In this paper we propose a framework for measuring and stress testing the systemic risk of a group of major financial institutions. The systemic risk is measured by the price of insurance against financial distress, which is based on ex ante measures of default probabilities of individual banks and forecasted asset return correlations. Importantly, using realized correlations estimated from high-frequency equity return data can significantly improve the accuracy of forecasted correlations. Our stress testing methodology, using an integrated micro–macro model, takes into account dynamic linkages between the health of major US banks and macro-financial conditions. Our results suggest that the theoretical insurance premium that would be charged to protect against losses that equal or exceed 15% of total liabilities of 12 major US financial firms stood at $110 billion in March 2008 and had a projected upper bound of $250 billion in July 2008.

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A framework for assessing the systemic risk of major financial institutions

Government bond spreads

We provide evidence that the movements in yield differentials between euro zone government bonds explained by changes in international risk factors – as measured by banking and corporate risk premiums in the United States – are more pronounced for bonds issued by Italy and Spain. Liquidity factors play a smaller role, so policies meant to increase financial market efficiency do not appear sufficient to deliver a ‘seamless’ bond market in the euro area. The risk of default is a small but important component of yield differentials movements, which signal market perceptions of fiscal vulnerability, impose market discipline on national fiscal policies, and may be reduced only by further convergence in debt ratios.

— Lorenzo Codogno, Carlo Favero and Alessandro Missale

Yield spreads on EMU government bonds

Over the last 20 years, some financial events, such as devaluations or defaults, have triggered an immediate adverse chain reaction in other countries -- which we call fast and furious contagion. Yet, on other occasions, similar events have failed to trigger any immediate international reaction. We argue that fast and furious contagion episodes are characterized by "the unholy trinity": (i) they follow a large surge in capital flows; (ii) they come as a surprise; and (iii) they involve a leveraged common creditor. In contrast, when similar events have elicited little international reaction, they were widely anticipated and took place at a time when capital flows had already subsided.

The unholy trinity of financial contagion

This paper provides a study of bond yield differentials among EU eurobonds issued between 1991 and 2002. Interest differentials between bonds issued by EU countries and Germany or the USA contain risk premia which increase with the debt, deficit and debt-service ratio and depend positively on the issuer's relative bond market size. Global investors' attitude towards credit risk, measured as the yield spread between low grade US corporate bonds and government bonds, also affects bond yield spreads between EU countries and Germany/USA. The start of the European Monetary Union had significant effects on the bond pricing of the member states.

Sovereign Risk Premia in the European Government Bond Market

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The Unholy Trinity of Financial Contagion

http://research.economics.unsw.edu.au/jmorley/gkm06.pdf

Detecting shift-contagion in currency and bond markets

This paper investigates why financial market crises often increase the interdependence between assets associated with different countries. Two sources of increased co-movement in asset returns are considered: (i) larger common shocks operating through standard cross-country linkages and (ii) changes in the structural transmission of shocks across countries, referred to as “shift-contagion”. To examine this issue, we develop a method for detecting shift-contagion with three notable features. First, parameters corresponding to the structural transmission of shocks across countries are identified in the presence of changing volatility regimes for the shocks. Second, the timing of changes in volatility is endogenously estimated instead of being exogenously assigned. Third, the countries in which crises originate need not be known or even included in the analysis. We apply the method to currency returns for developed countries and bond returns for emerging-market countries.

This paper describes a corporate sector vulnerability indicator, the expected number of defaults (END), based on the joint occurrence of defaults among a number of firms and/or institutions. The END indicator is general enough to assess systemic risk in the corporate and financial sectors, as well as systemic sovereign risk; and is also forward looking as it is constructed using information implied by financial securities prices. Using equity prices and balance-sheet data, we calculate the END to assess systemic risk in the corporate sector in Korea, Malaysia, and Thailand. We also discuss how the END systemic risk indicator overcomes some of the shortcomings of other vulnerability indicators.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID876385_code542089.pdf?abstractid=876385&mirid=5&type=2

The End: A New Indicator of Financial and Nonfinancial Corporate Sector Vulnerability

The aims of this study are to examine how liquidity in the Government of Canada securities market has evolved over the 1990s and to determine what factors influence the level of liquidity in this market, with some comparisons to the U.S. Treasury securities market. We find empirical support for the hypothesis that an increase in […]

/pdf/liquidity-of-the-government-of-canada-securities-market-3x2h576pb2.pdf

Liquidity of the Government of Canada Securities Market: Stylized Facts and Some Market Microstructure Comparisons to the United States Treasury Market

The authors present a detailed discussion of the Bank of Canada's framework for the implementation of monetary policy. As background, they provide a brief overview of the financial system in Canada, including a discussion of the financial services industry and the money market.

/pdf/the-implementation-of-monetary-policy-in-canada-1lazvx3ycs.pdf

Toni Gravelle

Papers

Detecting shift-contagion in currency and bond markets

Detecting shift-contagion in currency and bond markets

The End: A New Indicator of Financial and Nonfinancial Corporate Sector Vulnerability

Liquidity of the Government of Canada Securities Market: Stylized Facts and Some Market Microstructure Comparisons to the United States Treasury Market

The Implementation of Monetary Policy in Canada