Measuring the probability of a financial crisis

Abstract

When financial firms are undercapitalized, they are vulnerable to external shocks. The natural response to such vulnerability is to reduce leverage, and this can endogenously start a financial crisis. Excessive credit growth, the main cause of financial crises, is reflected in the undercapitalization of the financial sector. Market-based measures of systemic risk such as SRISK, which stands for systemic risk, enable monitoring how such weakness emerges and progresses in real time. In this paper, we develop quantitative estimates of the level of systemic risk in the financial sector that precipitates a financial crisis. Common approaches to reduce leverage correspond to specific scaling of systemic risk measures. In an econometric framework that recognizes financial crises represent left tail events for the economy, we estimate the relationship between SRISK and the financial crisis severity for 23 developed countries. We develop a probability of crisis measure and an SRISK capacity measure based on our estimates. Our analysis highlights the important global externality whereby the risk of a crisis in one country is strongly influenced by the undercapitalization of the rest of the world.