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Measuring the systemic risk in the South African and United States banking sectors
Foggitt, Gregory Malcolm
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Systemic risk can affect the entire global financial system and may therefore be one of the most important financial risks – yet it remains one of the least understood. The sub-prime crisis in 2008 illustrated how systemic risk in the financial sector of one country could spread to the financial sectors in other countries. The direct transfer of systemic risk was made possible by phenomena such as contagion and common shocks. It follows that the more interconnected a financial sector is, the more easily systemic risk would be spread. The failure of African Bank in 2014 and the subsequent intervention by the South African Reserve Bank (SARB) illustrated that the interconnectedness of the South African (SA) financial sector could potentially be a source of systemic risk, even though large levels of systemic risk are not an inherent part of the SA financial sector. When assessing systemic risk, the development level of the country, as well as its level of financial integration will need to be taken into account. As a result, the effective implementation of regulatory measures, such as the Basel capital requirements and other more country-specific items of legislation, should be based on an accurate, quantifiable measure of systemic risk. In order to quantify systemic risk, it can be defined as the capital shortfall an institution is likely to experience, conditional on the entire financial sector being undercapitalised. This propensity is referred to as the Systemic Risk Index (SRISK). A key component of SRISK is the Marginal Expected Shortfall (MES). This is calculated by taking into account conditional volatilities, Dynamic Conditional Correlations (DCCs) and tail expectations. This study applies a previously unused approach based on extreme value theory to model the tail expectations. The SRISK of the SA and United States (US) banking sectors is measured between 2001 and 2013. Additionally, the systemic risk transfer that took place over the period 2001 to 2014 from the US market to the SA market is measured by investigating potential contagion, volatility spillover effects, and the MES of the SA equity market as a hypothetical bank within the US equity market. Finally, a panel regression model is used to investigate which individual banking characteristics were the most significant determinants of systemic risk in SA and US banks over the period 2001 to 2013. The results show that the level of systemic risk in the US decreased following the sub-prime crisis, although the total contribution of the largest banks increased. Notwithstanding that the absolute levels of systemic risk did not increase, the relative contributions of the largest banks did. The panel regression model found that the most significant determinants of systemic risk in the US were the size of the bank, the stability of its funding source, and the bank’s degree of leverage. This increase in the systemic risk contributions of the large banks can therefore, most likely be attributed to their acquisition of a number of smaller banks. Furthermore, the panel regression results are in line with expected findings; however, the fact that the total financial sector systemic risk could remain relatively unchanged or even decrease, while the individual contributions of the largest banks increased, is worth questioning. The explanation for this could potentially be that capital deficits of large banks are being offset by the surpluses held by a number of smaller banks, therefore providing the illusion of decreased systemic risk. Contrastingly, the results for SA showed that the systemic risk of the entire financial sector was not particularly high for most of the period. However, there were significant spikes in the levels of systemic risk during periods of financial turmoil in countries apart from SA. Specifically, the stock market crash in 2002 and the sub-prime crisis in 2008. The highest systemic risk contribution during quiet periods was from Investec, the smallest bank dealt with in this study. However, during periods of financial turmoil, the contributions of other larger banks increased markedly. The implication of these spikes is that systemic risk levels may also be highly dependent on external economic factors, in addition to internal banking characteristics. Analyses were done to investigate the possibility of a direct transfer of systemic risk from the US to SA, but no significant evidence was found. The panel regression model for SA investigated the individual determinants of systemic risk and found that internal banking characteristics, such as the amount of market-based activities undertaken by a bank and its degree of leverage, were significant determinants of systemic risk. As for external factors, the levels of capital inflows were found to be a significant determinant of systemic risk. The implications of these results for regulations differ for the two economies. For the US, systemic risk may not have worsened in absolute terms, but the contributions of large banks have. A failure of one of these banks would therefore be likely to cause a financial crisis. Regulations that address the size, degree of leverage and the stability of the bank’s funding source will need to be addressed. For SA, the economic fundamentals of the country itself seem to have little effect on systemic risk. In fact, the systemic risk of the entire financial sector, as well as the individual banks within it, seems to be dependent on the stability of other financial sectors. The implication therefore, is that in addition to complying with individual banking regulations, such as Basel, and corporate governance regulations promoting ethical behaviour, such as King III, banks should always have sufficient capital reserves in order to mitigate the effects of a financial crisis in a foreign country and the subsequent outflow of capital. The use of worst-case scenario analyses (such as those in this study) could aid in determining exactly how much capital banks could need in order to be considered sufficiently capitalised during a financial crisis, and therefore safe from systemic risk