L14: Risk and the Basel Capital Accords

A Brief Overview

IMF Institute for Capacity Development Presenter

Africa Training Institute Ian Nield
Course on Financial Sector Surveillance (FSS – AT19.01)
March 25 – April 5, 2019
This training material is the property of the International Monetary Fund (IMF) and is intended for use in
IMF Institute for Capacity Development courses. Any reuse requires the permission of the IMF and ICD.
 Objectives

• The rationale and the evolution of the Capital

Accords
• Outline some key aspects of the Basel I, II and
III Accords
• Outline the G-SIB and D-SIB extensions to Basel
III and underlying risk measures and
surveillance tools
• Discuss the implications of the Accords for
Emerging and developing Markets

FSS 2
 Outline

• Background
• Risk weighted assets
– Basel I, Basel II and Basel III
• Enhancing risk measurement
– Basel II and Basel III
• Systemic risk
– More risk measurement enhancement
• Emerging markets and developing economies
– things to consider
FSS 3
Background

FSS 4
 45 years of the BCBS…
CRISIS REACTION REGULATION
November 1973 Formation of Basel Committee 1975 - Basel
Failure of Bankhaus Herstatt on Banking Supervision under Concordat and
- impairment of New York auspices of G-10 central banks in subsequent
interbank market late 1974. revisions

Early 1980s - Latin 1987 – BCBS supported by G10 1988 – Basel Capital
American debt crisis consults on capital regulatory Accord (“Basel I”).
Unease regarding erosion framework Updated in 1996 for
of capital standards Market Risk

1997/98 – East Asian debt 1999 – BCBS proposes revised 2004 – “Basel II”
crisis framework issued

2008 – Global Financial 2009-11 – BCBS supported by 2011 – “Basel III”

Crisis G20 consults: revised framework ongoing refinements

FSS 5
 Taxonomy of Risks faced by Banks
• Banking Crises - Concern that banks will be illiquid or insolvent.
• Banks evaluate the financial risks connected to illiquidity or
insolvency. Common types of such risks:
– Credit risk that loans that banks made will not be repaid.
– Market risk that assets will become worth less (due to changes in market
prices).
– Operational risk that internal processes (governance, control systems,
etc.) will fail.
– Liquidity risk that it will be hard for banks to meet short-term obligations,
leading to fire sales of assets.
• These risks are often interrelated. (For example, a market shock can
lead to credit losses.)

FSS
6
Basel Capital Accords: the risks considered

BASEL I BASEL II BASEL III

Credit risk Credit risk Credit risk
Market risk Market risk Market risk
(from 1996)
Operational risk Operational risk
Liquidity risk1,3
Systemic risk2,3
Contagion risk2,3
1: Often a micro-prudential focus, but with additional macro-prudential consequences
2: Frequently a macro-prudential focus with micro-prudential aspects and consequences.
3: Lead regulator may be either macro-prudential or micro-prudential authority.
FSS 7
 Basel Capital Accords: Background
• Capital adequacy requirements:
o consistent approach across countries
o provide a buffer against unexpected bank losses
o create disincentives for excessive risk taking

• Broadening:
o the risks considered from Basel I to Basel III
o from micro to macro supervision

• Improving:
o the quality of risk measurement - Basel II/III

FSS 8
Risk Weighted Assets

FSS 9
 Basel Accords core concept
Risk-weighted assets
At the core of all the Basel Accords is the concept of risk-
weighted assets

Some assets are riskier than others and this should inform
the desired level of capital that should be held against
them.
• The first Basel Accord introduced two minimum capital
ratios:
o Tier 1 capital ≥ 4%
o Total capital (the “Cooke ratio”) ≥ 8%
• The first accord1 only considered CREDIT RISK
1. The 1996 ‘Market risk amendment’ to the first Basel Accord added market risk and introduced the
terms ‘standardized risk approach’ and ‘internal ratings-based approach’.

