Market-implied systemic risk and shadow capital adequacy

Somnath Chatterjee and Andreas Jobst ()

No 823, Bank of England working papers from Bank of England

Abstract: This paper presents a forward-looking approach to measure systemic solvency risk using contingent claims analysis (CCA) as a theoretical foundation for determining an institution’s default risk based on the uncertainty in its asset value relative to promised debt payments over time. Default risk can be quantified as market-implied expected losses calculated from integrating equity market and balance sheet information in a structural default risk model. The expected losses of multiple banks and their non-parametric dependence structure define a multivariate distribution that generates portfolio-based estimates of the joint default risk using the aggregation technique of the Systemic CCA framework (Jobst and Gray, 2013). This market-implied valuation approach (‘shadow capital adequacy’) endogenises bank solvency as a probabilistic concept based on the perceived default risk (in contrast to accounting-based prudential measures of capital adequacy). The presented model adds to the literature of analytical tools estimating market-implied systemic risk by augmenting the CCA approach with a jump diffusion process of asset changes to inform a more comprehensive and flexible assessment of common vulnerabilities to tail risks of the four largest UK commercial banks.

Keywords: Systemic risk; contingent claims analysis; jump diffusion; CoVaR; systemic expected shortfall; conditional tail expectation; capital adequacy (search for similar items in EconPapers)
JEL-codes: C61 C63 G01 G21 G28 (search for similar items in EconPapers)
Pages: 53 pages
Date: 2019-09-16
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cfn, nep-ore and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:0823

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