Computing the Probability of a Financial Market Failure: A New Measure of Systemic Risk

DOI10.1007/S10479-022-05146-9MaRDI QIDQ6380912zbMATH OpenOpenAlexFDO

Authors Robert A. Jarrow, Philip Protter, Alejandra Quintos

Publication date 21 October 2021

Full work available at URL https://doi.org/10.1007/s10479-022-05146-9

Mathematics Subject Classification ID

Point processes (e.g., Poisson, Cox, Hawkes processes) (60G55) Financial markets (91G15) Financial networks (including contagion, systemic risk, regulation) (91G45)

Abstract: This paper characterizes the probability of a market failure defined as the default of two or more globally systemically important banks (G-SIBs) in a small interval of time. The default probabilities of the G-SIBs are correlated through the possible existence of a market-wide stress event. The characterization employs a multivariate Cox process across the G-SIBs, which allows us to relate our work to the existing literature on intensity-based models. Various theorems related to market failure probabilities are derived, including the probability of a market failure due to two banks defaulting over the next infinitesimal interval, the probability of a catastrophic market failure, the impact of increasing the number of G-SIBs in an economy, and the impact of changing the initial conditions of the economy's state variables. We also show that if there are too many G-SIBs, a market failure is inevitable, i.e., the probability of a market failure tends to 1.

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