FSS 10
 Risk-weighted Assets

Exposure Risk-
RWA
value weight

• Example:
– Bank holds a mortgage on residential property (€100)
– A 50% risk weight is applied to mortgage on residential
property under Basel I rules
– The Risk-Weighted Assets (RWA) for this loan amount to €50

FSS 11
 Risk-weighted Capital Ratio

• The objective is to assess the soundness of a bank

• We compare the capital held with the level of risk

taken:
Capital
Risk-weighted capital ratio =
Risk-weighted assets
(RWA)

FSS 12
Minimum (risk-weighted) Capital ratio
8% Minimum
RWA (minimum required
capital ratio) capital

• Example:
– a Bank holds a mortgage on residential property (€100)
– a 50% risk weight is applied to mortgage on residential
property (Basel I rule)
– The risk-weighted assets (RWA) for this loan are
RWA = €100 x 50% = €50
– The capital requirement the bank must hold for this loan is
RWA x minimum capital ratio = €50 x 8% = €4
FSS 13
 Capital Adequacy Ratio

Capital
Risk-weighted capital ratio =
Risk-weighted assets

Definition of Capital:
Capital = Core Capital (Tier 1)
+ Supplementary Capital (Tier 2)
- Deductions

FSS 14
 Capital under Basel I, II and III
Tier 1 and Tier 2 capital
The Basel Accords allocate capital to one of two tiers1:
• Tier 1 – “going concern” capital2
o Paid-up share capital/common stock
o Disclosed reserves (legal reserves, surplus and/or retained profits)
• Tier 2 – “gone concern” capital (see next slide)
o The elements of Tier 2 capital are essentially the same under
Basel I and Basel II
o Under Basel III the elements that can qualify as Tier 2 capital must
satisfy several criteria.

1. Tier 3 capital – “market risk” capital was Introduced into the first Basel Accord with the market risk amendment. Tier 3
capital was retained in Basel II, but eliminated under Basel III. Tier 3 capital is less “certain” capital than Tier 1 or Tier 2
capital.
2. Under Basel III, there is a strong preference for equity capital/equity “like” capital rather than other forms of capital.

FSS 15
Tier 1 and Tier 2 capital under Basel III1
• minimum maturity of 5 years Upper Tier 2
• No incentive to redeem (no step-up) Lower Tier 2
Tier 2 • Cumulative Trust Preferred
(T2) • Loss-absorption via permanent write-down Cumulative
or conversion into equity (in gone concern or Preferred
at the point of non viability “PNV”)  Hybrid Tier 1

• Perpetual Non cumulative

Additional • No incentive to redeem perpetual preferred
• Loss-absorption via temporary or securities
Tier 1
permanent write-down or conversion into Preference shares
(AT1) equity (in going concern)

Permanent
Common • Common shares (or equivalent)
 Fully loss-absorbing
Equity Tier 1 = mostly common
• Retained earnings & reserves
(CET1) …shares
• Minus Deductions

1. Basel I and Basel II have less stringent requirements than Basel III, it is suggested that a regulator adopt the Basel III definitions.

FSS 16
Risk weights:
Basel I and Basel II/III standardized approach (STA)
BASEL I : Risk weights based on the nature of the borrower, rather
than financial characteristics or credit history => limited risk
sensitivity
BASEL II : Risk weights based on the credit rating risk characteristics
Regulatory Capital = Risk Weight * Exposure * 8% = Risk-weighted Assets * 8%

Basel I Basel II STA

Obligor Risk Weight Rating of Entity Risk Weights
OECD central governments 0%
Domestic public sector entities 0%, 10%, 20% or 50%
Sovereigns Banks Corporates
(excluding central governments) Set by domestic regulator
AAA to AA- 0% 20% 20%
OECD banks and regulated firms 20%
A+ to A- 20% 50% 50%
Housing loans fully secured by residential property 50%
BBB+ to BBB- 50% 50% 100%
Counterparties in derivatives transactions 50%
BB+ to BB- 100% 100% 100%
Public sector corporations; non-OECD banks; private 100%
B+ to B- 100% 100% 100%
sector debt; all other assets
Below B- 150% 150% 150%
Unrated 100% 50% 100%

FSS 17
 1996 Market Risk Amendment
Introduction of “standardized” approach and risk models
• Specific inclusion of market risk
• Distinction between trading book and banking book
– For securities held in the trading book, the capital charge
from credit risk requirements is replaced by that generated
by the market risk amendment

