Systemic Contingent Claims Analysis: Estimating Market-Implied Systemic Risk

Abstract

The recent global financial crisis has forced a re-examination of risk transmission in the financialsector and how it affects financial stability. Current macroprudential policy and surveillance(MPS) efforts are aimed establishing a regulatory framework that helps mitigate the risk fromsystemic linkages with a view towards enhancing the resilience of the financial sector. This paperpresents a forward-looking framework ("Systemic CCA") to measure systemic solvency risk basedon market-implied expected losses of financial institutions with practical applications for thefinancial sector risk management and the system-wide capital assessment in top-down stresstesting. The suggested approach uses advanced contingent claims analysis (CCA) to generateaggregate estimates of the joint default risk of multiple institutions as a conditional tail expectationusing multivariate extreme value theory (EVT). In addition, the framework also helps quantify theindividual contributions to systemic risk and contingent liabilities of the financial sector duringtimes of stress.