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Measuring systemic risk with regime switching in tails

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  • Liu, Xiaochun

Abstract

This paper motivates the importance of modeling nonlinearities in measuring systemic risk. I capitalize this motivation by generalizing the CoVaR approach proposed by Adrian and Brunnermeier (2016) to allow it switching between a high and a normal risk regime filtered from data.. Considering the U.S. large bank holding companies (BHCs), this paper shows that modeling regime changes in tails is capable of capturing both amplification and mean-reversion effects of an adverse shock to a bank's balance sheet on the banking system. Using the Kolmogorov–Smirnov test statistics with and without bootstrapping, I perform the significance test to identify systemically important financial institutions (SIFIs), and the stochastic dominance test to rank the identified SIFIs. The stochastic dominance test raises the concern that the CoVaR measure underestimates systemic risk contributions for SIFIs but overestimates for non-SIFIs. Finally, applying the BHCs' characteristics and housing market price to forecast the regime-switching systemic risk out-of-sample, I obtain from 4- and 8-quarter-ahead horizons a desirable countercyclical, forward-looking measure of systemic risk.

Suggested Citation

  • Liu, Xiaochun, 2017. "Measuring systemic risk with regime switching in tails," Economic Modelling, Elsevier, vol. 67(C), pages 55-72.
  • Handle: RePEc:eee:ecmode:v:67:y:2017:i:c:p:55-72
    DOI: 10.1016/j.econmod.2016.09.015
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    References listed on IDEAS

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    More about this item

    Keywords

    Regime-switching CoVaR; Forward-looking systemic risk; Systemically important financial institutions; Stochastic dominance test; Countercyclical macroprudential policy; Bank systemic risk index;

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • C21 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Cross-Sectional Models; Spatial Models; Treatment Effect Models

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