• Calculation of RWA
– Standardized approach (based on credit ratings), or…
– Internal Risk Model → Value at Risk Methodology (VaR)

Tier 3 – “market risk” capital (at discretion of prudential authority)

o Introduced with the Basel I market risk amendment, retained in Basel II,
eliminated under Basel III – less “certain” capital than Tier 1 or Tier 2.
FSS 18
Enhancing risk measurement

FSS 19
 Basel II in outline
Enhanced the Basel I framework
• Three “pillars”:
o enhanced risk measurement
o comprehensive coverage of risks
 Inclusion of capital charges for operational risk as well as credit
and market risks
o better alignment of regulatory capital and underlying risk
o included roles of bank management and the market
• Encouraged banks to improve risk management
capabilities
• Applicable to wide range of banks/ systems
FSS 20
 Basel II: An Overview
– Enhanced Basel I
– Three pillars
– Increased role for bank management and the
market
– More reliance on banks own assessment of risk
– Greater recognition of credit risk mitigation
techniques
– Inclusion of capital charges for operational risk
– Menu of options to choose from

FSS 21
 BASEL II – The three pillars

Pillar 1 Pillar 2 Pillar 3

Minimum Supervision Market discipline
requirements • Supervisory Review • Disclosure
• Definition of Process: requirements
capital • Capital adequacy • Capital structure
• Credit risk • Assessment & • Risk exposure
• Market risk Monitoring • Capital adequacy
• Operational risk • Intervention /
Setting target
ratios

Basel III has the same three pillar approach, with enhancements to each pillar.
FSS 22
 BASEL II – Pillar 1
• Pillar 1 - Minimum capital requirements

More risk sensitive Largely unchanged

Explicit treatment of
approach for approach for
Operational risk Market risks
Credit risk
Basic Indicator approach
Standardized approach (BIA) Standardized approach

Standardized approach
(TSA)
Internal Ratings Based Internal Models
approach (IRB Foundation Advanced Measurement approach (IMM)
and Advanced) approach (AMA)

FSS 23
 Risk weighted capital under Basel II/III
• Risk weighted assets are determined using either the:
o standardized approach or
o Internal Ratings-Based (IRB) approach

• Standardized approach:
o Credit rating derived risk weights.

• IRB approach:
o based on measures of unexpected losses (UL) and
expected losses (EL) (recall Lectures 4 and 6).
o the risk-weight functions produce capital requirements
for the UL portion.

FSS 24
 Capital under IRB approach
• By means of a stochastic credit portfolio model, it is possible to
estimate the amount of unexpected loss which will be exceeded
with a small, pre-defined probability
• Credit VaR concept (maximum loss experienced at a given
confidence level – set by Basel Committee to be 99.9%)
Provisions and revenues to cover
EL Capital to cover UL

FSS 25
 Risk weighted capital under Basel II/III
• Banks that have received supervisory approval to use the
IRB approach may rely on their own internal estimates of
risk components in determining the capital requirement for
a given exposure. The risk components include measures
of the probability of default (PD), loss given default (LGD),
the exposure at default (EAD), and effective maturity (M).
• In some cases, banks may be required to use a
supervisory value as opposed to an internal estimate for
one or more of the risk components.

FSS 26
 Systemic risk
Assessment and measurement of systemic risk

FSS 27
Contagion risk

FSS 28
Basel III - The buffer zone

G-SIB/D-SIB

Counter Cyclical

Capital
Conservation

CET1

FSS 29
Assessing systemically important banks (SIBs)
Global and domestic SIB’s (G-SIBs and D-SIBs)

Category Indicators
Cross-jurisdictional Cross-jurisdictional claims and
activity liabilities
Size Total exposures
Interconnectedness (Intra)financial system assets and
liabilities, securities outstanding
Substitutability / financial Assets under custody, payments
institution infrastructure activity, underwriting activity
Complexity OTC deriviatives trading, securities
trading, asset composition
Each category has a 20% weight, within each category indicators are equally weighted.

