Analyzing Systemic Risk in the European Banking

System: A Portfolio Approach.

Helmut Elsinger

University of Vienna
Department of Business Studies
Alfred Lehar

University of Vienna
Department of Business Studies
Martin Summer

Oesterreichische Nationalbank
Economic Studies Division
February 27, 2004

We would like to thank Nyeong Lee for valuable research assistance. Martin Summer thanks the
Bank of England and the London School of Economics for their hospitality during the work on this
paper. The views and ndings of this paper are entirely those of the authors and do not necessarily
represent the views of Oesterreichische Nationalbank.

Br unner Strasse 72, A-1210 Wien, Austria, e-mail: helmut.elsinger@univie.ac.at, Tel: +43-1-4277
38057, Fax: +43-1-4277 38054

Corresponding author, Br unner Strasse 72, A-1210 Wien, Austria, e-mail: alfred.lehar@univie.ac.at,
Tel: +43-1-4277 38077, Fax: +43-1-4277 38074

Otto Wagner Platz 3, A-1011 Wien e-mail: martin.summer@oenb.co.at, Tel: +43-1-404207212,

Fax: +43-1-404207299
Abstract
This paper proposes a new method to measure and monitor the risk in a bank-
ing system. Standard tools that regulators require banks to use for their internal
risk management are applied at the level of the banking system to measure the
risk of a regulators portfolio of banks. Using a sample of European banks from
1997 until 2003, we estimate the dynamics and correlations between bank asset
portfolios. To obtain measures for the risk of a Europe wide portfolio of banks,
we model the individual liabilities a European regulator would have to face to
each bank as contingent claims on the banks assets. The portfolio aspect of the
regulators liability is explicitly considered and the methodology allows a compar-
ison of sub-samples from dierent countries. We obtain empirical results on the
correlation of asset values in our sample. Secondly we obtain quantications of
expected shortfall in the banking system, i.e. about the amount that would be
neccessary to push one or more insolvent institutions above the default threshold.
This number is interesting to give estimates of the amounts a European regulator
might have to be ready to inject into the system. Thirdly we analyze risk contri-
butions of individual regions to the European banking system and explain these
contributions with individual bank characteristics.
JEL-Codes: C15, E53, G21
2
1 Introduction
The European banking system has recently been confronted with a rapidly changing
environment. The establishment of EMU and the second Banking Directive in the EU
have transformed the institutional framework for European banks considerably.
1
Global
integration of nancial markets, ongoing nancial innovation and international compe-
tition have also radically changed the market environment in which banks operate. This
creates new challenges for supervisors as well. Basing risk assessment on the analysis of
individual institutions and national banking systems in isolation becomes particularly
questionable in such an environment.
To improve on the individual institution approach to banking supervision - which is
to a large extend current practice - we make a proposal for a risk assessment method
that takes a portfolio perspective. Furthermore to go beyond a national approach
we study the system of major, publicly traded European banks. We analyze banks at
a system level by taking correlations between individual bank asset risks explicitly into
account. Our method is designed such that it relies on publicly available information
only. It is therefore readily implementable for transeuropean institutions like the Euro-
pean Central Bank or for international organizations like the IMF and does not depend
on proprietary data of national supervisors.
Following Merton (1974), we interpret equity as a call option on a banks assets.
Using a time series of equity prices and balance sheet information, we estimate the
market value of a banks asset portfolio and its associated dynamics.
Our central idea is to look at the balance sheets of banks not individually (as it is done
in current supervision) but rather as a portfolio of balance sheets. To explore the threat
of a banking crisis, correlation between the values of individual banks asset portfolios is
the most important factor. In a banking sector with highly correlated asset portfolios,
the probability of multiple defaults is high, making positive correlation undesirable for
1
See Bikker and Wesseling (2003)
3
regulators. However, bank fragility is also inuenced by nancial soundness, because well
capitalized banks are able to absorb larger shocks, reducing the probability of failures,
and the volatility of the banks assets, as more volatile banks face a higher probability of
default.
To analyze the overall stability of the banking system the portfolio approach has an
important feature: It allows to estimate the probability of a systemic crisis, i.e., that a
certain fraction of nancial institutions (both in terms of numbers as well as in terms of
size) will default over a given time horizon. Our framework thus takes into account the
part of systemic risk, which arises from correlated asset portfolios.
2
The portfolio view has another attractive feature that is particularly interesting in the
