Systemic Real and Financial Risks: Measurement, Forecasting, and Stress Testing

Systemic Real and Financial Risks: Measurement, Forecasting, and Stress Testing. By Gianni de Nicolo & Marcella Lucchetta
IMF Working Paper No. 12/58
Feb 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25745.0

Summary: This paper formulates a novel modeling framework that delivers: (a) forecasts of indicators of systemic real risk and systemic financial risk based on density forecasts of indicators of real activity and financial health; (b) stress-tests as measures of the dynamics of responses of systemic risk indicators to structural shocks identified by standard macroeconomic and banking theory. Using a large number of quarterly time series of the G-7 economies in 1980Q1-2010Q2, we show that the model exhibits significant out-of sample forecasting power for tail real and financial risk realizations, and that stress testing provides useful early warnings on the build-up of real and financial vulnerabilities.

Excerpts

Introduction

The 2007-2009 financial crisis has spurred renewed efforts in systemic risk modeling. Bisias et al. (2012) provide an extensive survey of the models currently available to measure and track indicators of systemic financial risk. However, three limitations of current modeling emerge from this survey. First, almost all proposed measures focus on (segments of) the financial sector, with developments in the real economy either absent, or just part of the conditioning variables embedded in financial risk measures. Second, there is yet no systematic assessment of the out-of-sample forecasting power of the measures proposed, which makes it difficult to gauge their usefulness as early warning tools. Third, stress testing procedures are in most cases sensitivity analyses, with no structural identification of the assumed shocks.

Building on our previous effort (De Nicolò and Lucchetta, 2011), this paper contributes to overcome these limitations by developing a novel tractable model that can be used as a real-time systemic risks’ monitoring system. Our model combines dynamic factor VARs and quantile regressions techniques to construct forecasts of systemic risk indicators based on density forecasts, and employs stress testing as the measurement of the sensitivity of responses of systemic risk indicators to configurations of structural shocks.

This model can be viewed as a complementary tool to applications of DSGE models for risk monitoring analysis. As detailed in Schorfheide (2010), work on DSGE modeling is advancing significantly, but several challenges to the use of these models for risk monitoring purposes remain. In this regard, the development of DSGE models is still in its infancy in at least two dimensions: the incorporation of financial intermediation and forecasting. In their insightful review of recent progress in developments of DSGE models with financial intermediation, Gertler and Kyotaki (2010) outline important research directions still unexplored, such as the linkages between disruptions of financial intermediation and real activity. Moreover, as noted in Herbst and Schorfheide (2010), there is still lack of conclusive evidence of the superiority of the forecasting performance of DSGE models relative to sophisticated data-driven models. In addition, these models do not typically focus on tail risks. Thus, available modeling technologies providing systemic risk monitoring tools based on explicit linkages between financial and real sectors are still underdeveloped. Contributing to fill in this void is a key objective of this paper.

Three features characterize our model. First, we make a distinction between systemic real risk and systemic financial risk, based on the notion that real effects with potential adverse welfare consequences are what ultimately concerns policymakers, consistently with the definition of systemic risk introduced in Group of Ten (2001). Distinguishing systemic financial risk from systemic real risk also allow us to assess the extent to which a realization of a financial (real) shock is just amplifying a shock in the real (financial) sector, or originates in the financial (real) sector. Second, the model produces real-time density forecasts of indicators of real activity and financial health, and uses them to construct forecasts of indicators of systemic real and financial risks. To obtain these forecasts, we use a dynamic factor model (DFM) with many predictors combined with quantile regression techniques. The choice of the DFM with many predictors is motivated by its superior forecasting performance over both univariate time series specifications and standard VAR-type models (see Watson, 2006). Third, our design of stress tests can be flexibly linked to selected implications of DSGE models and other theoretical constructs. Structural identification provides economic content of these tests, and imposes discipline in designing stress test scenarios. In essence, our model is designed to exploit, and make operational, the forecasting power of DFM models and structural identification based on explicit theoretical constructs, such as DSGE models.

Our model delivers density forecasts of any set of time series. Thus, it is extremely flexible, as it can incorporate multiple measures of real or financial risk, both at aggregate and disaggregate levels, including many indicators reviewed in Bisias et al. (2012). In this paper we focus on two simple indicators of real and financial activity: real GDP growth, and an indicator of health of the financial system, called FS. Following Campbell, Lo and MacKinlay (1997), the FS indicator is given by the return of a portfolio of a set of systemically important financial firms less the return on the market. This indicator is germane to other indicators of systemic financial risk used in recent studies (see e.g. Acharya et al., 2010 or Brownlee and Engle, 2010).