FSS 30
 Measuring interconnection risk and
estimating the capital requirement
“It is important to note that there is no single correct approach
that is reliable enough to inform the assessment of the
magnitude of the higher loss absorbency requirement… All
the approaches suffer from data gaps, and the results are
sensitive to assumptions made. Therefore… generate
information using a range of modelling approaches, and to
examine the sensitivity of the results to various assumptions.”
Source: BCBS, “Global systemically important banks: updated assessment methodology and the
higher loss absorbency requirement”, Annex 2, page 17. https://www.bis.org/publ/bcbs255.htm

FSS 31
 Interconnection risk
estimation methods
• There are many techniques that have been developed and
are being developed to estimate the capital required to
ameliorate for interconnection and contagion risks.
• In the Systemic Risk lecture, Lecture 12, we focused on
Network Analysis as a tool for estimating Systemic Risk.
• Here we outline four other methods:
o Co-dependence VaR (CoVar)
o Co-dependence Risk (CoRisk)
o Joint Probability of Distress and Distress Dependence
o Diebold-Yilmaz Measure

FSS 32
 CoVaR
CoVaR between two
institutions, is the VaR
of one institution at
some percentile q,
conditional on the
other institution being
at its q-VaR threshold
FSS
For systemic
surveillance, the
CoVaR of institution i
is the VaR of the whole
financial system
conditional on i being
at its q-VaR
33
 CoVaR Illustration
Step 1:
View the financial system as a portfolio of banks

Step 3:
Probability
0.2

Estimate bank’s i contribution to

distribution of market 0.15
systemic risk
value of Bank i and 0.1

the rest of the system Take the difference between

CoVaRVaR i=q-CoVaRVar i=50%
0.05

0
4
2 4
0 2
0

Step 2:
-2 -2
-4 -4

Compute CoVaR with VaR of Bank i at the q% and

50% levels
Compute the System VaR, conditional on bank i
being at its VaR at the q% confidence level
Compute the System VaR, conditional on bank i
being at its VaR at the 50% confidence level.
FSS 34
 Using CoVaR and ΔCoVaR
CoVaR: What is the VaR of the financial system if a particular institution is under financial stress?

• Can be used to infer the size of the

CoVaR losses to the system caused by
financial distress of one institution

• Measure institutions’ contribution

ΔCoVaR to systemic risk
• Can be the basis of policy (capital
charges on SIFIs)
ΔCoVaR: How does the VaR of the financial system change when a particular institution becomes
financially stressed?

FSS 35
 CoRisk
• Proposed by IMF in the April 2009 GFSR
(https://www.imf.org/~/media/Websites/IMF/imported-full-text-pdf/external/pubs/ft/gfsr/2009/01/pdf/_text.ashx)

• Similar to CoVaR but using credit default

swaps (CDS) data instead
• Captures financial institutions’ co-dependence
risk arising from direct and indirect linkages
o Indirect linkages from exposure to common risk
factors such as reliance on wholesale funding
markets, similar portfolios, and so on
CoRisk: What happens to the rest of the financial system if a particular institution under fails?

FSS 36
 Joint Probability of Distress

Step 1:
View the financial system as a portfolio of banks
Step 4:
0.2
Estimate Financial Stability
PoD of Bank X 0.15
Measures.
0.1
Based on conditional
0.05 Probabilities of distress
0
4
2 4
0 2
0
-2 -2

PoD of Bank Y
-4 -4

Step 3:
Step 2: Recover the Financial System Multivariate Density
Estimate individual FIs It characterizes the implied asset values of the portfolio of FIs and
Probabilities of Distress the distress dependence among these FIs.
(PoDs)

FSS 37
 Distress Dependence Matrix
• The probability of distress (default) (PoD) for individual financial
institution can be estimated from equity prices, CDS spreads, etc.
• Given these estimates, a joint probability of distress (JPoD) can
be estimated.
o e.g.., the probability that financial institutions A and B are
under distress but C is not
• From JPoD, conditional probability of distress can be obtained
o That is, the probability that A is under distress conditional on
B’s distress.
• Output: Pairwise conditional probabilities of distress, called
“distress dependence matrix”

FSS
38
 Diebold-Yilmaz Measure
• Diebold-Yilmaz (2009) measure, or “DY” measure: A
time-varying indicator of returns spillovers of
institutions
o Uses market data on equity returns, and the
volatility of equity returns to estimate average
contributions of institutions to systemic risk using
a VaR model
• It also has good in-sample forecasting properties for
systemic stress, but does not identify the underlying
spillover channels
FSS
39
Emerging and developing economies
What to do?

