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Risk-Factor Portfolios and Financial Stability

Economic Research Institute (82-2-759-5466) 2010.02.05 3899

This paper defines a risk-stability index (RSI) that takes into account the
extreme dependence structure and the conditional probability of joint failure
(CPJF) among risk factors in a portfolio. In combination, both the RSI and CPJF
provide a valuable tool for analyzing risk from complementary perspectives;
thereby allowing the measurement of (i) common distress of risk factors in a
portfolio, (ii) distress between specific risk factors, and (iii) distress to a portfolio
related to a specific risk factor. With an application to a financial system comprised
of 18 banks from around the world, the results herein show that financial stability
must be viewed as a continuum, since risk varies from period to period. The riskstability
index indicates that U.S. banks tend to cause the most stress to the global
financial system (as defined herein), followed by Asian and European banks. The
results also show that Asian banks seem to experience the most persistence of
distress, followed by U.S. and European banks. The panel VAR results show that
monetary policy should "lean against the wind", since it has a significant effect in
reducing the (potential) instability of a financial system.

I. Introduction
II. Measures of Dependence
III. Distress Dependence Matrix and CPJF
IV. Distress to Financial System Linked to a Specific Bank
V. Directionality of Contagion and Persistence
VI. VAR Analysis
VII. Conclusion
Appendix A
Appendix B