context of European supervision. It allows us to analyze the present value of the expected
future shortfall at individual banks and in individual regions. Within the framework of
our model one can interpret the potential liabilities of the regulator as a portfolio of
put options on correlated assets. Using standard risk management techniques, we can
estimate the current value as well as the volatility of the regulators liability. Using
standard value-at-risk tools, the contribution of an individual bank or of a group of
banks to the volatility of a regulators liability can be derived. This allows to identify
the banks or bank groups with the highest contribution to systemic risk. Such an analysis
can help to shed light on potential conicts that can arise in the context of lender of
last resort lending in Europe, where the question of scal backup has not yet been really
resolved. If for instance an Italian bank with Spanish owners has lent to German rms
and receives liquidity assistance from the Italian central bank but subsequently turns out
to be insolvent there might be serious issues who picks up the scal bill. If the distressed
institution is conned in terms of ownership as well as activities to the national territory,
such conicts do not arise. To assess their potential severity our analysis of individual
2
The portfolio view developed here is similar to the work of Lehar (2003). Our methodology can by
construction not capture second round eects of bank insolvencies that come from mutual interbank
credit exposures. Such an analysis requires detailed portfolio information which is usually not publicly
available. From results in Elsinger, Lehar, and Summer (2003) we furthermore know that the correlation
factor is far more important for the probability of bank insolvencies than domino eect insolvencies.
4
contributions to the systems risk exposure as a whole can be helpful.
Our main ndings can be grouped into three categories. We obtain some empirical
results on the correlation of asset values in our sample. Secondly we obtain quanti-
cations of expected shortfall in the banking system, i.e. about the amount that would
be necessary to push one or more insolvent institutions above the default threshold.
This number is interesting to give estimates of the amounts a European regulator might
have to be ready to inject into the system. Thirdly we analyze risk contributions of
individual regions to the European banking system and explain these contributions with
individual bank characteristics using a regression. As far as correlation is concerned we
nd that the median correlation of pairs of asset values is positive for the whole sample
period. An analysis of correlation of the bank asset values in dierent regions with the
entire bank assets in the European banking system reveals that the correlations become
stronger and more alligned between regions after the introduction of the Euro. Analyz-
ing the expected shortfall a European regulator might face we nd that the volatility
of expected shortfall is relatively low and below 10%. The regions in Europe that con-
tributed most to the risk of the system are the banks of Southern Europe and more
recently also the German banks. Banks in the Benelux countries and in the UK and
in northern Europe contributed very little to overall system risk. A regression analysis
of the individual bank risk contributions on their individual characteristics reveals that
the individual contribution depends positively on the return on average assets and on a
time trend and negatively on the book value of equity over total assets and on the banks
size. This increasing protability increases a banks contribution to overall risk whereas
the capitalization relative to the risky assets and its size decreases its contribution.
The paper is organized as follows: Section 2 describes our methodology. Section 3
describes our data sample. Section 4 analyzes the asset dynamics in detail. In Section
5 we look at the expected shortfall. The nal Section 6 concludes.
5
2 Methodology
A banks asset portfolio, consisting of loans, traded securities and many other items, is
re-nanced by debt and equity. If the value of the banks assets falls below the face value
of its debt, the bank is insolvent. For the estimation of insolvency risk, we therefore
need information on the future development of asset values and the face value of debt.
The problem is that the actual market value of assets is not directly observable.
3
What
is however observable is the market value of equity and the face value of debt for each
publicly traded bank. By viewing equity as a call option on the banks assets with a
strike price given by the face value of debt, we can make use on this information to get
an estimate of the market value of assets.
4
.
Denote by V the market value of the banks asset portfolio. Assume that the asset
value V of the bank follows a geometric Brownian motion with drift and volatility
dV = V dt + V dz (1)
Then equity E
t
can be seen as a call option on the banks assets with a strike price equal
to the current notional value of the banks debt B
t
, which is assumed to have a maturity
of T. We assume that all bank debt is insured and will therefore grow at the risk-free
rate.
6
The value of bank equity is then given by:
E
t
= V
t
N(d
t
) B
t
N(d
t

