The ongoing financial crisis brought to the forefront gaps in clear, objective assessments of systemic risk relating to the U.S. banking sector. Many observers believe that there are unresolved questions in this area, and that the so-called “too big to fail” problem for large banks persists. But how to measure fragility and risk accurately remains an open question.

A 2012 paper for the National Bureau of Economic Research, “Variation in Systemic Risk at U.S. Banks during 1974-2010,” develops a new economic model that incorporates data such as stock prices as a way of helping to calculate risk in a more realistic and timely way.  The goal of the researchers, from Boston College, Baruch College and the International Monetary Fund, is to provide a better early warning of banking trouble; their calculations are premised on the idea that risk to the taxpayers — the implicit guarantees of bailouts — can and should be measured and accounted for.

Major points include:

• “Although [a bank’s stand-alone risk] and implied capital and asset volatility are not publicly reported or explicitly monitored by banking regulators today, our methods have the advantage that they can be estimated from publicly available data. Unlike methods that rely on the prices of credit default swaps or on data measuring interbank exposures to one another, stock-price and balance-sheet data are readily accessible.”
• While the authors’ calculations of implied capital and implied asset volatility showed substantial fluctuations over every business cycle, Tier I capital — a bank’s core capital, as assessed by regulators — on bankbooks barely changed. Moreover, despite declines in accounting leverage during the 1990s, hidden leverage ballooned during the build-up to the 2008 crisis period. This highlights the dangers of regulating banks and monitoring their risk based solely on the numbers on their balance sheets.
• There were certain larger banks in the sample that had large positive systemic risk, suggesting that “larger banks tend to increase the aggregate cost of insuring the debt of the sectoral portfolio and that, on average, smaller banks help taxpayers to finance this cost.” Moreover, increased concentration in the banking sector also raised susceptibility to the systemic risk of the sector.
• Smaller banks were found to have the largest stand-alone risk, the highest equity and asset risk and lowest implied capital ratios. However, systemic risk was found to increase as bank size increased. The difference between systemic risk of banks belonging to the largest quartile and those in the smallest quartile was 0.27 basis points before the crisis, but it widened to 148 basis points during the extreme or “tail” events of the crisis. Hence bank size is a “key driver of systemic risk.”
• Banks with the highest stand-alone risks had regulatory action taken against them (six banks were shut down, three subject to consent orders, and one was acquired) by the end of the sample period. However, none of the leaders of systemic risk received similar stringent regulatory treatment.

“The significantly positive effect of deposits on stand-alone risk is consistent with the hypothesis that deposit insurance intensifies moral-hazard incentives at insured financial institutions and leads to higher individual-bank risk exposures,” the researchers conclude. “Nevertheless, the deposit effect proves negative for systemic risk, albeit insignificantly so during the crisis period. This pattern of results is consistent with the hypothesis that authorities’ rescue option provides banks with more complex balance sheets forms of implicit credit support that tempt such firms to make themselves systemically riskier.”

Tags: financial crisis