Measuring Systemic Risk

We present an economic model of systemic risk and show that each financial institution's contribution to systemic risk can be measured as its systemic expected shortfall (SES), i.e., its propensity to be undercapitalized when the system as a whole is undercapitalized. SES increases in the institution's leverage and its marginal expected shortfall (MES), i.e., its losses in the tail of the system's loss distribution. Institutions internalize their externality if they are "taxed" based on their SES. We demonstrate empirically the ability of components of SES to predict emerging systemic risk during the financial crisis of 2007-2009, in particular, (i) the outcome of stress tests performed by regulators; (ii) the decline in equity valuations of large financial firms in the crisis; and, (iii) the widening of their credit default swap spreads