Measuring Systemic Risk in the Financial Sector in Denmark

Emil Nols√łe Leifsson

Student thesis: Master thesis

Abstract

Executive summary: This thesis presents an alternative approach that regulators can apply when measuring systemic risk. Instead of applying the more traditional bottom-up approach which seeks to ensure the robustness of the individual financial institutions this thesis applies a top-down approach that takes into account the interconnectedness of the financial institutions as well as their financial robustness. By applying a top-down approach this thesis looks to measure systemic risk as the propensity of a financial institution to be under-capitalized when the financial system as a whole is under-capitalized. The methodological approach used in this thesis is inspired by (Acharya, et al., 2010) and (Brownless & Engle, 2012), where certain modifications have been necessary in order to measure systemic risk in the financial sector in Denmark. Also, in order to take into account the possibility of capital savings and outside funding the model has been further extended. As a concrete case study this thesis measures systemic risk in the financial sector in Denmark during the time period 2006-2013. The systemic risk level is found to peak in 2011 reaching an estimated level of 624 billion DKK. Today (end of 2013), the systemic risk level is estimated to be 413 billion DKK, corresponding to roughly one-fifth of the annual GDP in Denmark. Even though the systemic risk level has decreased over the recent years it is still found to be approximately twice as large as it was before the 2007-2009 financial crisis. This case study holds 60 financial institutions that are still active or have been at some point during the time period considered. This thesis makes the following recommendations on how systemic risk can be reduced. Firstly, the leverage ratio of the financial institutions generally needs to be lowered through stricter capital requirement. Secondly, the capital requirements should be imposed by applying a non-uniform approach where larger and more interconnected financial institutions are given stricter capital requirements. Lastly, a countercyclical capital buffer should be imposed that forces financial institutions to put aside capital in good times to help withstand the financial pressure during bad times. The size of the countercyclical capital buffer should also be increased for larger and more interconnected financial institutions.

EducationsMSc in Advanced Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2013
Number of pages132