The joint dynamics of GDP growth and the FS indicator is modeled through a dynamic factor model, following the methodology detailed in Stock and Watson (2005). Density forecasts of GDP growth and the FS indicator are obtained by estimating sets of quantile autoregressions, using forecasts of factors derived from the companion factor VAR as predictors.  The use of quantile auto-regressions is advantageous, since it allows us to avoid making specific assumptions about the shape of the underlying distribution of GDP growth and the FS indicator. The blending of a dynamic factor model with quantile auto-regressions is a novel feature of our modeling framework.

Our measurement of systemic risks follows a risk management approach. We measure systemic real risk with GDP-Expected Shortfall (GDPES ), given by the expected loss in GDP growth conditional on a given level of GDP-at-Risk (GDPaR), with GDPaR being defined as the worst predicted realization of quarterly growth in real GDP at a given (low) probability. Systemic financial risk is measured by FS-Expected Shortfall (FSES), given by the expected loss in FS conditional on a given level of FS-at-Risk (FSaR), with FSaR being defined as the worst predicted realization of the FS indicator at a given (low) probability level.

Stress-tests of systemic risk indicators are implemented by gauging how impulse responses of systemic risk indicators vary through time in response to structural shocks. The identification of structural shocks is accomplished with an augmented version of the sign restriction methodology introduced by Canova and De Nicolò (2002), where aggregate shocks are extracted based on standard macroeconomic and banking theory. Our approach to stress testing differs markedly from, and we believe significantly improves on, most implementations of stress testing currently used in central banks and international organizations. In these implementations, shock scenarios are imposed on sets of observable variables, and their effects are traced through "behavioral" equations of certain variables of interest. Yet, the ?shocked? observable variables are typically endogenous: thus, it is unclear whether we are shocking the symptoms and not the causes. As a result, it is difficult to assess both the qualitative and quantitative implications of the stress test results.

We implement our model using a large set of quarterly time series of the G-7 economies during the 1980Q1-2010Q1 period, and obtain two main results. First, our model provides significant evidence of out-of sample forecasting power for tail real and financial risk realizations for all countries. Second, stress tests based on this structural identification provide early warnings of vulnerabilities in the real and financial sectors.

Economic crisis: Views from Greece

I asked some Greek professionals about the crisis in their country on behalf of Hanna Intelligence's CEO, Mr. Jose Navio:

dear sir, I got some questions for you, if you have the time:

1  could you please make mention of effects in the citizenry like more children abandoned in hospices because the family cannot maintain them?
2  do you know of lack of food/medicines or lower quality of them?
3  is it better in your opinion to get out of the Euro and use again the old drachma (or any other new currency)?
4  is it better in your opinion to default and to reject the troika bail-outs?

thank you very much in advance,

xxx

The answer of one of those professionals:

Date: 2/27/2012
Subject: RE: Greece and the economic crisis

Dear Mr xxx,

thank you for asking about my country's present; my comment should focus on two issues:

The first one refers to the huge "brain drain" that is in progress during this period in Greece, even to a greater extent than the period after the WWII, which was the greatest immigration period in Greek history. People of all ages and professions are migrating in foreign countries around the world seeking for a job and better living conditions, in all financial, communal and governance/ infrastructural terms.

The second one refers to the sharp rise of homeless people and unable to sustain their families' every day living, dignity and income, due to the unprecedented percentages of unemployment, wages' cuttings and increase of the prices of almost all commodities. In cooperation with the church and under the coordination of various entities and NGOs, citizens are gathering food and clothing to assist all those who suffer the "human insecurity" that prevails nowadays in Greece.

I can't say what could have been better for Greece in economic terms, since it's out of my area of expertise, and I don't want to follow the paradigm of all those who suddenly became experts in economic strategies, options, terms and conspiracy theories. I can confirm though that this situation is the result of bad Greek governance for the last thirty years and that although Greece didn't loose sovereignty through wars in it's modern history, it did through economic procedures and EU norms; in any case Greeks are experiencing a very hard austerity policy, humiliation from various (mostly) European governments and states, and most important, instead of facing a hopeful future and prospect, they see things getting worst every day, even after all this inhuman behaviors.

