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The 2007-09 financial crisis spread to markets and institutions around the world, demonstrating why global systemic risk is a major concern in modern financial markets. Funding difficulties in one country can spill over to other countries via internationally active institutions, and the risk of dire financial outcomes can be transmitted across the globe. Because the crisis caused sudden and significant damage to people’s wealth and income, efforts to prevent a recurrence are imperative. The task will be a challenging one, however, owing to the complexity of modern financial markets, institutions, and regulatory regimes.
Wonk alert: technical content During the 2007-09 financial crisis, we saw that losses spread rapidly across institutions, threatening the entire financial system. Distress spread from structured investment vehicles to traditional deposit-taking banks and on to investment banks, and the failures of individual institutions had outsized impacts on the financial system. These spillovers were realizations of systemic risk—the risk that the distress of an individual institution, or a group of institutions, will induce financial instability on a broader scale, distorting the supply of credit to the real economy. In this post, we draw on our working paper “CoVaR”—issued in the New York Fed’s Staff Reports series—to do two things: first, propose a new measure of systemic risk and, second, outline a method that can help bring about the early detection of systemic risk buildup.
Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.
The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Asani Sarkar, all economists in the Bank’s Research Group.
The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.
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