Modeling Financial Sector Joint Tail Risk in the Euro Area

A. Lucas; B. Schwaab; X. Zhang

doi:10.1002/jae.2518

Modeling Financial Sector Joint Tail Risk in the Euro Area

A. Lucas, B. Schwaab, X. Zhang

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Abstract

We develop a novel high-dimensional non-Gaussian modeling framework to infer measures of conditional and joint default risk for numerous financial sector firms. The model is based on a dynamic generalized hyperbolic skewed-t block equicorrelation copula with time-varying volatility and dependence parameters that naturally accommodates asymmetries and heavy tails, as well as nonlinear and time-varying default dependence. We apply a conditional law of large numbers in this setting to define joint and conditional risk measures that can be evaluated quickly and reliably. We apply the modeling framework to assess the joint risk from multiple defaults in the euro area during the 2008-2012 financial and sovereign debt crisis. We document unprecedented tail risks between 2011 and 2012, as well as their steep decline following subsequent policy actions.

Original language	English
Pages (from-to)	171-191
Number of pages	21
Journal	Journal of Applied Econometrics
Volume	32
Issue number	1
Early online date	12 Apr 2016
DOIs	https://doi.org/10.1002/jae.2518
Publication status	Published - Feb 2017

Funding

We thank the associate editor, two referees, as well as conference participants at the Banque de France and SoFiE conference on \u2018Systemic risk and financial regulation\u2019, the Cleveland Fed and Office for Financial Research conference on \u2018Financial stability analysis\u2019, the European Central Bank, the FEBS 2013 conference on \u2018Financial regulation and systemic risk\u2019, LMU Munich, the 2014 SoFiE conference in Cambridge, the 2014 workshop on \u2018The mathematics and economics of systemic risk\u2019 at UBC Vancouver, and the Tinbergen Institute Amsterdam. Andr\u00E9 Lucas thanks the Dutch Science Foundation (NWO, grant VICI453-09-005) and the European Union Seventh Framework Programme (FP7-SSH/2007\u20132013, grant agreement 320270\u2014SYRTO) for financial support. The views expressed in this paper are those of the authors and they do not necessarily reflect the views or policies of the European Central Bank or the Sveriges Riksbank.

Funders	Funder number
University of British Columbia
Tinbergen Institute Amsterdam
European Central Bank
Seventh Framework Programme
Ludwig-Maximilians-Universität München
European Commission	320270
FP7-SSH/2007	320270—SYRTO
Nederlandse Organisatie voor Wetenschappelijk Onderzoek	VICI453-09-005

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Modeling Financial Sector Joint Tail Risk in the Euro Area

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