Market-implied systemic risk and shadow capital adequacy

Staff working papers set out research in progress by our staff, with the aims of encouraging comments and debate.
Published on 13 September 2019

Staff Working Paper No. 823

Somnath Chatterjee and Andreas A Jobst

This paper presents a forward-looking approach to measure systemic solvency risk using contingent claims analysis (CCA) as a theoretical foundation for determining an institution’s default risk based on the uncertainty in its asset value relative to promised debt payments over time. Default risk can be quantified as market-implied expected losses calculated from integrating equity market and balance sheet information in a structural default risk model. The expected losses of multiple banks and their non-parametric dependence structure define a multivariate distribution that generates portfolio-based estimates of the joint default risk using the aggregation technique of the Systemic CCA framework (Jobst and Gray, 2013). This market-implied valuation approach ('shadow capital adequacy') endogenises bank solvency as a probabilistic concept based on the perceived default risk (in contrast to accounting-based prudential measures of capital adequacy). The presented model adds to the literature of analytical tools for estimating market-implied systemic risk by augmenting the CCA approach with a jump diffusion process of asset changes to inform a more comprehensive and flexible assessment of common vulnerabilities to tail risks of the four largest UK commercial banks.

PDFMarket-implied systemic risk and shadow capital adequacy

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