I don't know what the plan or EU's "Grand Strategy" might be for Greece, but definately the proud and cultural Greeks don't deserve what they experience during these years, not even what is yet to come. The civil society is a "boiling pot" due to the downgrade of the every day living standards, unpunished and "untouchable" politicians responsible for this situation,explicit inequalities and non-existing options for the future generations. Let's hope at least that we'll not experience also a bloodshed or Egypt-like uprisings..

I hope I gave you a brief and indicative picture of contemporary Greece, and been of some help to your questions.

Best regards,

xxx

Can Institutional Reform Reduce Job Destruction and Unemployment Duration?

Can Institutional Reform Reduce Job Destruction and Unemployment Duration? Yes It Can. By Esther Perez & Yao Yao
IMF Working Paper No. 12/54
February 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25738.0

Summary: We read search theory’s unemployment equilibrium condition as an Iso-Unemployment Curve(IUC).The IUC is the locus of job destruction rates and expected unemployment durations rendering the same unemployment level. A country’s position along the curve reveals its preferences over the destruction-duration mix, while its distance from the origin indicates the unemployment level at which such preferences are satisfied Using a panel of 20 OECD countries over 1985-2008, we find employment protection legislation to have opposing efects on destructions and durations, while the effects of the remaining key institutional factors on both variables tend to reinforce each other. Implementing the right reforms could reduce job destruction rates by about 0.05 to 0.25 percentage points and shorten unemployment spells by around 10 to 60 days. Consistent with this, unemployment rates would decline by between 0.75 and 5.5 percentage points, depending on a country’s starting position.


Introduction

This paper investigates how labor market policies affect the unemployment rate through its two defining factors, the duration of unemployment spells and job destruction rates.  To this aim, we look at search theory’s unemployment equilibrium condition as an Iso-Unemployment Curve (IUC). The IUC represents the locus of job destruction rates and expected unemployment durations rendering the same unemployment level. A country’s position along the curve reveals its preferences over the destruction-duration mix, while its distance from the origin indicates the unemployment level at which such preferences are satisfied. We next provide micro-foundations for the link between destructions, durations and policy variables. This allows us to explore the relevance of institutional features using a sample of 20 OECD countries over the period 1985-2008.

The empirical literature investigating the influence of labor market institutions on overall unemployment rate is sizable (see, for instance, Blanchard and Wolfers, 1999, and Nickell and others, 2002). Equally numerous are the studies splitting unemployment into job creation and job destruction flows (see, for example, Blanchard, 1998, Shimer, 2007, and Elsby and others, 2008). This work connects these two strands of the literature by investigating how labor market policies shape both job separations and unemployment spells, which together determine the overall unemployment rate in the economy. The IUC schedule used in our analysis is novel and is motivated by the need to understand the nature of unemployment, as essentially coming from destructions, durations or a combination of both these factors. This can help clarify whether policy makers should focus primarily on speeding up workers’ reallocation across job positions rather than protecting them in the workplace.

One fundamental question raised in this context is whether countries with dynamic labor markets significantly outperform countries with more stagnant markets. By dynamic (stagnant) we mean labor markets displaying high (low) levels of workers’ turnover in and out of unemployment. Is it the case that countries featuring high job destruction rates but brief unemployment spells tend to display lower unemployment rates than labor markets characterized by limited job destruction but longer unemployment durations?  And how do institutional features shape destructions and durations?


Conclusions

This paper reads the basic unemployment equilibrium condition postulated by search theory as an Iso-Unemployment Curve (IUC). The IUC is the locus of job destruction rates and expected unemployment durations that render the same unemployment level.  We use this schedule to classify countries according to their preferences over the job destruction-unemployment duration trade-off. The upshot of this analysis is that labor markets characterized by high levels of job destruction but brief unemployment spells do not necessarily outperform countries characterized by the opposite behavior. But, the IUC construct makes it clear that high unemployment rates result from extreme values in either durations or destructions, or intermediate-to-high levels in both.

Looking at unemployment through the lenses of the IUC schedule focuses the attention on each economy’s revealed social preferences over the destruction-duration mix. Policy packages fighting unemployment should take into consideration such preferences. Some countries seem to tolerate relatively high destruction rates as long as unemployment duration is short. Others are biased towards job security and do not mind financing longer job search spells. A few unfortunate countries are trapped in a high inflow-high duration combination, seemingly condemned for long periods of high unemployment.

An optimistic message arising from this study, especially for countries located on higher IUCs, is that an ambitious structural reform program tackling high labor tax wedges, activating unemployment benefits and removing barriers to competition in key services can effectively contain job losses, limit the duration of unemployment spells and yield substantial reduction in unemployment.

