Econometric modeling of systemic risk: going beyond pairwise comparison and allowing for nonlinearity

Jalal Etesami, Ali Habibnia and Negar Kiyavash

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: Financial instability and its destructive effects on the economy can lead to financial crises due to its contagion or spillover effects to other parts of the economy. Having an accurate measure of systemic risk gives central banks and policy makers the ability to take proper policies in order to stabilize financial markets. Much work is currently being undertaken on the feasibility of identifying and measuring systemic risk. In principle, there are two main schemes to measure interlinkages between financial institutions. One might wish to construct a mathematical model of financial market participant relations as a network/graph by using a combination of information extracted from financial statements like the market value of liabilities of counterparties, or an econometric model to estimate those relations based on financial series. In this paper, we develop a data-driven econometric framework that promotes an understanding of the relationship between financial institutions using a nonlinearly modified Granger-causality network. Unlike existing literature, it is not focused on a linear pairwise estimation. The method allows for nonlinearity and has predictive power over future economic activity through a time-varying network of relationships. Moreover, it can quantify the interlinkages between financial institutions. We also show how the model improve the measurement of systemic risk and explain the link between Granger-causality network and generalized variance decompositions network. We apply the method to the monthly returns of U.S. financial Institutions including banks, broker and insurance companies to identify the level of systemic risk in the financial sector and the contribution of each financial institution.

Keywords: systemic risk; risk measurement; financial linkages and contagion; nonlinear granger causality; directed information graphs (search for similar items in EconPapers)
JEL-codes: C14 C51 D8 D85 G1 G14 G21 G28 G31 (search for similar items in EconPapers)
Pages: 28 pages
Date: 2017-03-23
New Economics Papers: this item is included in nep-ban, nep-cfn, nep-ecm, nep-net and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:70769

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