T) (2)
3
The dynamics of the market value of a banks liabilities is not important, as the bank is assumed
to default whenever the market value of the assets is below the promised payments, which is the book
value of liabilities.
4
This idea goes back to Black and Scholes (1973) and Merton (1973) and has been widely used
by academics and practitioners to price deposit insurance (Ronn and Verma (1986), Giammarino,
Schwartz, and Zechner (1989))
5
, or to assess credit risk (Ericsson and Reneby (2001), Vassalou and
Xing (forthcoming), and KMV corporations credit risk model). In the banking literature the Merton
framework is also used to evaluate the risk of individual banks over time (Gizycki and Levonian (1993)),
to assess the government subsidy to individual banks (Laeven (2002)), and to test for risk shifting
behavior of banks (Duan, Moreau, and Sealey (1992) and Hovakimian and Kane (2000))
6
Relaxing this assumption will not dramatically change the results, since the papers focus is not
on deposit insurance pricing. From the available data, we can not determine the amount of uninsured
debt for every bank.
6
where
d
t
=
ln(V
t
/B
t
) + (
2
/2)T

T
(3)
In the market one can observe a time series of equity prices E
t
and read the face
value of bank debt from the balance sheet. With assumptions on the other parameters
it is possible to solve Equation (2) for the market value of the banks asset portfolio
V
t
. We use the maximum likelihood estimator approach developed by Duan (1994) to
estimate the time series of asset values.
7
Given a sequence E = (E
t
), t {1 . . . m} of
equity values, the parameters (, ) of the asset value process in Equation (1) can be
estimated by maximizing the following likelihood function:
L(E, , ) =
m 1
2
ln(2)
m 1
2
ln
2

t=2
ln
_
N(

d
t
)
_

1
2
2
m

t=2
_
ln
_

V
t
()

V
t1
()
_

_
2
(4)
where

V
t
() is the solution of Equation (2) with respect to V and

d
t
corresponds to d
t
in Equation (3) with V
t
replaced by

V
t
().
For each year in the sample period the parameters of the asset process and are
estimated by assuming the maturity of debt T being equal to one year
8
and using a
rolling window of weekly market values of total equity E
t
of the last year (m = 52).
The procedure gives parameter sets for every bank and every year in the sample, which
can then be used to back out the asset value

V
t
for every given equity price. For each
year the weekly equity prices are used to obtain a time series of 52 corresponding asset
values. By connecting these over the dierent years of the sample we get a time series
7
Ronn and Verma (1986) estimate V by rst estimating the volatility of equity
E
. They assume a
linear relationship between asset volatility and
E
. This together with Equation 2 denes a system
of two equations, which can be solved for asset value V and asset volatility . Duan (1994), however,
points out that
E
is stochastic when one assumes a geometric Brownian motion for the asset price
process. Therefore
E
is hard to estimate and it is not linear in the asset volatility. The maximum
likelihood estimator used here overcomes this problem.
8
The maturity of debt can also be seen as the time until the next audit of the bank, because then
the regulator can observe V and close the bank, when it is under-capitalized. In the U.S. the FDIC
performs audits every 12 to 18 month.
7
Table 1: Summary statistics of all banks included in the sample
Country Number Total Assets(book values in mill, USD)
of banks Sample 2002 max (2002) median (2002) min (2002)
AUSTRIA 7 128,968 90,285 6,346 1,201
BELGIUM 5 1,411,762 498,910 272,119 32,745
DENMARK 38 266,040 217,249 349 45
FINLAND 3 15,195 13,275 1,769 150
FRANCE 34 1,811,056 866,080 3,779 13
GERMANY 14 1,948,694 751,643 35,259 493
GREECE 10 181,620 55,250 15,952 1,293
IRELAND 5 238,157 91,155 36,111 6,441
ITALY 28 1,437,691 328,618 13,214 712
LUXEMBOURG 4 77,950 44,861 16,425 240
NETHERLANDS 6 1,384,378 739,972 8,630 9
PORTUGAL 5 167,218 66,063 28,719 5,993
SPAIN 14 846,625 373,495 7,825 1,042
SWEDEN 4 612,465 253,488 127,532 103,911
UNITED KINGDOM 36 2,630,030 686,533 1,801 57
Total 213 13,157,854
of asset values for all banks over the entire sample period.
3 Sample
We have included data on 324 EU banks in our sample. The accounting data are from
Bankscope whereas the market values have been collected from Datastream. Equity
prices are recorded on a weekly basis from January 1992 until December 2002 and
balance sheet information is collected annually starting in 1996. We deleted all banks
for which less than three years of data was available (111 banks).
The largest bank in the sample BNP Paribas has assets of USD 811 billion,
the smallest bank has USD 9 million, and the median bank size is USD 4,8 billion.
Table 1 shows summary information for the included banks. For parts of our analysis
8
we have grouped banks in six dierent regions: Benelux (Netherlands, Belgium, Lux-
embourg), France, UK & IR (United Kingdom and Ireland), DE & AT (Germany and
Austria), Southern Europe (Greece, Italy, Portugal, and Spain), and Scandinavia (Den-
mark, Finland, and Sweden). Appendix A contains additional summary statistics of
bank accounting variables used in the subsequent analysis.
4 Dynamics of bank asset values
With the methodology explained in Section 2, it is possible to extract a time series
of market values of bank assets. To measure the correlations and volatilities of the
banks portfolios, for each week in the sample period a variance- covariance matrix
t
of the asset-returns is estimated using a simple exponentially weighted moving average
(EWMA) model with a decay factor of 0.94
9
The covariance
ij,t
at time t between
the asset portfolios of bank i and j are estimated by