FSS 40
 What Should EMDEs do?
Things to consider:
• Basel II - standardized model and at least Pillar 1
• Basel III – consider the various attributes and
determine what could be implemented:
o Definition of capital (focus on equity capital)
o The various capital buffers (including SIBs)
o Not discussed/ fully detailed in this course but…
– Leverage ratio
– Liquidity coverage ratio (LCR)
– Net stable funding ratio (NSFR)

FSS 41
 Some Takeaways
• Capital Accords: a key financial sector risk mitigant
o Financial sector risks evolve and so should regulation… crucial to
be forward looking.
o Methods of measuring risk have been enhanced and refined to
support more effective risk amelioration.
o Several risk measurement tools have been proposed to support
macro-prudential surveillance
 Heavy use of market information
 Some of these methods can be used to
□ Identify SIFIS
□ Compute capital surcharges for systemic risk

• Understand risks… cannot apply regulation mechanically

• Given the volume of international regulatory changes…
…prioritize reforms.

FSS 42
Thank you!

FSS 43
 Appendix – Interconnection risk
The four methods described in more detail
• Co-dependence VaR (CoVar)
• Co-dependence Risk (CoRisk)
• Joint Probability of Distress and Distress Dependence
• Diebold-Yilmaz Measure

FSS 44
Appendix - Content Outline

CoVaR

CoRisk

JoPD and Distress Dependence

Diebold-Yilmaz Measure

45
Background: Quantile Regressions

• The estimation weights

Provide a observations away from the mean
more heavily than OLS regressions
method to
focus on • Allows development of systemic risk
“tail” measures that can condition on an
institution being in distress or
observations multiple institutions in distress
simultaneously

46
 Quantile Regression
Start by considering Ordinary Lease Squares
(OLS) and Least Absolute Difference (LAD):

min  2

β  i ∑ ( yi − X i β ) 


min  

β  i ∑ yi − X i β 

 Quantile Regression (cont.)
Consider Typical Residuals in OLS framework

Image from Pindyck and Rubinfield (Econometric models and economic forecasts)
 Quantile Regression (cont.)
Quantile (q) regression is essentially a variant
of LAD at q≠.5
q is the chosen quantile, say 0.95
for “tail” observations

min  
 ∑ q yi − X i β + ∑ (1 − q ) yi − X i β 
β {i yi ≥ X i β } {i yi < X i β } 
Positive residuals Negative residuals
Example: Quantile Regression

50
Quantile regressions: Pros and Cons
Pros:
• Useful to assess risks and extreme events (tail)
• Forecasts capture both timing and incidence of
“stress” or “crisis” events
• The choice of p (size of the tail) can be interpreted
as capturing policy-makers’ risk tolerance

Cons:
• Time series applications require
substantial amounts of data (but we can
resort to panels)

51
 CoVaR

CoVaR between two For systemic

institutions, is the VaR surveillance, the
of one institution at CoVaR of institution i
some percentile q, is the VaR of the whole
conditional on the financial system
other institution being conditional on i being
at its q-VaR threshold at its q-VaR

52
 CoVaR (cont.)
• Recall: the q percent VaR of institution i is:
Pr ( X i ≤ VaRqi ) =
q

• Then, define the CoVaR of j|i as:

Pr( Xj ≤ CoVarqj|i | Xi = VaRqi) = q

• Institution i’s contribution to systemic risk is:

system| X i =VaRqi system| X i = Mediani
∆CoVaR = CoVaR
system|i
q q − CoVaR
q

53
 CoVaR Illustration
Step 1:
View the financial system as a portfolio of banks

Step 3:
Probability
0.2

Estimate bank’s i contribution to

distribution of market 0.15
systemic risk
value of Bank i and 0.1

the rest of the system Take the difference between

CoVaRVaR i=q-CoVaRVar i=50%
0.05

0
4
2 4
0 2
0

Step 2:
-2 -2
-4 -4

Compute CoVaR at with VaR of Bank i at the q%

and 50% levels
Compute the System VaR, conditional on bank i
being at its VaR at the q% confidence level
Compute the System VaR, conditional on bank i
being at its VaR at the 50% confidence level
54
 Using CoVaR and ΔCoVaR

