Assessing the Risk of Multiple Defaults in the Banking System

Among the various risks faced by banks that may have a systemic impact on the banking system, the credit risk has long been one of the concerns of central banks. This paper illustrates how to assess the credit risk of the banking system in Hong Kong by constructing an index of multiple default risk from a structural approach, using accounting information and up-to-date market-based information such as equity prices. In addition to an aggregate measure of individual banks' default probabilities, central banks also use an indicator of multiple defaults to monitor the systemic risk in the banking system. By incorporating asset correlations between banks, the multiple default risk index derived in this paper is useful to capture the possible contagion in the banking system, especially during the financial crisis when banks' defaults might be highly correlated. Estimates of asset correlations show that they are time-varying and positive. The multiple default risk index indicates that the most stressful period for the banking system was the Asian financial crisis. The results also show that the index jumped in advance of the crisis. The index with early-warning capability may serve as a vulnerability indicator for the banking sector in addition to the aggregate measure of individual banks' default probabilities. The multiple default risk index has declined steadily since 1999 due to the economic recovery in Hong Kong and consolidation in the banking sector. The study shows that, from a financial stability perspective, the multiple default risk index derived from the extended Merton model, together with individual banks' default probabilities, is useful for monitoring systemic risk in the banking system.