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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.
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.