We propose a new method for the analysis of systemic stability of a banking system relying mostly on market data. We model both asset correlations and interlinkages from interbank borrowing so that our analysis gauges two major sources of systemic risk: correlated exposures and mutual credit relations that may cause domino effects of insolvencies. We apply our method to a data set of the ten major UK banks and analyze insolvency risk over a one-year horizon. We also suggest a stress-testing procedure by analyzing the conditional asset return distribution that results from the hypothetical failure of individual institutions in this system. Rather than looking at individual bank defaults ceteris paribus, we take the change in the asset return distribution and the resulting change in the risk of all other banks into account. This takes previous stress tests of interlinkages a substantial step further.
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Find related papers by JEL classification: C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Statistical Simulation Methods C81 - Mathematical and Quantitative Methods - - Data Collection and Data Estimation Methodology; Computer Programs - - - Microeconomic Data E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages
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