ij,t
=
ij,t1
+ (1 ) ln
_
V
i
t
V
i
t1
_
ln
_
V
j
t
V
j
t1
_
(5)
Figure 1 plots the correlations between bank asset portfolios over the sample period.
10
The asset correlations give superior information compared to equity correlations as they
are not inuenced by changes in the capital structure. For the whole sample the median
9
The EWMA model was chosen because it is used in the RiskMetrics framework, which is a standard
in market risk management. Since the time series is relatively short, it is hard to evaluate alternative
volatility models and identify the best tting one. For this reason the decay factor was also chosen as
in the RiskMetrics set- up. Following the RiskMetrics specication I also neglect the mean return. The
mean return for the asset portfolio is quite small, on average 0.0014 for the whole sample. Including
the mean does not signicantly change results. For robustness a simple equally weighted 24 month
moving average was also tested but the results were very similar. One could also use the estimate
from equation (4) for bank volatility. This volatility is equal to a simple moving average (taken over
the last 24 month) at the end of every scal year. I did not use this measure for two reasons: rst, it
corresponds to the simple average at the end of every scal year, and the results of the simple average
are similar to the EWMA model. Second, there is just one estimate available for every year and the
volatility would have to be assumed constant during that year and then jump to a new level.
10
Correlations in market values of liabilities do not have to be considered here. The focus of correla-
tions of asset values is consistent with the theoretical assumptions of the model, as default is assumed
to occur when the market value of the banks assets is below the face value of the liabilities.
9
Figure 1: Weekly correlation estimates between banks from Jan. 1997 until Dec. 2002.
From all pair wise correlations, the median correlation as well as the 10% and the 90%
quantile are shown.
correlation was positive for the whole time period. It was declining until the beginning
of 1999 where the median correlation was close to zero. Note that during that period
the distance between the 10% and the 90% quantile of the correlations was growing. In
early 1999 the median correlation began to increase. It reached its peak of 38% at the
end of 2000. In the following two years the level decreased quite steadily to 16%.
In Figure 2 we display the estimates of correlations of bank asset values in dierent
regions with the entire asset portfolio of banks across Europe. The asset portfolios in
the regions are value weighted. Regional groups are as dened in Section 3.
The graphic at the top of Figure 2 shows that the correlations for the rst three
regions. We see that correlation becomes more aligned and stronger across all three
regions displayed in the graph soon after the introduction of the Euro. Whereas the UK
10
and Ireland had a strong correlation of asset values during the entire period. Scandinavia
and and the region consisting of Germany and Austria show a small correlation before
1998. A similar pattern can be observed for the second group where we see increased
correlation after the Euro introduction. While the Benelux banks and the banks of
southern Europe had a fairly high correlation throughout the sample period, France has
a low correlation during the rst year of the Euro introduction. Finally the last chart
shows the correlations of countries outside the Eurozone with the asset value of the
European banking portfolio. While correlations increased recently only the UK had a
persistent high correlation with the overall European asset values.
Figure 3 shows weekly estimates of annual volatilities of banks asset portfolios from
January 1997 until December 2002. The graph shows the median volatilities as well as
the 10% and the 90% quantiles of the volatility distribution. The median volatility of
bank asset values is more or less constant over time. Even during the East Asian crises
in 1998 the median volatility remains unaected. The 90% quantile of the volatility
distribution shows however an increase during that period.
Data on the nancial soundness of the European banking sector are displayed in
Figure 4. The median capitalization ratio, which is measured as market value of assets
V over face value of debt B, is increasing over time, which is as one can see from the
sub-samples mainly driven by a moderate increase at the beginning of the sample
period and a decline since 2001. Comparing capitalization with a benchmark of 8%
(i.e. capitalization ratio 1.08), the median bank in the European banking system is
under-capitalized in terms of market values of assets.
5 Expected shortfall
From a regulators perspective it is interesting to look at the expected shortfall in the
banking system under his supervision. The expected shortfall is the present value of
the amount of debt that can not be covered by the assets of the bank in case of default
11
Figure 2: Weekly correlation estimates of the correlation of the value-weighted portfolio
of all bank assets in a given region to the portfolio of all bank assets held by European
Banks.
12
Figure 3: Weekly estimates of annual volatilities of banks asset portfolios from Jan. 1997
until Dec. 2002. The volatilities are on a monthly base, the median volatilities as well
as the 10% and the 90% quantiles of the volatility distribution are shown.
(i.e. max(B V, 0)). In the simple Merton (1977) framework, this is given by the value
of a put option. If all the debt is insured then the expected shortfall is equal to the
future liability of the deposit insurance, as the regulator must pay the dierence between
the face value of deposits and the proceeds from selling the banks assets at the market
value.
11
Previous studies such as Giammarino, Schwartz, and Zechner (1989) or Duan
and Simonato (2002) use the same methodology to compute the value of the deposit
insurance liability. Formally we compute the expected shortfall S
i
t
of bank i at time t
for a horizon of T years as the value of a put option
S
i
t
= B
i
t
N(d
t
+

