Banking Balance Sheet Channel of Systemic Risk

Abstract

The role of the banking balance sheet as the source and transmitter of systemic risk is explored. We find that the key balance sheet channels of systemic risk are; (i) bank capital structure choice, (ii) interconnectedness and interdependencies among firms, (iii) correlations of asset composition and returns and; (iv) behavioral determinants that affect the choices of bank managers. Furthermore, we argue that the source of systemic risk lies with the endogenous risk of the banking balance sheet. We discuss the challenges in managing and measuring endogenous and systemic risk. Considering the strong evidence that book values of leverage are key state variables, we suggest new methods to manage and measure systemic risk.