Latent fragility: Conditioning banks' joint probability of default on the financial cycle

Paul Bochmann, Paul Hiebert, Yves Schüler and Miguel A. Segoviano

Journal of International Money and Finance, 2024, vol. 146, issue C

Abstract: We propose the CoJPoD, a novel framework explicitly linking the cross-sectional and cyclical dimensions of systemic risk. In this framework, banking sector distress in the form of the joint probability of default of financial intermediaries (reflecting contagion from both direct and indirect interconnectedness) is conditioned on the financial cycle (reflecting the buildup and unwinding of system-wide balance-sheet leverage). An empirical application to large systemic banks in the euro area, US and UK illustrates how the unraveling of excess leverage can magnify banking sector distress, including during the 2023 US banking sector turmoil. Capturing this dependence of banking sector distress on prevailing financial imbalances can enhance risk surveillance and stress testing alike. An empirical signaling exercise confirms that the CoJPoD outperforms the individual capacity of either its unconditional counterpart or the financial cycle in signaling financial crises – particularly at their onset – suggesting scope to increase the precision with which macroprudential policies are calibrated.

Keywords: Systemic risk; Financial crises; Portfolio credit risk; Multivariate density optimization; Financial cycle (search for similar items in EconPapers)
JEL-codes: C19 C54 E58 G01 G21 (search for similar items in EconPapers)
Date: 2024
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Working Paper: Latent fragility: conditioning banks’ joint probability of default on the financial cycle (2022)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:146:y:2024:i:c:s0261560624000949

DOI: 10.1016/j.jimonfin.2024.103107

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