Risk Assessment for Banking Systems

TLDR

Risk assessment is performed at the system level rather than on individual banks. The study proposes a new approach to assess the financial stability of an entire banking system by combining modern risk‑management tools with a network model of inter‑bank loans. The authors apply this combined model to a unique dataset of all Austrian banks. Correlation in banks’ asset portfolios dominates systemic risk, contagion is rare but potentially devastating, low bankruptcy costs and efficient crisis resolution limit impact, the required lender‑of‑last‑resort funds are surprisingly small, and increased inter‑bank diversification does not necessarily reduce contagion risk.

Abstract

We propose a new approach to assess the financial stability of an entire banking system using standard tools from modern risk management in combination with a network model of inter-bank loans. Rather than looking at banks individually, we analyze risk at the level of the banking system as a whole. We apply our model to a unique dataset of all Austrian banks. We find that correlation in banks' asset portfolios dominates contagion as the main source of systemic risk. Contagion occurs rarely but can wipe out a major part of the banking system. Low bankruptcy costs and an efficient crisis resolution policy are crucial to limit the system wide impact of contagious default events. We compute the "value at risk" for a lender of last resort and find the necessary funds to prevent contagion to be surprisingly small. More diversification in the inter-bank market does not necessarily reduce the risk of contagion.