for enhanced sustainability of
the system.

Following on from the conclusions of Acharya (2009), an ex-post funded deposit

insurance may be more realistic. This entails that a bank having survived a crisis is
taxed to repay the central bank that stepped in as a lender of last resort. This has indeed
been seen in the past, notably during the Japanese “lost decade” (see Hoshi and
Kashyap, 2000). There could arise issues with the original suggestions of Acharya and
Yorulmazer (2007), as such an ex-post crisis tax on bailouts still carries a moral hazard
as banks have less incentives to survive a crisis knowing that they will have to repay
losses at penalty rates. In order to combat a risky bank approach in the run up to a
crisis, the systemic insurance fund must be supplemented by capital ratios that adjust to
any excesses in credit growth. This would allow minimum capitals to withstand the risks
of liquidity shocks and financial contagion, whilst limiting ex-ante the choices of
correlated asset exposures.

see Deutsche Bank’s Josef Ackermann’s proposition of a European rescue and resolution fund, at Davos Forum

Section IV- Recommendations & Conclusion

As seen in Section II, systemic risk may be detected early on from publicly available
market information. This entails that regulators may use systemic risk indicators as a
further basis for preventing financial crises as well as a determinant in regulation

Recommendation 1:
Calibrating risk measurement tools
 Regulatory bodies should widen their tools of detecting financial stability, beyond
the stand risk measures currently in place. The use of systemic risk indicators,
able to analyse the risk of common exposures and excess credit growth should be
added to the regulator’s tool box, with the intention of detecting early the risks of
financial crises.
 This could be achieve through the systemic expected shortfall (SES) model,
adapted from publicly available information, which may be able to help in
detecting a firm’s levered common exposures which pose a risk to the financial
system as a whole.

Recommendation 2:
Adjusting Capital Requirements for Systemic Risk
 Bank supervisors should base minimum capital requirements on the correlation
of assets in between the individual bank and the financial system as a whole, and
on the given leverage of a bank.
 Bank regulators should counter pro-cyclicality by adjusting policy tools to create
a build-up of buffers in prosperous times, in order to weather liquidity shocks and
financial stress. This would counter the pro-cyclical deleveraging period that
tends to create imbalances due to high levels of leverage.

Core Recommendation 3:
Reducing Moral Hazard
 I recommend a tax or penalty rate to be applied to all bailed-out banks. This
would discourage taking excessive risks, as bailouts incur additional costs to the
 Firms predicting a financial crisis, and a bail-out could in fact take-on additional
risk (as the bailout authority may be seen to have a call-option on the bank’s
assets). To avoid this, macro-prudential regulation needs to survey closely the
most systemically important firms.

Recommendation 4:
Planned Failures
 A stronger failure resolution, such as “bank wills” could create ways of promoting
stability when faced with insolvent banks. Following on from my second
recommendation of preventing the “too-big-too-fail” dilemma, bank supervision
may not be able to aim for zero-failures, and hence needs to establish contingency
plans for assisted failures. Mitigating financial crises requires rapid intervention,
but not just to rescue a bank, but also to co-ordinate a buyout or assist a bank
into bankruptcy without its counterparties failing. To achieve this, banks could
submit quarterly accounts of their most liquid assets and disposable assets, to be
used in case of insolvency. This could allow bank supervisors to control fire-
selling as well as maintain financial stability.

Recommendation 5:
Extending Financial System Supervision Beyond Banks
 Non-bank financial institutions operating in the same financial markets should
be overseen by macro-prudential regulation to ensure minimum standards for
capital needs, and risk management1. The message here is that prudential
regulation should oversee all systemically important parties, regardless of type.
Optimally, dialogue should be formed between regulator and institution with both
parties having the intent of sharing information in order to avoid systemic risks.
This means a greater focus on growing concentration of risks and exposures and
paying close attention to crowded trades.

Recommendation 6:
Accounting methods in periods of market stress and illiquidity
 Accounting methods such as “fair value” should be reconsidered in an attempt to
produce more realistic ways of valuing illiquid assets, specifically in stressed
market conditions. This recommendation suggests that assets which are not
actively traded or that can suffer from illiquidity should be accounted for in a
different way on the balance sheet. Pushing such items off-balance sheet
intensifies the problem, and regulation should take this into account.
Furthermore, additional pressure on accounting standards should lead to

Financial institution regulation should broaden its horizons, in order to reassess the requirements for non-bank
financial institutions that are also considered systemically important. Although I have not discussed Hedge Funds (as no
systemic failures were apparent during the crisis), an updated review of the sector, as carried out by Chan et Al. (2006)1,
should be carried out in order to determine the risks imposed, and whether these are systemically significant.

increased transparency. Making institutions and products more transparent will
benefit markets with more efficient pricing and robustness.