Intra-group support measures in times of stress or unexpected loss by financial groups in the banking, insurance and securities sectors

The Joint Forum: Report on intra-group support measures
Feb 2012
http://www.bis.org/publ/joint28.htm

The Joint Forum (BIS, IOSCO, IAIS) just published a report to assist national supervisors in gaining a better understanding of the use of intra-group support measures in times of stress or unexpected loss by financial groups across the banking, insurance and securities sectors. The report provides an important overview of intra-group support measures used in practice at a time when authorities are increasingly focused on ways to ensure banks and other financial entities can be wound down in an orderly manner during periods of distress.

The Joint Forum was established in 1996 under the aegis of the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) to deal with issues common to the banking, securities and insurance sectors, including the regulation of financial conglomerates.

Excertps

Executive Summary

The objective of this report prepared by the Joint Forum is to assist national supervisors in gaining a better understanding of the use of intra-group support measures in times of stress or unexpected loss by financial groups across the banking, insurance and securities sectors.  The report provides an important overview of the use of intra-group support at a time when authorities are increasingly focused on ways to ensure banks and other financial entities can be wound down in an orderly manner during periods of distress. The report may also assist the thematic work contemplated by the Financial Stability Board (FSB) on deposit insurance schemes and feed into the ongoing policy development in relation to recovery and resolution plans.

The report is based on the findings of a high-level stock-take which examined the use of intra-group support measures available to banks, insurers and securities firms. The stocktake was conducted through a survey by the Joint Forum Working Group on Risk Assessment and Capital (JFRAC) that was completed by 31 financial institutions headquartered in ten jurisdictions on three continents: Europe, North America and Asia.  Participants were drawn from the banking, insurance and securities sectors and from many of the jurisdictions represented by Joint Forum members. Many participating firms were large global financial institutions.

The report provides an overview and analysis of the types and frequency of intra-group support measures used in practice. It is based only on information provided by participants in the survey. Responses were verified by supervisors only in certain instances.

The survey’s main findings are as follows:

1. Intra-group support measures can vary from institution to institution, driven by the regulatory, legal and tax environment; the management style of the particular institution; and the cross-border nature of the business. Authorities should be mindful of the complicating effect of these measures on resolution regimes and the recovery process in the event of failure.

2. The majority of respondents surveyed indicated centralised capital and liquidity management systems were in place. According to proponents, this approach promotes the efficient management of a group’s overall capital level and helps maximise liquidity while reducing the cost of funds. However, the respondents that favoured a “self-sufficiency” approach pointed out that centralised management potentially has the effect of increasing contagion risk within a group in the event of distress at any subsidiaries. The use of these systems impacts the nature and design of intra-group support measures with some firms indicating that the way they managed capital and liquidity within the group was a key driver in their decisions about the intra-group transactions and support measures they used.

3. Committed facilities, subordinated loans and guarantees were the most widely used measures. This was evident across all sectors and participating jurisdictions.

4. Internal support measures generally were provided on a one-way basis (eg downstream from a parent to a subsidiary). Loans and borrowings, however, were provided in some groups on a reciprocal basis. As groups surveyed generally operated across borders, most indicated support measures were provided both domestically and internationally. Support measures were also in place between both regulated and unregulated entities and between entities in different sectors.

5. The study found no evidence of intra-group support measures either a) being implemented on anything other than an arm’s length basis, or b) resulting in the inappropriate transfer of capital, income or assets from regulated entities or in a way which generated capital resources within a group. However, this does not necessarily mean that supervisory scrutiny of intra-group support measures is unwarranted. As this report is based on industry responses, further in-depth analysis by national supervisors may provide a more complete picture of the risks potentially posed by intra-group support measures.

6. While the existing regulatory frameworks for intra-group support measures are somewhat limited, firms do have certain internal policies and procedures to manage and restrict internal transactions. Respondents pointed out that the regulatory and legal framework can make it difficult for some forms of intra-group support to come into force while supervisors aim to ensure that both regulated entities and stakeholders are protected from risks arising from the use of support measures. For instance, upstream transfers of liquidity and capital are monitored and large exposure rules can limit the extent of intra-group interaction for risk control purposes. Jurisdictional differences in regulatory settings can also pose a challenge for firms operating across borders.

