Asymmetric Systemic Risk

Available as: PDF

Modern bank regulation is based on the premise that risks spill over more easily from large banks to the banking system than vice versa. On the contrary, we document that this is not the case, and that the capacity to transmit risk is larger in the system-to-bank direction. We call this finding asymmetric systemic risk and explore the consequences and channels behind it.

We hypothesize that banks with different business models undertake activities that affect their contributions and exposures to the system differently. These differences create asymmetric (directional) linkages with the rest of the banking system that matter for individual bank stability. We capture this directionality by consistently comparing the flows of risk in the bank-to-system and system-to-bank direction. We find that banks with a stronger system-to-bank connection had a higher default risk during the global financial crisis (2008–09), and that the mechanism behind increased default risk runs through trading and asset risk, increasing the volatility of profits.

Our findings offer two important policy implications. Firstly, linkages in the financial system can be directional, and regulation should concentrate on imposing buffers on banks with positive net exposures, rather than just on large banks. Secondly, current bank supervision objectives can be achieved more efficiently if regulation focuses on preventing such net exposures, rather than buffering the default risks arising from them.