Systemic Contingent Claims Analysis

Book excerpt: The recent global financial crisis has forced a re-examination of risk transmission in the financial sector and how it affects financial stability. Current macroprudential policy and surveillance (MPS) efforts are aimed establishing a regulatory framework that helps mitigate the risk from systemic linkages with a view towards enhancing the resilience of the financial sector. This paper presents a forward-looking framework ("Systemic CCA") to measure systemic solvency risk based on market-implied expected losses of financial institutions with practical applications for the financial sector risk management and the system-wide capital assessment in top-down stress testing. The suggested approach uses advanced contingent claims analysis (CCA) to generate aggregate estimates of the joint default risk of multiple institutions as a conditional tail expectation using multivariate extreme value theory (EVT). In addition, the framework also helps quantify the individual contributions to systemic risk and contingent liabilities of the financial sector during times of stress.