• Can be used to infer the size of the

CoVaR losses to the system caused by
financial distress of one institution

• Measure institutions’ contribution

to systemic risk
ΔCoVaR • Can be the basis of policy (capital
charges on SIFIs)

55
 Questions Answered by
CoVaR and ΔCoVaR
• What is the VaR of the financial system if a
particular institution is under financial stress?
(CoVaR)

• How does the VaR of the system change when

a particular institution becomes financially
stressed? (ΔCoVaR)

56
 CoVaR Implementation
One alternative:
• Estimate two quantile regressions
α i + γ i M t −1 + ε ti
X ti =
α system + β system X ti + γ system M t −1 + ε tsystem
X tsystem =
• For institution i and the entire financial system
• Where:
o X stands for market value
o M is a set of macro controls (VIX, 3M repo rate-3M Tbill, change
in credit spread, equity returns, etc.) to capture the evolution of
the joint distribution over time
• Must estimate the first quantile regression twice: once for
q=1% and again for q=50%

57
 CoVaR Implementation (cont.)
The estimation of these two equations yields estimates for VaRi
and CoVaRi
The contribution of institution i to systemic risk is:

∆CoVaRti (q ) = CoVaRti (q ) − CoVaRti (50%)

= βˆ system (VaR i (q ) − VaR i (50%) )
t t

Adrian and Brunnemeier (2011) find that a bank’s VaR and its
contribution to CoVaR are only very loosely related. Focusing
only on VaR is misleading!
Also, higher leverage, maturity mismatch, and larger size predict
higher contribution to CoVaR in the future

58
 CoVaR and ΔCoVaR:
Implementation with Quantile regressions

System Changes in Market Value, in percent

1.00

0.80

0.60

0.40

0.20

0.00

-0.20
Quantile Regression q=0.10
-0.40
q%
-0.60 ΔCoVaR
-0.80
q%
-1.00
-4.00 -3.00 -2.00 -1.00 0.00 1.00 2.00 3.00 4.00
CoVaR
q% VaR of bank i 50% quantile for bank i Bank i

59
 Selected Methods

CoVaR

CoRisk

JoPD and Distress Dependence

Diebold-Yilmaz Measure

60
 CoRisk
• Proposed by IMF in the 2009 GFSR
• Similar to CoVaR but using CDS data instead
• Captures financial institutions’ co-dependence
risk arising from direct and indirect linkages
o Indirect linkages from exposure to common risk
factors such as reliance on wholesale funding
markets, similar portfolios, and so on

61
 CoRisk (cont.)
Uses the following quantile regression of CDS
spreads on some aggregate risk factors Rm,t

K
α +∑β
CDSi ,t = i
q
i
q ,m Rm ,t +β CDS j ,t + ε i ,t
i
q, j
m =1
How i’s CDS is affected
Controlling for aggregate by j’s CDS
risk factors Rm,t, incl:
VIX, LIBOR spread,
slope of US yield curve,
etc.

62
 CoRisk (cont.)
• Using the results of quantile regression:
K
α qi + ∑ β qi ,m Rm,t +β qi , j CDS j ,t + ε i ,t .
CDSi ,t =
m =1

• Define the CoRisk of i conditional on j as

i’s 95th percentile CDS when j is also at 95% percentile
(implied by the quantile regression)

 i K

 α 95% + ∑ β95%,m Rm ,t +β95%, j CDS j (95%) 
i i

CoRisk it , j 100 × 
= m =1
− 1 .
 CDSi (95%) 
 
 i’s 95th percentile CDS, unconditional 

• If positive, then j’s distress will raise i’s CDS when i is in distress
63
 CoRisk: Example
j
(source
banks)

i
(recipient BoA’s stress would
banks) Increase Bear Stearns’
CDS spread (under
distress) by 154bps.

64
CoRisk: Example (cont.)

Source: IMF GFSR,

April 2009.