T) V
i
t
N(d
t
) (6)
11
Note that in this analysis we do not distinguish between insured and uninsured bank debt
13
Figure 4: Capitalization ratios from Jan. 1997 until Dec. 2002. The ratio is computed
by dividing the market value of the banks assets by the face value of debt. The graph
shows the median capitalization ratio as well as the 10% and the 90% quantiles of the
distribution.
where B
i
t
is the face value of the banks debt, V
i
t
is the market values of the asset
portfolio, and d
t
is dened as in Equation (3). The expected shortfall for all banks the
sample is therefore S
t
=

i
S
i
t
. This measure will inform the deposit insurance agency
of the value of its liabilities. Figure 5 shows this future liability for the whole sample
of all banks. The expected shortfall varies considerably over time as one would expect
after looking at the time variations in bank asset volatility and in bank capitalization.
Because of this variation, the regulator might thus not only be concerned about the level
of the expected shortfall but also about its dynamics. In an economy with uncorrelated
bank portfolios a shock to the assets of one bank will increase the volatility of expected
shortfall of this bank directly but it will not aect costs due to failures of other banks.
In a low correlation banking system, in which the shocks to the bank asset portfolios are
14
Figure 5: The present value of the regulators expected shortfall for a holding horizon
of one year plotted from Jan. 1997 until Dec. 2002 (in million USD).
mainly idiosyncratic, the expected shortfall should be low. With highly correlated asset
portfolios a shock will again hit the regulator directly but will also adversely aect the
expected shortfall at other banks. Thus, high systemic risk in the banking system will
imply high volatility of expected shortfall.
It is thus important to look at the potential future shortfall in a banking system from
a portfolio perspective and not just at the level of individual banks. The regulators
portfolio can be dened at multiple levels. Deposit insurers and national regulators can
apply the methodology of this section to the banks under their supervision. Supra-
national institutions like the European Central Bank, the IMF or the BIS may want to
include banks from several countries in their analysis.
When we look at the regulators exposure to expected shortfall, we have a portfolio of
put options written on the individual banks asset portfolios. We can then use standard
methods from the risk management literature (see, e.g., Jorion (2000)) to compute the
volatility of the expected shortfall in the banking system.
15
Let
t
be the variance-covariance matrix of the returns on the banks asset portfolios,
an
t
the vector of partial derivatives (V
i
t
S
i
t
/V
i
t
). Then, using rst order terms, the
Dollar-volatility of the expected shortfall z
t
can be approximated by
12
:
z
t
=
_

t
(7)
To break down the contribution of an individual bank or a group of banks to the reg-
ulators risk exposure, we decompose the volatility of the expected shortfall using the
standard concept of component value at risk.
13
Dene

t
=
1
z
t
(
t

t
)