Recommendation 7:

 The quasi-regulatory status of Credit Rating Agencies (CRAs) should be revoked,
as well as their fee structure, reliant on fees from the issuer of a credit
instrument. Protecting investors, whereby CRAs provide independent and
asymmetric information to the market is a step towards establishing efficient

Concluding Comments
This paper addresses some of the serious concerns for policy makers, providing
suggestions for the directions needed in order to restore a sound, robust and efficient
financial system, which will sustain economic growth.

In this study, I have tested a tool used in predicting and measuring systemic risk. Due to
its reliance on publicly available information, the Systemic Expect Shortfall (SES)
measure can be added to investors, banks and most importantly regulators’ toolbox of
systemic risk management measures. The SES measure proved to provide the best
predictor of systemic risks amid other standard risk measures.
Predicting systemic risks early on is vital to mitigate risks of financial crises, which
tend to affect the economy as a whole. Using macro-prudential analysis, factoring in
systemic risk with global repercussions, will help avoid widespread losses leading to
financial and economic instability. This however needs the co-coordinated approaches
from policy makers globally.

To conclude, systemic risk is generally, outside the control of each individual bank. Only
if risk estimation techniques are effective can bank supervisors tie standard risk
measures to minimum capital requirements. As revealed during the crisis, standard
measures did not capture the aggregate risks of the financial system. New tools should
be implemented to predict system-wide and individual firm risk and these should be
used for capital requirement decisions, in order to not repeat past mistakes and prevent
the next period of systemic risk.

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Panel A presents the descriptive statistics and Panel B presents the sample correlation matrix
for each of the following risk measures:
Event return: the stock return during July 2007 until December 2008.
ES: the Expected Shortfall of an individual stock at the 5th percentile.
MES: the marginal expected shortfall of a stock given that the market return is below its
5th percentile.
Volatility: the annualized daily individual stock return volatility.
Beta: the estimate of the coefficient in a regression of a firm’s stock return on that of the
SES: the leverage!adjusted MES, as explained in Section II.
LVG: measured as quasi-market value of assets divided by market value of equity, where
quasi-market value of assets is book value of assets minus book value of debt + market value
of equity.
ES, MES, SES, Vol and Beta were measured for each individual company’s stock using the period J
une 2006 till June 2007.

Table 1: Summary statistics and correlation matrix of stock returns

during the crisis, risk (ES, Vol) and systemic risk (MES, SES, Beta)

Panel A: Descriptive statistics of the measures Event return, ES, MES, SES, Vol and Beta

Event Return ES MES Volatility Beta SES 2007Q2
Average -165.09% 2.61% 1.85% 19% 1.08 0.26 7.75
Median -106.56% 2.38% 1.63% 17% 0.97 0.07 6.88
Std. dev. 196.93% 0.73% 0.83% 6% 0.44 0.56 4.72
Min -786.89% 1.42% 0.04% 12% -0.02 -0.85 1.03
Max 20.77% 4.68% 3.56% 36% 1.89 1.57 21.23

Panel B: Correlation
Event LVG
Return ES MES Volatility Beta SES 2007Q2
EventReturn 1
ES -0.35 1.00
MES -0.37 0.70 1.00
(Annualized) -0.29 0.98 0.69 1
Beta -0.35 0.68 0.98 0.68 1
SES -0.48 0.65 0.85 0.58 0.82 1
LVG2007Q2 -0.45 0.42 0.49 0.32 0.45 0.87 1

In table 2, I present the cross!sectional regression analysis of company stock returns (Event
return) on risk (ES, Vol) and systemic risk (MES, SES, Beta) measures.
Event return and risk measures are as described in Table 1.
t!statistics are given in parentheses. ***, ** and * indicate significance at 1, 5 and 10%
levels, respectively.

Table 2: Stock returns during the crisis, risk and systemic risk during the crisis

The dependent variable is Event return, i.e. the company stock returns during the
(1) (2) (3) (4) (5) (6) (7)

Intercept -1.65** 0.77 0.30 0.42 0.03 -1.28** -0.12

(-4.51) (0.60) 0.30 (0.31) (0.30) (-3.64) (-0.18)
ES -97.44**
MES -115.77**
Volatility -11.13
Beta -1.89*
SES -1.98**
LVG -0.19**
Adj. R^2 0.00% 9.28% 10.43% 4.99% 8.68% 20.06% 17.71%

Table 3 presents the results of the cross-sectional regression Table analysis of company stock
returns (Event return) on systemic risk measures (MES, SES). MES and SES are measured over
different pre-crisis periods. The stock return during the crisis is measured during July 2007 until
December 2008.
t-statistics are given in parentheses ***, ** and * indicate the significance levels of 1%, 5% and 10%

