A simple indicator of systemic risk

Dilip K. Patro, Min Qi and Xian Sun

Journal of Financial Stability, 2013, vol. 9, issue 1, 105-116

Abstract: We examine the relevance and effectiveness of stock return correlations among financial institutions as an indicator of systemic risk. By analyzing the trends and fluctuations of daily stock return correlations and default correlations among the 22 largest bank holding companies and investment banks from 1988 to 2008, we find that daily stock return correlation is a simple, robust, forward-looking, and timely systemic risk indicator. There is an increasing trend in stock return correlation among banks, whereas there is no obvious correlation trend among non-banks. We also disaggregate the stock returns into systematic and idiosyncratic components and find that the correlation increases are largely driven by the increases in correlations between banks’ idiosyncratic risks, which give rise to increasing systemic risk. Correlation spikes tend to predict or coincide with significant economic or market events, especially during the 2007–2008 financial crisis. Furthermore, we show that stock return correlations offer a perspective on the level of systemic risk in the financial sector that is not already captured by default correlations. Stock return correlations are not subject to data limitations or model specification errors that other potential systemic risk measures may face. Therefore, we recommend that regulators and businesses monitor daily stock return correlations among those large and highly leveraged financial institutions to track the level of systemic risk.

Keywords: Systemic risk; Correlation; Stock returns (search for similar items in EconPapers)
JEL-codes: G01 G10 G18 G21 G28 (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (76)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:9:y:2013:i:1:p:105-116

DOI: 10.1016/j.jfs.2012.03.002

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