Banking systemic vulnerabilities: A tail-risk dynamic CIMDO approach

• This study provides an early-warning measure of banks’ systemic vulnerabilities, estimates systemic credit risk, and forecasts it out of sample.
• It is applied to a set of European banking groups and their affiliates in Luxembourg.
• The framework contributes to the macroprudential literature with a method to monitor systemic credit risk in advance over a couple of years.
• The framework also allows measuring the other two sources of systemic risk, i.e., systemic risk due to common distress and to contagion.
• The methodology links the systemic risk measures with the state of the economy to extract its driving forces and thus facilitates policy decisions.

This study proposes a novel framework which combines marginal probabilities of default estimated from a structural credit risk model with the consistent information multivariate density optimization (CIMDO) methodology and the generalized dynamic factor model (GDFM) supplemented by a dynamic t-copula. The framework models banks’ default dependence explicitly and captures the time-varying non-linearities and feedback effects typical of financial markets. It measures banking systemic credit risk in the three forms categorized by the European Central Bank: (1) credit risk common to all banks; (2) credit risk in the banking system conditional on distress on a specific bank or combinations of banks; and (3) the buildup of banking system vulnerabilities over time which may unravel disorderly. In addition, the estimates of the common components of the banking sector short-term and conditional forward default measures contain early warning features, and the identification of their drivers is useful for macroprudential policy. Finally, the framework produces robust out-of-sample forecasts of the banking systemic credit risk measures. This paper advances the agenda of making macroprudential policy operational.