Table 3
Sub-period results

June06-June07 Apr06-M ar07 M ar06-Feb07 Jan06-Dec06

Intercept 0.06 0.04 -0.26 -0.29

(0.07) (0.05) (-0.33) (-0.38)
M ES -92.85** -91.48** -76.60** -79.01**
(-1.96) (-2.18) (-1.96) (-2.00)
Adj. R^2 9.23% 11.84% 9.24% 9.74%

Intercept -1.21** -1.22** -1.28** -1.34**

(-3.28) (-3.38) (-3.56) (-3.81)
SES -1.72** -1.67** -1.52** -1.57**
(-2.69) (-2.81) (-2.64) (-2.70)
Adj. R^2 18.27% 19.72% 17.61% 18.32%

Intercept 0.55 0.53 0.36 0.37

(0.62) (0.62) (0.43) (0.44)
M ES -57.76 -57.78 -44.47 -47.91
(-1.26) (-1.28) (-1.06) (-1.14)
LVG -0.17 -0.17 -0.18* -0.17*
(-1.62) (-1.65) (-1.72) (-1.73)
Adj. R^2 19.93% 19.90% 18.51% 19.04%

** at the significance level of 5%

* at the significance level of 10%

Table 4
Robustness check 1: using S&P 500 index as the market
index with event return July 2007 to June 2008
The dependent variable is Event return from July 2007 to June 2008, i.e. company stock returns during
(1) (2) (3) (4) (5) (6) (7)

Intercept -1.65** 1.41 0.91 0.91 1.34 -0.92* 0.06

(-4.51) (0.83) (0.72) (0.58) 0.93 (-1.94) (0.08)
ES -115.94*
MES -125.17**
Vol -12.88
Beta 2.53**
SES -1.99**
LVG -0.21**
Adj. R^2 0 10.79% 14.79% 8.71% % 22.73% 20.21%
** at the significance level of 5%
* at the significance level of 10%

Table 5
Robustness check 2: using the MSCI US Equity Financial index as the market with
event return July 2008-Aug 2009
Stock returns during the crisis, risk and systemic risk during the crisis

Dependent variable is Event return from July 2008-August 2009, i.e. company stock returns
during crisis
(1) (2) (3) (4) (5) (6) (7)

Intercept -1.65 -0.25 -0.12 -0.26 -0.38 -0.61 -0.17

-4.51 -0.75 -0.40 -0.68 -1.92 -2.52 -0.44
ES -2.13
MES -45.46
Vol -0.28
Beta 0.59
SES -0.59
LVG -0.04
Adj. R^2 0 -2.22% 4.20% -2.75% -3.14% 2.80% -0.91%