t
(8)
as the vector of contributions to the expected shortfall risk, where is the element-wise
product of two vectors. Due to the nice property that the sum of the elements of
t
is
equal to z
t
, the elements of this vector are the contributions of individual banks to the
overall volatility in expected shortfall. These contributions can also be negative, when
a bank reduces the risk of the regulators portfolio.
Figure 6 shows the volatility of the regulators expected shortfall in percent.
14
The
volatility is relatively low (in general below 10%), which is surprising given the fact that
the regulators portfolio consists of out of the money put options that are very sensitive
to changes in the underlying (i.e. the value of a banks asset portfolio). Maybe our
ndings are due to the fact that the European banking sector is not that integrated yet.
When we look at the dierent regions, we nd that banks in Belgium, the Netherlands,
and Luxembourg contribute almost nothing to the risk of the European banking sys-
tem, whereas banks in Southern Europe contribute most. Recently German banks have
contributed a lot to the risk in the European banking sector, which reects the recent
12
By taking into account second order eects (Gamma), the accuracy of the value-at-risk estimation
could be enhanced. The simpler method used in this section is used because it allows us to compute
the contribution of each bank to the value-at-risk, which is used in the subsequent analysis.
13
see e.g. Jorion (2000) p. 159.
14
i.e. the graph shows
zt
St
for the whole sample and

