Systemic Risk: What Defaults Are Telling Us

This paper develops dynamic measures of the systemic risk of the financial sector as a whole. It defines systemic risk as the conditional probability of failure of a sufficiently large fraction of the total population of financial institutions. This definition recognizes that the cause of systemic distress is the correlated failure of institutions to meet obligations to creditors, customers, and trading partners. The likelihood estimators of the failure probability are based on a dynamic hazard model of correlated failure timing that captures the influence on failure timing of time-varying macroeconomic and sector-specific risk factors, and of spillover effects. Tests indicate that our measures provide accurate out-of-sample forecasts of the term structure of systemic risk in the United States for the period from 1998 to 2009.