Aggregate and Firm-level Measures of Systemic Risk from a Structural Model of Default
by Alexander Reyngold of Moody's Analytics,
June 13, 2013
Abstract: The breadth and dynamics of the recent financial crisis have led to efforts to develop forward-looking tools to monitor systemic risk. In this paper we propose a new measure which is an extension of the absorption ratio (AR) introduced in Kritzman et al. (2010). Using principal component analysis (as in the original AR methodology) in conjunction with a structural model of default we develop a measure of systemic risk that may be calculated using only publicly available data. We call our new measure the credit absorption ratio (CAR). We find that increases in the CAR preceded periods of financial distress during the recent crisis. The CAR may be interpreted economically: it highlights states of the financial system during which the credit fundamentals of institutions and markets exhibit heightened coupling and higher potential for cascading distress. We also demonstrate that a byproduct of CAR analysis provides a measure of the degree to which specific financial institutions are exposed to systemic risk factors at any point in time. We find that a number of the institutions that exhibited high potential exposure under our measure during the lead-up to the recent crisis subsequently experienced higher levels of distress or required external assistance.
Keywords: Systemic risk, PCA, correlation, structural model.