An early warning tool for measuring the build up of systemic risks in banks and financial systems

This paper develops, analyses and implements an early warning tool for systemic risk in banks and financial entities. The tool is based on a refined approach to stress testing. Calculations performed on Australian bank data are shown to predict past distres. Risk is measured as a function of expected capital shortfall in individual firms. A simple model of regulatory capital is assumed. Systemic risk is shown to be driven by the size and leverage of balance sheets and interdependence between firms. Firm balance sheets are modelled using publicly available information and assumed to depend on market returns. Model refinements using more comprehensive information and practical implementation are also discussed