Network Linkages to Predict Bank Distress

Building on the literature on systemic risk and financial contagion, the paper introduces estimated network linkages into an early-warning model to predict bank distress among European banks. We use multivariate extreme value theory to estimate equity-based tail-dependence networks, whose links proxy for the markets' view of bank interconnectedness in case of elevated financial stress. The paper finds that early warning models including estimated tail dependencies consistently outperform bank-specific benchmark models with- out networks. The results are robust to variation in model specification and also hold in relation to simpler benchmarks of contagion. Generally, this paper gives direct support for measures of interconnectedness in early-warning models, and moves toward a unified representation of cyclical and cross-sectional dimensions of systemic risk. JEL Classification: G21, G33, C54, D85

[1]  Peter Sarlin,et al.  Leading Indicators of Systemic Banking Crises: Finland in a Panel of EU Countries , 2014, SSRN Electronic Journal.

[2]  Camelia Minoiu,et al.  Crisis Transmission in the Global Banking Network , 2016, SSRN Electronic Journal.

[3]  Vineet Agarwal,et al.  Comparing the Performance of Market-Based and Accounting-Based Bankruptcy Prediction Models , 2006 .

[4]  V. S. Subrahmanian,et al.  Does Financial Connectedness Predict Crises?1 , 2013 .

[5]  M. Čihák,et al.  Determinants of Bank Distress in Europe: Evidence from a New Data Set , 2011 .

[6]  H. Shin,et al.  Liquidity Risk and Contagion , 2005 .

[7]  S. Battiston,et al.  Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic Risk , 2009 .

[8]  C. Borio,et al.  Asset Prices, Financial and Monetary Stability: Exploring the Nexus , 2002 .

[9]  Peter Sarlin,et al.  Macroprudential Oversight, Risk Communication and Visualization , 2014, SSRN Electronic Journal.

[10]  Peter Sarlin,et al.  Predicting Distress in European Banks , 2013, SSRN Electronic Journal.

[11]  Jean-Charles Rochet,et al.  Systemic risk, interbank relations and liquidity provision by the Central Bank , 2000 .

[12]  Asli Demirgüç-Kunt,et al.  Monitoring Banking Sector Fragility: A Multivariate Logit Approach with an Application to the 1996-97 Banking Crises , 1999 .

[13]  J. Tawn,et al.  Extreme Value Dependence in Financial Markets: Diagnostics, Models, and Financial Implications , 2004 .

[14]  Peter Sarlin,et al.  On policymakers’ loss functions and the evaluation of early warning systems , 2013 .

[15]  P. Hartmann,et al.  Asset Market Linkages in Crisis Periods , 2001, Review of Economics and Statistics.

[16]  R. Huisman,et al.  Tail-Index Estimates in Small Samples , 2001 .

[17]  Franklin Allen,et al.  Networks in Finance , 2008 .

[18]  Carmen M. Reinhart,et al.  The Twin Crises: The Causes of Banking and Balance-of-Payments Problems , 1996 .

[19]  Galina Hale,et al.  Crisis transmission through the global banking network , 2016 .

[20]  Stefan Straetmans,et al.  Banking System Stability: A Cross-Atlantic Perspective , 2005, SSRN Electronic Journal.

[21]  Janet E. Heffernan,et al.  Dependence Measures for Extreme Value Analyses , 1999 .

[22]  F. Longin,et al.  Extreme Correlation of International Equity Markets , 2000 .

[23]  Chanhyun Kang,et al.  Does Financial Connectedness Predict Crises? , 2013 .

[24]  Luc Laeven,et al.  How good is the market at assessing bank fragility? A horse race between different indicators , 2002 .

[25]  A. Ledford,et al.  Statistics for near independence in multivariate extreme values , 1996 .

[26]  A. Milne.  Distance to default and the financial crisis , 2014 .

[27]  Jing Yang,et al.  Network Models and Financial Stability , 2007 .

[28]  Kee-Hong Bae,et al.  A New Approach to Measuring Financial Contagion , 2000 .

[29]  Nikolaus Hautsch,et al.  Financial Network Systemic Risk Contributions , 2013 .

[30]  Markus K. Brunnermeier,et al.  Market Liquidity and Funding Liquidity , 2005 .

[31]  A. Demirguç-Kunt,et al.  The Determinants of Banking Crises in Developing and Developed Countries , 1998 .

[32]  Dieter Gramlich,et al.  SAFE: An Early Warning System for Systemic Banking Risk , 2011 .

[33]  Nikolaus Hautsch,et al.  Forecasting Systemic Impact in Financial Networks , 2013 .

[34]  M. Cropper,et al.  Sulfur Dioxide Control by Electric Utilities: What Are the Gains from Trade? , 1998, Journal of Political Economy.

[35]  P. Phillips,et al.  Testing the covariance stationarity of heavy-tailed time series: An overview of the theory with applications to several financial datasets , 1994 .

[36]  F. Diebold,et al.  UNIVERSITY OF SOUTHERN CALIFORNIA Center for Applied Financial Economics (CAFE) On the Network Topology of Variance Decompositions: Measuring the Connectedness of Financial Firms , 2011 .

[37]  Paul R. Kleindorfer,et al.  The Network Challenge: Strategy, Profit, and Risk in an Interlinked World , 2009 .

[38]  Jean Tirole,et al.  Illiquidity and All its Friends , 2010 .

[39]  Reint Gropp,et al.  Measurement of Contagion in Banks' Equity Prices , 2003, SSRN Electronic Journal.

[40]  Prasanna Gai,et al.  Complexity, concentration and contagion , 2011 .

[41]  Tue Tjur,et al.  Coefficients of Determination in Logistic Regression Models—A New Proposal: The Coefficient of Discrimination , 2009 .

[42]  G. Caldarelli,et al.  DebtRank: Too Central to Fail? Financial Networks, the FED and Systemic Risk , 2012, Scientific Reports.

[43]  M. Flannery.  Using Market Information in Prudential Bank Supervision: A Review of the U.S. Empirical Evidence , 1998 .

[44]  J. Wooldridge,et al.  Dynamic Conditional Beta , 2014 .

[45]  Jukka M. Vesala,et al.  Cross-Border Bank Contagion in Europe , 2006, SSRN Electronic Journal.

[46]  B. M. Hill,et al.  A Simple General Approach to Inference About the Tail of a Distribution , 1975 .

[47]  L. Glosten,et al.  On the Relation between the Expected Value and the Volatility of the Nominal Excess Return on Stocks , 1993 .

[48]  Markus K. Brunnermeier.  Deciphering the Liquidity and Credit Crunch 2007-08 , 2008 .

[49]  Comparing the Performance of Market-Based and Accounting-Based Bankruptcy Prediction Models , 2006 .