Analyzing Systemic Risk in the European Banking System: A Portfolio Approach.∗

This paper proposes a new method to measure and monitor the risk in a banking system. Standard tools that regulators require banks to use for their internal risk management are applied at the level of the banking system to measure the risk of a regulator’s portfolio of banks. Using a sample of European banks from 1997 until 2003, we estimate the dynamics and correlations between bank asset portfolios. To obtain measures for the risk of a Europe wide portfolio of banks, we model the individual liabilities a European regulator would have to face to each bank as contingent claims on the bank’s assets. The portfolio aspect of the regulator’s liability is explicitly considered and the methodology allows a comparison of sub-samples from different countries. We obtain empirical results on the correlation of asset values in our sample. Secondly we obtain quantifications of expected shortfall in the banking system, i.e. about the amount that would be neccessary to push one or more insolvent institutions above the default threshold. This number is interesting to give estimates of the amounts a European regulator might have to be ready to inject into the system. Thirdly we analyze risk contributions of individual regions to the European banking system and explain these contributions with individual bank characteristics. JEL-Codes: C15, E53, G21