7. Based on the survey and independent of remaining concerns and information gaps, single sector supervisors should be aware of the risks that intra-group support measures may pose and should fully understand the measures used by an institution, including its motivations for using certain measures over others. In order to obtain further insight into the intra-group support measures put in place by financial institutions within their jurisdiction, national supervisors should, where appropriate, conduct further analysis in this area. A high-level model questionnaire is provided in Annex II with the aim of assisting national supervisors with ongoing work relating to intra-group support measures.

Short-term Wholesale Funding and Systemic Risk: A Global CoVaR Approach

Short-term Wholesale Funding and Systemic Risk: A Global CoVaR Approach. By German Lopez-Espinosa, Antonio Moreno, Antonio Rubia, and Laura Valderrama
IMF Working Paper No. 12/46
Feb 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25720.0

Summary: In this paper we identify some of the main factors behind systemic risk in a set of international large-scale complex banks using the novel CoVaR approach. We find that short-term wholesale funding is a key determinant in triggering systemic risk episodes. In contrast, we find no evidence that a larger size increases systemic risk within the class of large global banks. We also show that the sensitivity of system-wide risk to an individual bank is asymmetric across episodes of positive and negative asset returns. Since short-term wholesale funding emerges as the most relevant systemic factor, our results support the Basel Committee’s proposal to introduce a net stable funding ratio, penalizing excessive exposure to liquidity risk.

Excerpts

Introduction

That financial markets move more closely together during times of crisis is a well-documented fact. Conditional correlations among assets are much higher when market returns are low in periods of financial stress; see, among others, King and Wadhwani (1990) and Ang, Chen and Xing (2006). Co-movements typically arise from common exposures to shocks, but also from the propagation of distress associated with a decline in the market value of assets held by individual institutions, a phenomenon we dub balance sheet contraction and which is of particular concern in the financial industry. The recent crisis has shown how the failure of large individual credit institutions can have dramatic effects on the overall financial system and, eventually, spread to the real economy. As a result, international financial policy institutions are currently designing a new regulatory framework for the so-called systemically important financial institutions in order to ensure global financial stability and prevent, or at least mitigate, future episodes of systemic contagion.

In this paper, building on a global system of international financial institutions that comprises the largest banks in a sample of 18 countries, we analyze the main determinants of systemic contagion from an individual institution to the international financial system, i.e., the empirical drivers of tail-risk interdependence. We restrict our attention to a set of large-scale, complex institutions that are the target of current regulation efforts and that would likely be considered too-big-to-fail by central banks. These firms are characterized by their large capitalization, global activity, cross-border exposures and/or representative size in the local industry. Using data spanning the 2001-2009 period, we explicitly measure the contribution of the balance-sheet contraction of these institutions to international financial distress. As regulators seek for meaningful measures of interconnectedness (Walter 2011), this paper contributes to the current debate on prudential regulatory requirements by showing formal evidence that short-term wholesale funding is a major driver of systemic risk in global banking.

Financial institutions use wholesale funding to supplement retail deposits and expand their balance sheets. These funds are typically raised on a short-term rollover basis with instruments such as large-denomination certificates of deposits, brokered deposits, central bank funds, commercial paper and repurchase agreements. Whereas it is agreed that wholesale funding provides certain managerial advantages (see Huang and Ratnovski, 2011, for a discussion), the effects on systemic risk of an overreliance on these liabilities were under-recognized prior to the recent financial crisis. Banks with excessive short-term funding ratios are typically more interconnected to other banks, exposed to a large degree of maturity mismatch and more vulnerable to market conditions and liquidity risk. These features can critically increase the vulnerability of interbank markets and money market mutual funds which act as wholesale providers of liquidity and, eventually, of the whole financial system. The empirical analysis on this paper provides clear evidence on the major role played by short-term wholesale funding to spread systemic risk in global markets.

Additionally, we explore the possibility that the contribution to systemic risk may be asymmetric, i.e. that it depends on whether the market value of a bank’s balance sheet is increasing or decreasing. Because a distressed institution is likely to generate larger externalities on the rest of the financial system when its balance sheet is contracting, an empirical analysis of tail risk-dependence within a financial system should distinguish between episodes of expanding and contracting balance sheets. We deal with this previously unaddressed but key issue, finding strong evidence supporting the existence of asymmetric patterns. Finally, we also analyze the effects of the 2008-2009 global financial crisis on systemic risk and assess the impact of public recapitalizations directly targeted at individual banks.

