Market-based systemic risk metrics ‘crucial’ for supervisors

Measures of systemic risk based on market indicators show “substantial and robust predictive power” ahead of financial crises in the US, making them a “crucial” tool for supervisors, new research finds.

Viral Acharya, Markus Brunnermeier and Diane Pierret evaluate four measures of systemic risk, each based on US financial firms’ stock return co-movements with market- or sector-wide returns under stress. They test the metrics on data from 1927 to 2023.

The results – published in a working paper by the US National Bureau of Economic Research – show the systemic risk measures are effective at explaining the “cross-section of market outcomes”, or how stress spreads between firms. The measures also have a “time-series component”, meaning they are useful as early warning indicators of a potential financial crisis. Additionally, they can be used to predict how outcomes in the banking sector will spill over to the real economy.

“Our findings highlight, therefore, that market-based systemic risk measures should be a crucial part of the toolbox for macro-prudential and supervisory assessments of the financial sector,” the authors say.

In contrast to the accounting-based measures widely used by supervisors, the systemic risk metrics are not backward-looking, as they are based on current stock market prices. The authors say reliance on accounting and regulatory ratios before the global financial crisis created a “misleading illusion” that banks were well capitalised. They suggest their metrics would be a useful complement to other forward-looking tools, such as stress tests.