jJ

j
t
St
for the subset of banks in sub-sample J
16
Table 2: Results from a xed eects panel regression explaining the contribution of an
individual bank to the risk of a global deposit insurers portfolio () standardized by the
banks liabilities (B). The explanatory variables are a time trend and return on average
assets (ROAA) the book value of equity over total assets in percent (EQBK) and the
log of the book value of total assets (SIZE).
Variable Coecient p-value
ROAA 0.003023 0.0016
EQBK -0.634585 0.0368
SIZE -0.210554 0.0003
T 0.013261 0.0376
Nobs 971
Cross Sections 213
Sample 1997-2002
R
2
0.220309
Prob(F-statistic) 0.000000
period of distress in the German banking sector.
To conclude this section we perform an econometric analysis of volatility contribu-
tions. We try to explain the contributions of banks by their characteristics. In order
to do so it is useful to standardize regulatory risk by a bank specic variable, which is
quite stable over time. Since deposit insurance premiums are often expressed per dollar
of insured deposits, the liabilities of the bank are a natural candidate to standardize the
risk of the deposit insurer as well.
Table 2 shows the results from a xed eects panel regression of
i
t
/B
i
t
on a time
trend (T), the return of average assets (ROAA), the book value of equity over total
assets in percent (EQBK), and the log of the book value of total assets (SIZE). We
include bank specic xed eects because the risk that a specic bank contributes can
also be inuenced by factors such as the location of the bank, the local regulators
policies, accounting and auditing standards or listing requirements.
The regression yields that an increasing protability makes banks riskier. Increasing
book values of equity over total assets, the prime instrument of bank regulation, and
increasing total assets lower the risk contributions of a bank to the global regulators
17
Figure 6: Volatility p.a. of the regulators expected shortfall from Jan. 1997 until
Dec. 2002. The graphs of the six sub-samples (UK and Ireland, Benelux, Germany and
Austria, France, Scandinavia, and Southern Europe) show the volatility contributions
of each sub-sample to the portfolio volatility.
18
portfolio. These ndings are robust under dierent specications. Less convincing is the
positive time trend that is mainly driven by the tremendous increase of riskiness in the
second half of 2002.
6 Conclusion
Traditional banking supervision relies mostly on the analysis of single institutions. The
idea behind this approach and the current regulatory framework which is focused on
individual bank balance sheets is, that there is little insolvency risk in the banking
system as long as the default of individual banks is low. While individual institutions
are encouraged by regulators to take a portfolio perspective on their internal nancial
operations, regulators have not yet implemented this portfolio perspective at the level of
the banking system. They do not see the banks under their jurisdiction as a portfolio,
they do not consider correlations between them, and the ideas and tools of modern risk
management have not found their way into prudential banking supervision.
This paper closes this gap and attempts to measure risk at the level of the banking
system rather than at the level of individual banks using standard tools of modern risk
management similar to those applied by major banks in their internal operations. Our
method provides a forward looking risk assessment tool that is applicable in developed
nancial markets by the use of publicly available information only. The method is able
to study asset correlations, and the contribution of individual institutions to the overall
risk of the system.
We apply this method to the European banking system and get a couple of insights
into the systemic dynamics of bank asset values. Our rst set of results apply to cor-
relation of asset values. We nd that the median correlation between all possible pairs
of correlated asset values in our sample is positive over the whole sample period. They
decline until 1999 and reach a peak at the end of 2000. Studying the correlation of bank
asset values in dierent regions with the entire bank portfolio we nd that correlations
19
get stronger and more alligned after the introduction of the Euro. Our analysis of volatil-
ity reveals that the median asset value volatility was largely constant over the sample
period. Our analysis of soundness shows that European banks are under-capitalized in
terms of market values of assets. The nal set of results exploit the portfolio perspective
to study the volatility and the amount of expected shortfall for a European regulator
as well as the contributions of individual regions to the correlation of asset portfolios
and thus to the systems risk exposure. The volatility of expected shortfall is relatively
low and largely below 10%. The European regions that contribute most to the overall
risk of the system are southern Europe and recently also German banks. Finally we
regress individual bank characteristics on the contribution of banks to the risk of the
system and nd that protability is positively correlated with risk contribution whereas
the ratio of equity over total assets and the banks size are negatively correlated with
the banks risk contribution.
Clearly our results are only a rst step to analyze bank risk at a system level. The
attractive feature of our approach is that we take standard tools from risk management
that are applied daily within nancial institutions to the level of the banking system by
looking at banks as a portfolio of contingent claims of a regulator. Of course the method
gives only a coarse picture because it has to disregard non publicly traded banks and
inter-linkages. The analysis of inter-linkages usually requires a set of non public data
15
and are not readily integrated in the framework used here. We hope to make progress on
this line in future research. In a rst step, we believe that the approach presented here
should provide an attractive tool to institutions that are involved in nancial system
