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This paper uses the co-incidence of extreme shocks to banks’ risk to examine within country and across country contagion among large EU banks. Banks’ risk is measured by the first difference of weekly distances to default and abnormal returns. Using Monte Carlo simulations, the paper examines whether the observed frequency of large shocks experienced by two or more banks simultaneously is consistent with the assumption of a multivariate normal or a student t distribution. Further, the paper proposes a simple metric, which is used to identify contagion from one bank to another and identify “systemically important” banks in the EU.
Stocks are exposed to the risk of sudden downward jumps. Additionally, a crash in one stock (or index) can increase the risk of crashes in other stocks (or indices). Our paper explicitly takes this contagion risk into account and studies its impact on the portfolio decision of a CRRA investor both in complete and in incomplete market settings. We find that the investor significantly adjusts his portfolio when contagion is more likely to occur. Capturing the time dimension of contagion, i.e. the time span between jumps in two stocks or stock indices, is thus of first-order importance when analyzing portfolio decisions. Investors ignoring contagion completely or accounting for contagion while ignoring its time dimension suffer large and economically significant utility losses. These losses are larger in complete than in incomplete markets, and the investor might be better off if he does not trade derivatives. Furthermore, we emphasize that the risk of contagion has a crucial impact on investors' security demands, since it reduces their ability to diversify their portfolios.
The recent financial crisis has led to a major debate about fair-value accounting. Many critics have argued that fair-value accounting, often also called mark-to-market accounting, has significantly contributed to the financial crisis or, at least, exacerbated its severity. In this paper, we assess these arguments and examine the role of fair-value accounting in the financial crisis using descriptive data and empirical evidence. Based on our analysis, it is unlikely that fair-value accounting added to the severity of the current financial crisis in a major way. While there may have been downward spirals or asset-fire sales in certain markets, we find little evidence that these effects are the result of fair-value accounting. We also find little support for claims that fair-value accounting leads to excessive write-downs of banks’ assets. If anything, empirical evidence to date points in the opposite direction, that is, towards overvaluation of bank assets.
This paper analyzes the equilibrium pricing implications of contagion risk in a two-tree Lucas economy with CRRA preferences. The dividends of both trees are subject to downward jumps. Some of these jumps are contagious and increase the risk of subsequent jumps in both trees for some time interval. We show that contagion risk leads to large price-dividend ratios for small assets, a joint movement of prices in the case of a regime change from the calm to the contagion state, significantly positive correlations between assets, and large positive betas for small assets. Whereas disparities between the assets with respect to their propensity to trigger contagion barely matter for pricing, the prices of robust assets that are hardly affected by contagion and excitable assets that are severely hit by contagion differ significantly. Both in absolute terms and relatively to the market, the price of a small safe haven increases if the economy reaches the contagion state. On the contrary, the price of a small, contagion-sensitive asset exhibits a pronounced downward jump.
We introduce a new measure of systemic risk, the change in the conditional joint probability of default, which assesses the effects of the interdependence in the financial system on the general default risk of sovereign debtors. We apply our measure to examine the fragility of the European financial system during the ongoing sovereign debt crisis. Our analysis documents an increase in systemic risk contributions in the euro area during the post-Lehman global recession and especially after the beginning of the euro area sovereign debt crisis. We also find a considerable potential for cascade effects from small to large euro area sovereigns. When we investigate the effect of sovereign default on the European Union banking system, we find that bigger banks, banks with riskier activities, with poor asset quality, and funding and liquidity constraints tend to be more vulnerable to a sovereign default. Surprisingly, an increase in leverage does not seem to influence systemic vulnerability.
We outline a procedure for consistent estimation of marginal and joint default risk in the euro area financial system. We interpret the latter risk as the intrinsic financial system fragility and derive several systemic fragility indicators for euro area banks and sovereigns, based on CDS prices. Our analysis documents that although the fragility of the euro area banking system had started to deteriorate before Lehman Brothers' file for bankruptcy, investors did not expect the crisis to affect euro area sovereigns' solvency until September 2008. Since then, and especially after November 2009, joint sovereign default risk has outpaced the rise of systemic risk within the banking system.
We introduce a new measure of systemic risk, the change in the conditional joint probability of default, which assesses the effects of the interdependence in the financial system on the general default risk of sovereign debtors. We apply our measure to examine the fragility of the European financial system during the ongoing sovereign debt crisis. Our analysis documents an increase in systemic risk contributions in the euro area during the post-Lehman global recession and especially after the beginning of the euro area sovereign debt crisis. We also find a considerable potential for cascade effects from small to large euro area sovereigns. When we investigate the effect of sovereign default on the European Union banking system, we find that bigger banks, banks with riskier activities, with poor asset quality, and funding and liquidity constraints tend to be more vulnerable to a sovereign default. Surprisingly, an increase in leverage does not seem to influence systemic vulnerability.
This paper compares two classes of models that allow for additional channels of correlation between asset returns: regime switching models with jumps and models with contagious jumps. Both classes of models involve a hidden Markov chain that captures good and bad economic states. The distinctive feature of a model with contagious jumps is that large negative returns and unobservable transitions of the economy into a bad state can occur simultaneously. We show that in this framework the filtered loss intensities have dynamics similar to self-exciting processes. Besides, we study the impact of unobservable contagious jumps on optimal portfolio strategies and filtering.
This paper analyzes the equilibrium pricing implications of contagion risk in a Lucas-tree economy with recursive preferences and jumps. We introduce a new economic channel allowing for the possibility that endowment shocks simultaneously trigger a regime shift to a bad economic state. We document that these contagious jumps have far-reaching asset pricing implications. The risk premium for such shocks is superadditive, i.e. it is 2.5\% larger than the sum of the risk premia for pure endowment shocks and regime switches. Moreover, contagion risk reduces the risk-free rate by around 0.5\%. We also derive semiclosed-form solutions for the wealth-consumption ratio and the price-dividend ratios in an economy with two Lucas trees and analyze cross-sectional effects of contagion risk qualitatively. We find that heterogeneity among the assets with respect to contagion risk can increase risk premia disproportionately. In particular, big assets with a large exposure to contagious shocks carry significantly higher risk premia.
We outline a procedure for consistent estimation of marginal and joint default risk in the euro area financial system. We interpret the latter risk as the intrinsic financial system fragility and derive several systemic fragility indicators for euro area banks and sovereigns, based on CDS prices. Our analysis documents that although the fragility of the euro area banking system had started to deteriorate before Lehman Brothers' file for bankruptcy, investors did not expect the crisis to affect euro area sovereigns' solvency until September 2008. Since then, and especially after November 2009, joint sovereign default risk has outpaced the rise of systemic risk within the banking system.