Two business professors have come up with an ingenious way to measure the likelihood of a financial crisis by looking at an entire economy as if it were a failing bank.
Their analysis is based on RISK (pdf) an analytical tool designed to assess the strength of financial institutions during a prolonged market downturn. By aggregating SRISK across a country’s economy, Robert Engle, a Nobel laureate at NYU, and Tianyue Ruan of the National University of Singapore believe they can estimate the relationship between projected capital shortfalls and the likelihood of a financial crisis. Their work shines a light on the interconnected nature of the economy, reminding investors that potential danger is rarely isolated to a single country. Indeed, the risk of a domestic financial crisis largely depends on the financial situation of the rest of the world.
“Our approach is motivated by the observation that excessive credit growth, the main cause of financial crises, results in the undercapitalization of the financial sector”, write the professors in their to study (pdf), published yesterday (August 27) in Proceedings of the National Academy of Sciences (PNAS). “Market-based systemic risk indicators provide real-time monitoring of the emergence and progression of this weakness.”
In other words, by looking at a combination of stock market data and accounting liabilities (especially in financial services companies), it is possible to assess the chances of a crisis. The professors also found that the likelihood of a crisis was generally higher in global models than in single-country models, illustrating the interdependence of national economies.
Although the probability of a crisis in the United States seems low, this could change quickly, as evidenced by past experience. During CFA Institute Conference in November, Engle highlighted the importance of global collaboration to monitor and regulate risk. Although he doesn’t seem overly agitated about the prospects of another global crisis, Engle cautioned: “I think we have reason to be concerned. I leave you with that.
Additional information on the professors’ methodology and country-by-country results is available here.