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What is the Relation Between Systemic Risk Exposure and Sovereign Debt?

by Michael Pagano & John Sedunov, Villanova University

Discussion by Paul Kupiec, American Enterprise Institute


Southern Finance Association Meetings, November 2013

Summary
This paper uses data on the Euro area system and finds:
Empirical measures of domestic bank systemic risk & sovereign risk are linked
Higher domestic bank systemic risk implies higher sovereign risk yields

Sovereign risk and domestic bank systemic risk are endogenously determined
Evidence of the bank-sovereign-risk linkage that the EU is trying to break with the new single bank regulator

Tests to see if bank systemic risk spills over:


To other nations sovereign risk
Yeshigher systemic risk in member countries can lead to lower sovereign yields in other member countries

To bank systemic risk in other member countries


Yespositive systemic risk contagion among member countries domestic banks

Systemic Risk Measure


Paper uses modified CoVar measure [Adrian and Brunnermeier (2011)].
The value at risk of bank j conditional on the financial sector return hitting its value at risk. The 99% lower bound on an institutions loss, conditional on the financial sector having a 99 percent loss event. Papers measure each banks contribution to systemic risk as CoVar CoVar is the difference between CoVar conditional on the financial sector at a 99% tail event, and CoVaR conditional on the financial sector at a median event. An example calculation my help to clarify ideas.

CoVar and CoVaR calculation example


Example of CoVaR calculation: Take bank with return generated by a simple market model = + + Say: ~ . 07, .15 , ~(0, .10)

99% market loss event= -27.895%, 99% idiosyncratic loss event= -23.26%

99% Market VaR=-20.895=1% loss tail value mean value

| = 99% = + 20.895 23.26 | = 50% = 23.26 = | = 99% | = 50% = 20.26

Market return is symmetric

So for each bank is just a simple multiple of each banks systematic risk! (| = 99% ) = 20.26

Non normality may change scalars value

CoVaR specification in paper


A slightly more complicated model

= + + 1 +
Where 1 are lagged macro explanatory variables (state variables). Paper estimates the CoVaR for this model using quantile regression Unless the distributions for depend on 1 , CoVaR should be independent of 1

Paper uses Adaptive CoVar


Allows CoVaR to vary over time
Estimates rolling 500 day CoVaR estimates Similar to a multiple of a 500-day rolling Beta coefficient estimate

Paper use quantile regression to estimate

= + + 1 +
Paper uses the MSCI European Financial Index as a proxy for the market return factor in their quantile regressions

Sovereign Yield Regressions


For banking sectors systemic risk measure they use the countrys average daily CoVaR beta estimates which are essentially equal to the average banks market model beta estimates Then they ask, are the banking systemic risk measure and the sovereign yields spreads endogenous? 1. use 2SLS 2. regress country banking system systemic risk measure on size of banking system relative to country GDP Then they treat Europe as a system and stack each countries equation (2.5) and estimate the system using Seemingly Unrelated Regressions.to control for the fact that the residuals are not independent across countries.

They find that yield and banking system systemic risk measures are linked high systemic riskhigh sovereign yields

Very high R-squares

Sovereign Yield Regressions Potential Issues

Yield spread series are also very smooth. They do not look like daily returns. Their time series process also has a unit root, or close to a unit root. Potential spurious regressions problem? When you regress one series with a unit root on another series with a unit root you will get strong statistical significance even though the innovations in the two series are uncorrelated. Suggestion: Try using changes in the yield spread and changes in systemic risk measure instead of levels. See if results hold up.

The X-country contagion regressions

For each country, they create 2 new variables 1. Average sovereign yield spread for the rest of Europe 2. Average banking system CoVar for the rest of Europe 3. The run these 2 additional systems of regressions

Stat sig negative crosscountry systemic risk effects

The X-country contagion regressions

For each country, they create 2 new variables 1. Average sovereign yield spread for the rest of Europe 2. Average banking system CoVar for the rest of Europe 3. The run these 2 additional systems of regressions Here again, I think there is a strong possibility that unit roots in the LHS and many RHS variables are an important driver of results.the underlying economic story is that innovations in these respective series are related and potentially casual Suggestion: Replace all the spread and CoVaR variables with there first differences and see if the results hold up

Summary
Interesting paper on a timely topic Systemic risk measurement is a hot topic but measures that have been proposed in the literature are not yet well-sorted Is there real new data on systemic risk that arrives continuously (each day)? Maybe worthwhile doing some econometric tweeks and reassess results Thanks