Measuring systemic risk with regime switching in tails

Xiaochun Liu ()

Economic Modelling, 2017, vol. 67, issue C, 55-72

Abstract: This paper motivates the importance of modeling nonlinearities in measuring systemic risk. I capitalize this motivation by generalizing the CoVaR approach proposed by Adrian and Brunnermeier (2016) to allow it switching between a high and a normal risk regime filtered from data.. Considering the U.S. large bank holding companies (BHCs), this paper shows that modeling regime changes in tails is capable of capturing both amplification and mean-reversion effects of an adverse shock to a bank's balance sheet on the banking system. Using the Kolmogorov–Smirnov test statistics with and without bootstrapping, I perform the significance test to identify systemically important financial institutions (SIFIs), and the stochastic dominance test to rank the identified SIFIs. The stochastic dominance test raises the concern that the CoVaR measure underestimates systemic risk contributions for SIFIs but overestimates for non-SIFIs. Finally, applying the BHCs' characteristics and housing market price to forecast the regime-switching systemic risk out-of-sample, I obtain from 4- and 8-quarter-ahead horizons a desirable countercyclical, forward-looking measure of systemic risk.

Keywords: Regime-switching CoVaR; Forward-looking systemic risk; Systemically important financial institutions; Stochastic dominance test; Countercyclical macroprudential policy; Bank systemic risk index (search for similar items in EconPapers)
JEL-codes: C21 G01 G21 G32 (search for similar items in EconPapers)
Date: 2017
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (15)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:67:y:2017:i:c:p:55-72

DOI: 10.1016/j.econmod.2016.09.015

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