risk assessment but dont have full access to national supervisory data. The method
is applicable with publicly available informations and allows regulators to draw on all
the insights an techniques from modern portfolio theory and risk management in their
challenging task to keep a macro-prudential eye on the stability of an entire banking
system.
15
Elsinger, Lehar, and Summer (2003) develop a method that analyzes correlation of asset values and
inter-linkages within a dierent framework for the Austrian banking system.
20
References
Allen, Linda, and Anthony Saunders, 1993, Forbearance and valuation of deposit insur-
ance as a callable put, Journal of Banking and Finance 17, 629643.
Bikker, J.A., and A.T Wesseling, 2003, Intermediation, Integration and Internationali-
sation, Research Series Supervision no. 53, De Netherlandsche Bank.
Black, Fischer, and Myron Scholes, 1973, The pricing of options and corporate liabilities,
Journal of Political Economy 8, 16371659.
Duan, Jin-Chuan, 1994, Maximum Likelyhood Estimation using the Price Data of the
Derivative Contract, Mathematical Finance 4, 155167.
Duan, Jin-Chuan, Arthur F. Moreau, and C. Sealey, 1992, Fixed-rate deposit insurance
and risk-shifting behavior at commercial banks, Journal of Banking and Finance 16,
715742.
Duan, Jin-Chuan, and Jean G. Simonato, 2002, Maximum Likelihood Estimation of
Deposit Insurance Value with Interest Rate Risk, Journal of Empirical Finance 9,
109132.
Duan, Jin-Chuan, and Min-Teh Yu, 1999, Capital Standard, Forbearance and Deposit
Insurance Pricing under GARCH, Journal of Banking and Finance 23, 16911706.
Elsinger, Helmut, Alfred Lehar, and Martin Summer, 2003, Risk Assessment for Banking
Systems, Working Paper, University of Vienna.
Ericsson, Jan, and Joel Reneby, 2001, The Valuation of Corporate Liabilities: Theory
and Tests, mimeo, McGill University.
Giammarino, Ron, Eduardo Schwartz, and Josef Zechner, 1989, Market Valuation of
Bank Assets and Deposit Insurance in Canada, Canadian Journal of Economics 22,
109127.
Gizycki, Marianne C., and Mark Levonian, 1993, A Decade of Australian Banking Risk:
Evidence from Share Prices, Research Discussion Paper 9302, Reserve Bank of Aus-
trailia.
Hovakimian, Armen, and Edward J. Kane, 2000, Eectiveness of Capital Regulation at
U.S. Commercial Banks, 1985 to 1994, Journal of Finance 55, 451468.
Jorion, Philippe, 2000, Value-at-Risk. (McGraw-Hill) second edn.
Laeven, Luc, 2002, Banking Risks around the World - The Implicit Safety Net Subsidy
Approach, working paper, World Bank.
21
Lehar, Alfred, 2003, Implementing a Portfolio Perspective in Banking Supervision, Work-
ing Paper, University of Vienna.
Merton, Robert C., 1973, A Rational Theory of Option Pricing, Bell Journal of Eco-
nomics and Management Science 4, 141183.
Merton, Robert C., 1974, On the pricing of corporate debt: The risk structure of interest
rates, Journal of Finance 29, 449470.
Merton, Robert C., 1977, An analytic derivation of the cost of deposit insurance and
loan guarantees: An application of modern option pricing theory, Journal of Banking
and Finance 1, 311.
Merton, Robert C., 1978, On the cost of Deposit Insurance When There Are Surveillance
Costs, Journal of Business 51, 439452.
Ronn, E.I., and A.K. Verma, 1986, Pricing Risk-Adjusted Deposit insurance: An Option-
Based Model, Journal of Finance 41, 871895.
Ronn, E., and A. Verma, 1989, Risk-based Capital Adequacy Standards for a Sample of
43 Banks, Journal of Banking and Finance pp. 2129.
Vassalou, Maria, and Yuhang Xing, forthcoming, Default Risk in Equity Returns, Jour-
nal of Finance.
A Summary statistics of regression variables
The following table contains summary statistics of the included banks. Bank size (SIZE)
is measured as log of the book value of total assets measured in million US- Dollars,
Return on Average Assets (ROAA) as included in the Bankscope database and EQBK
is the book value of equity over total assets in percent.
22
Table 3: Summary statistics of all banks included in the sample
SIZE min 0.25 median 0.75 max mean stdev
Benelux 2.23 7.58 10.40 12.67 13.51 9.79 3.48
France 2.60 6.43 8.24 8.87 13.67 7.96 2.41
UK & IR 4.04 6.49 7.79 9.65 13.44 8.14 2.68
DE & AT 6.20 9.09 10.17 11.41 13.53 10.09 1.85
Southern Europe 6.57 8.38 9.46 10.51 12.83 9.54 1.60
Scandinavia 3.81 5.01 6.09 7.48 12.44 6.73 2.32
ROAA
Benelux -0.46 0.47 0.56 0.69 2.60 0.64 0.65
France 0.04 0.93 1.20 2.29 15.48 1.91 2.65
UK & IR -80.55 -15.43 -4.52 0.81 10.46 -8.72 15.33
DE & AT -0.21 0.13 0.25 0.41 1.06 0.27 0.26
Southern Europe -2.56 0.51 0.73 0.97 3.94 0.82 0.78
Scandinavia 0.08 0.74 1.06 1.28 3.73 1.13 0.63
EQBK
Benelux 0.03 0.03 0.04 0.06 0.99 0.14 0.26
France 0.02 0.07 0.12 0.23 0.91 0.19 0.20
UK & IR 0.04 0.07 0.64 0.84 0.97 0.50 0.37
DE & AT 0.01 0.02 0.04 0.05 0.06 0.04 0.01
Southern Europe 0.03 0.05 0.07 0.09 0.18 0.08 0.04
Scandinavia 0.04 0.07 0.11 0.13 0.94 0.12 0.13
Total Equity
Benelux 9.21 155.47 1642.67 12065.75 26756.22 6902.25 8824.46
France 6.93 108.93 454.45 840.75 30105.99 2118.48 6043.05
UK & IR 35.66 362.66 846.12 2776.81 52889.00 5001.32 11029.11
DE & AT 25.92 330.57 603.95 2123.91 27041.66 2875.66 6281.52
Southern Europe 80.70 276.63 878.27 2478.43 28231.71 2895.79 5336.32
Scandinavia 5.95 19.16 69.56 133.31 12442.02 864.31 2407.68
Total Assets
Benelux 9.28 3308.74 32745.30 320378.47 739971.67 191606.04 254990.68
France 13.43 621.52 3779.04 7105.44 866080.39 53266.36 172596.82
UK & IR 56.85 660.52 2414.10 15500.30 686533.00 69955.86 168275.00
DE & AT 493.02 8834.40 26152.90 90285.44 751643.40 98936.32 190343.50
Southern Europe 711.62 4348.52 12864.94 36846.15 373495.22 46195.68 84219.89
Scandinavia 44.97 150.49 440.37 1769.34 253488.30 19860.00 55943.38
Total Liabilities
Benelux 0.07 3153.27 31190.26 308312.73 713215.45 184703.79 246303.10
France 1.15 428.43 3221.48 6182.29 835974.39 51147.87 166568.78
UK & IR 2.50 78.74 388.61 14731.22 633644.00 64954.55 157700.72
DE & AT 467.10 8408.96 25822.33 87032.22 724601.74 96060.66 184186.07
Southern Europe 591.04 4066.53 12148.60 34616.12 345263.51 43299.90 79017.03
Scandinavia 9.76 129.83 366.38 1688.63 241046.28 18995.68 53560.30
23