Figure 1a


Return during crisis: July07 to Dec08 






y = ‐91.871x + 0.7462 
‐6.00  R² = 0.11468 



ES Vs. Event Return 
ES measured Jan05 to June07 

Figure 1b


Return during crisis: July07 to Dec08 






‐5.00  y = ‐91.481x + 0.0418 
R² = 0.14986 



MES Vs. Event Return 
MES measured Jan05 to June07 

Figure 1c


Return during crisis: July07 to Dec08 





y = ‐1.5597x + 0.0298 
‐5.00  R² = 0.12264 



Beta Vs. Event Return 
Beta measured Jan05 to June07 

Figure 1d


Return during crisis: July07 to Dec08 






y = ‐1.6668x ‐ 1.221 
‐6.00  R² = 0.22592 


SES Vs. Event Return 
SES measured Jan05 to June07 

Appendix A: Data Description
Event LVG Volatility
NAME Type* Return ES MES SES 2007Q2 Annualized Beta
BEAR STEARNS 1 -270.84% 3.35% 3.02% 1.57 21.23 23.33% 1.71
E*TRADE 1 -295.54% 4.68% 3.31% 0.85 7.24 33.35% 1.82
BROTHERS 1 -786.89% 3.60% 3.56% 1.47 15.80 25.08% 1.89
MERRILL LYNCH 1 -197.14% 2.82% 2.78% 1.11 15.34 19.49% 1.40
SCHWAB 1 -23.82% 3.53% 2.70% 0.32 2.71 27.34% 1.56
TROW 1 -38.13% 2.73% 2.35% 0.07 1.03 20.48% 1.30
BB&T 2 -39.30% 1.96% 1.37% 0.04 6.14 14.56% 0.88
MELLON 2 -43.86% 2.34% 1.63% 0.02 4.64 18.50% 1.06
AMERICA 2 -124.48% 1.82% 1.69% 0.17 7.45 12.96% 0.90
CITIGROUP 2 -203.39% 2.02% 1.48% 0.19 9.20 14.49% 1.00
WACHOVIA 2 -222.47% 2.38% 1.38% 0.05 7.64 16.05% 0.96
MUTUAL 2 -759.25% 2.56% 1.71% 0.25 8.63 17.81% 1.04
WELLS FARGO 2 -17.65% 2.02% 1.58% 0.01 5.17 13.33% 0.91
JP MORGAN 2 -42.96% 2.15% 1.88% 0.35 9.13 15.93% 1.22
SUNTRUST 2 -106.56% 2.14% 1.29% 0.06 6.44 14.41% 0.81
TRUST 2 -20.87% 2.58% 1.82% 0.07 4.92 17.67% 1.16
PNC FINANCIAL 2 -37.90% 2.19% 1.46% 0.04 5.48 15.48% 0.84
UNIONBANCAL 2 20.77% 2.81% 1.58% 0.09 6.88 16.63% 0.87
KEYCORP 2 -139.36% 2.25% 1.60% 0.13 7.38 15.13% 0.94
BANK 2 0.56% 1.92% 1.24% 0.30 2.81 17.34% 0.65
STANLEY 2 -146.81% 3.05% 2.89% 1.25 16.85 20.22% 1.53
GOLDMAN SACHS 2 -94.33% 2.98% 2.73% 0.80 10.51 22.21% 1.58
BANK 2 -157.17% 2.33% 1.52% 0.03 5.33 17.59% 0.97
AIG 3 -379.78% 2.04% 1.48% 0.00 6.09 13.33% 0.68
HATHAWAY 3 -11.48% 1.42% 0.21% 0.85 1.03 11.25% 0.26
METLIFE 3 -102.54% 3.18% -0.04% 0.37 10.86 20.24% -0.02
FINANCIAL CORP 3 -214.63% 4.06% 2.62% 0.72 9.99 28.87% 1.66
CORP 3 -272.70% 2.70% 1.65% 0.05 5.62 20.74% 0.94
LOEWS 3 -59.03% 2.05% 1.16% 0.32 3.16 15.86% 0.72

*Type of Institution
1: Brokerage Firms
2:Commercial Banks
3: Insurance Firms

Appendix B: Analysis of concerns surrounding CDS & Derivatives
1. Complexity
Complex instruments were not fully understood by investors and issuers, including top-management.
Specifically, their underlying risks and implicit exposures to various third parties led to many unexpected
losses during the recent crisis. Hector Sants notes that investors had been all too willing to reject the golden
rule of “don’t take risks you do not understand”1.

2. Contagion Effects
While the trend of market interconnectedness has led to greater growth, it has also facilitated greater
systemic risk. If one major participant were to default on its derivative-related obligations, market panic
would sweep in and spread to other participants, ultimately causing significant price declines.

3. Misaligned Incentives
Certain regulatory guidelines inadvertently encouraged institutions to purchase and issue derivatives. The
Basel I accords allowed banks to reduce their reserves if risky instruments were hedged by derivatives such
as CDS. As a result, banks purchased large amounts of CDS, partly to simply free up capital and earn more

4. Concentration of Risk
The majority of CDS were issued by only a handful of insurers. Thus, investors who had purchased CDS to
spread counterparty risk elsewhere had actually concentrated counterparty risk into a few major
institutions. The insurers that dominated the market-share of CDS thus became a potential source of
counterparty risk themselves.

5. Downward Spirals
Many derivatives required counterparties to supply additional collateral in the event of a credit rating
downgrade. When AIG had it’s rating initially downgraded, it was required to post additional collateral on
its many contracts, hurting its liquidity position and increasing the probability of default on future
obligations. As a result, its credit rating was further downgraded, prompting more collateral requirements.
This spiral continued until finally it was bailed out by the U.S. government .

6. Opaqueness
Many complex derivatives became notorious for their lack of transparency. They were often recorded off the
balance sheet, making it difficult for investors, counterparties, and regulators to monitor institutions’ overall
risk. Also, as shown by Lehman Brothers, institutions with a plethora of opaque derivatives were more
difficult to wind down3. Finally, different firms had different ways of valuing their derivative positions, often
leading to price discrepancies among firms.

7. Excessive leverage
Some institutions had levered themselves excessively through the use of derivatives. This greatly increased
their insolvency risk and amplified losses on shareholders’ value. As a firm may take extremely large
positions off-balance sheet without having their minimum capital requirements change, levered positions
may prove very dangerous in crisis.

8. Lack of Risk Management

Factors such as liquidity risk and counterparty risk were largely neglected in the recent crisis. Insurers had
also not properly examined the debt contracts which they were actually insuring. The P&G crisis in 1993
was also largely caused by a lack of risk analysis on its interest rate derivatives4.

1 Sants, Hector. “Delivering Intensive Supervision and Credible Deterrence”. Speech at the Reuters
Newsmakers Event, March 12, 2009.
Dudley, William. “More Lessons From the Crisis”. Speech at the Center for Economic Policy Studies
3 Pratley, Niles. “Wall Street Crisis: Is This The Death Knell for Derivatives?” Guardian, September 15, 2008.

4 Chew, Donald. Corporate Risk Management, Columbia Business School: March, 2008.