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In Rememberance: World Trade Center (WTC)

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A Framework for Assessing the Systemic Risk of Major Financial Institutions

by Xin Huang of the University of Oklahoma,
Hao Zhou of the Federal Reserve Board, and
Haibin Zhu of the Bank for International Settlements

April 2009

Abstract: In this paper we propose a framework for measuring and stress testing the systemic risk of a group of major financial institutions. The systemic risk is measured by the price of insurance against financial distress, which is based on ex ante measures of default probabilities of individual banks and forecasted asset return correlations. Importantly, using realized correlations estimated from high-frequency equity return data can significantly improve the accuracy of forecasted correlations. Our stress testing methodology, using an integrated micro-macro model, takes into account dynamic linkages between the health of major US banks and macro-financial conditions. Our results suggest that the theoretical insurance premium that would be charged to protect against losses that equal or exceed 15% of total liabilities of 12 major US financial firms stood at $110 billion in March 2008 and had a projected upper bound of $250 billion in July 2008.

JEL Classification: G21, G28, G14, C13.

Keywords: Systemic risk, stress testing, portfolio credit risk, credit default swap, high-frequency data.

Published in: Journal of Banking & Finance, Vol. 33, No. 11, (November 2009), pp. 2036-2049.

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