Estimating Systemic Risk in the International Financial System

This paper develops methods for assessing the probability of a systemic failure of the global banking system. We examine a sample of 334 banks (representing 80% of global bank equity) in 28 countries around global financial crises such as the Asian crisis and September 11, 2001. The maximum probability of a systematic failure is estimated as the maximum cumulative abnormal return experienced by the subset of banks not directly exposed to a negative shock. Across different crisis events, this maximum level is between 1%-12%. More precise point estimates of the likelihood of systemic failure are obtained from structural models. For example, maximum likelihood estimation of bank failure probabilities implied by equity prices suggests the Russian crisis induced about a 6% change in systemic bank failure. Also, we demonstrate that estimates of systemic risk can be obtained from default probabilities of banks that are implied in their equity option prices. The findings of low probabilities of a breakdown of the international financial system suggests that the distress of central bankers, regulators and politicians about such events may be overrated, and that policy intervention may be much less needed from a pure safety point of view.