65
 Selected Methods

CoVaR

CoRisk

JoPD and Distress Dependence

Diebold-Yilmaz Measure

66
 Joint Probability of Distress

Step 1:
View the financial system as a portfolio of banks
Step 4:
0.2
Estimate Financial Stability
PoD of Bank X 0.15
Measures.
0.1
Based on conditional
0.05 Probabilities of distress
0
4
2 4
0 2
0
-2 -2

PoD of Bank Y
-4 -4

Step 3:
Step 2: Recover the Financial System Multivariate Density
Estimate individual FIs It characterizes the implied asset values of the portfolio of FIs and
Probabilities of Distress the distress dependence among these FIs.
(PoDs)

67
 Distress Dependence Matrix
• The probability of distress (default) (PoD) for individual financial
institution can be estimated from equity prices, CDS spreads, etc.
• Given these estimates, a joint probability of distress (JPoD) can be
estimated.
o That is, f(FIA=1, FIB=1, FIC=0, …) is the probability that financial
institutions A and B are under distress but C is not
• From JPoD, conditional probability of distress can be obtained
o That is, f(FIA=1|FIB=1) is the probability that A is under distress
conditional on B’s distress.
• Output: Pairwise conditional probabilities of distress, called “distress
dependence matrix”

68
 Example: Distress Dependence Matrix

Source
banks

Recipient Source: IMF GFSR, April

banks 2009.

Before
Lehman’s
bankruptcy

Lehman’s default
would cause
significant
disruptions to the
system.
69
 JPoD and BSI: United States

Joint Probability of Distress (JPoD): Banking Stability Index:

Likelihood of common distress of all the FIs Expected number of FIs in distress given that
in the system. at least one became distressed.

3.5 0.025
1 2 34
1. Bear Stearns episode (3/11/08)
2. Lehman Bankruptcy and AIG bailout (9/15-16/08)
3.0 3. TARP I bill failure (9/30/08)
4. Global central bank intervention (10/8/08) 0.020

2.5

Bank Stability Index 0.015

2.0 (Number of banks, left scale)

1.5
0.010

1.0
JPoD
(Probability of default %, right scale) 0.005
0.5

0.0 0.000
Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08

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 Selected Methods

CoVaR

CoRisk

JoPD and Distress Dependence

Diebold-Yilmaz Measure

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 Diebold-Yilmaz Measure
• Diebold-Yilmaz (2009) measure, or “DY” measure: A
time-varying indicator of returns spillovers of institutions
o Uses market data on equity returns, and the volatility
of equity returns to estimate average contributions of
institutions to systemic risk using a VAR model
• It also has good in-sample forecasting properties for
systemic stress, but does not identify the underlying
spillover channels

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 Diebold-Yilmaz Measure
• Consider a vector of two variables xt=[x1t, x2t]’.
• The time-series behavior of xt is given by a
VAR(p) (vector autoregression) model
• Example with VAR(1)
Φ1 xt −1 + ε t .
xt = E[ε t ε t '] = Ω.

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 Diebold-Yilmaz Measure
• Under some conditions (“covariance
stationarity”), our VAR(1) can be written as the
following “moving average” representation:
=
xt +1 A0ut +1 + A1ut , E[ut +1ut +1 '] = I .
• Then, 1-step-ahead error vector is 2’s impact on 1

 a0,11 a0,12   u1,t +1 

et +1,t =xt +1 − xt +1,t =A0ut +1 =  ,
 a0,21 a0,22   u2,t +1 
• 1’s impact on 2
• where
xt +1,t = Φ1 xt .
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 Diebold-Yilmaz Measure
• Decomposing the error matrix provides a
measure of the proportion of cross-variance
shares (i.e., the spillovers)

• Namely, 1’s variance explained by innovations

of 2 is
a0,122 / (a0,112+ a0,122)
• The technique is essentially a variance
decomposition exercise

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 Diebold-Yilmaz Measure: Equity
Returns Example

Source: Diebold and Yilmaz (2009), p. 163.

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 Main takeaways
• Several methods have been recently proposed
to support macro-prudential surveillance
o Heavy use of market information
• Some of these methods can be used to
o Identify SIFIS
o Compute capital surcharges for systemic risk

• This is an area of ongoing research

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Thank you!

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