Our study builds on the novel procedure put forward by Adrian and Brunnermeier (2009), the so-called CoVaR methodology, and generalizes it in several ways in order to deal with the characteristics of a sample of international banks and to address the asymmetric patterns that may underlie tail dependence. The main empirical findings of our analysis can be summarized as follows. First, we find that short-term wholesale funding is the most significant balance sheet determinant of individual contributions to global systemic risk. An increase of one percentage point in this variable leads to an increase in the contribution to systemic risk of 40 basis points of quarterly asset returns. These results support regulatory initiatives aimed at increasing bank liquidity buffers to lessen asset-liability maturity mismatches as a mechanism to mitigate individual liquidity risk, such as the liquidity coverage ratio standard recently laid out by the Basel Committee on Banking Supervision under the new Basel III regulatory framework.3 This paper shows that these provisions may also help to reduce the likelihood of systemic contagion. By contrast, we find little evidence that, within the class of large-scale banks, either relative size or leverage is helpful in predicting future systemic risk after accounting for short-term wholesale funding.

Second, our analysis shows that individual balance sheet contraction produces a significant negative spillover on the Value-at-Risk (VaR) threshold of the global index. Whereas the sensitivity of left tail global returns to a shock in an institution’s market valued asset returns is on average about 0.3, the elasticity conditional on an institution having a shrinking balance sheet is almost three times larger. This result reveals a strong degree of asymmetric response that has not been discussed in the extant literature and which turns out to be larger the more systemic the bank is when its balance sheet is contracting. Therefore, controlling for balance sheet contraction is crucial to rank financial institutions by their contribution to systemic risk.

Third, restricting attention to balance sheet contraction episodes, the credit crisis added up 0.1 percentage points to the co-movement between individual and global asset returns while recapitalization during the crisis period dampened co-movement by 0.2 percentage points.  Furthermore, the timing of recapitalization also matters for systemic risk. Banks that received prompt recapitalization in Q4 2008 proved able to improve their relative position during the crisis period, whereas banks that were rescued by public authorities later in Q4 2009 became relatively more systemic during the crisis period. Finally, the marginal contribution of an individual bank to overall systemic risk increases from 0.76 quarterly percent returns in an average quarter to 0.92 in a quarter characterized by money market turbulence. These results highlight the relevance of crisis episodes in measuring systemic risk and of policy actions in controlling it.

Concluding remarks and policy recommendations

In this paper we examine some of the main factors driving systemic risk in a global framework. We focus on a set of large-scale, international complex institutions which would in principle be deemed too-big-to-fail by national regulators and which are therefore of mayor interest for policy makers. For this class of firms, the evidence based on the CoVaR methodology suggests that short-term wholesale funding –a variable strongly related to interconnectedness and liquidity risk exposure-, is positively and significantly related to systemic risk, whereas other features of the firm, such as leverage or relative size, do not seem to provide incremental information over wholesale funding. This suggests that this latter variable subsumes to a large extent most of the relevant information on systemic risk conveyed by other firm characteristics. We also uncover the relevant role played by asymmetric responses when assessing the impact of individual institutions on system-wide risk, as we find that the sensitivity of system returns to individual bank returns is much higher in periods of balance sheet deleveraging.

Regulators are currently developing a methodological framework within the context of Basel III that attempts to embody the main factors of systemic importance; see Walter (2011). These factors are categorized as size, interconnectedness, substitutability, global activity and complexity, and will serve as a major reference to determine the amount of additional capital requirements and funding ratios for systemically important financial institutions. Our analysis provides formal empirical support to the Basel Committee’s proposal to penalize excessive exposures to liquidity risk by showing that short-term wholesale funding, a variable capturing interconnectedness, largely contributes to systemic risk. Furthermore, since our findings suggest that some factors are much more important than others in determining systemic risk contributions, an optimal capital buffer structure on systemic banks could in principle be designed by suitably weighting the different driving factors as a function of their relative importance. This is an interesting topic for further research. Similarly, the evidence in this paper also offers empirical support to justify the theoretical models that acknowledge the premise that wholesale funding can generate large systemic risk externalities; see, for instance, Perotti and Suarez (2011) for a recent analysis and references therein.

Given the relevance of liquidity strains as a contributing factor to systemic risk, the regulation of systemic risk could be strengthened by giving incentives to disclose contingent short-term liabilities, in particular those related to possible margin calls under credit default swap contracts and repo funding. Our study also points at the role of large trading books as a source of systemic risk –for those banks which were recapitalized during the crisis. As a result, the 2010 revamp of the Basel II capital framework to cover market risk associated with banks’ trading book positions will not only decrease individual risk but will also contribute to mitigate systemic risk.