Risk Assessment for Banking Systems

It is found that correlation in banks' asset portfolios dominates contagion as the main source of systemic risk and the “value at risk” for a lender of last resort is surprisingly small.

Abstract

We propose a new approach to assess the financial stability of an entire banking system using standard tools from modern risk management in combination with a network model of inter-bank loans. Rather than looking at banks individually, we analyze risk at the level of the banking system as a whole. We apply our model to a unique dataset of all Austrian banks. We find that correlation in banks' asset portfolios dominates contagion as the main source of systemic risk. Contagion occurs rarely but can wipe out a major part of the banking system. Low bankruptcy costs and an efficient crisis resolution policy are crucial to limit the system wide impact of contagious default events. We compute the "value at risk" for a lender of last resort and find the necessary funds to prevent contagion to be surprisingly small. More diversification in the inter-bank market does not necessarily reduce the risk of contagion.