Research Highlights

Measuring the Probability of a Financial Crisis

Robert Engle
Undercapitalization in the financial sector, a sign of excessive credit growth, is a key factor in predicting the next financial crisis, according to new research by Nobel Laureate Robert Engle, Professor and Director of the Volatility Institute at the NYU Stern School of Business, and Tianyue Ruan, Professor at NUS Business School, National University of Singapore. The study, “Measuring the Probability of a Financial Crisis,” was recently published in Proceedings of the National Academy of Sciences (PNAS).
A measure of the probability of financial crisis for a nation is a function of the weakness of its financial institutions as measured by the Systemic Risk Contribution Index (SRISK), the amount of capital that a financial institution would have to raise in order to continue to function normally under stressful market conditions. The authors find that high SRISK can precipitate a financial crisis through asset sales, which drive down asset prices, not only for the United States but also for the rest of the world.
The authors also emphasized the global nature of systemic risk and the interconnectedness of undercapitalization and financial regulation. “Risk of a crisis in one country is strongly influenced by undercapitalization in other parts of the world,” they wrote, calling for a coordinated approach for regulation to maintain financial stability. “A country that relaxes its regulation or fails to adequately capitalize its institutions will increase the risk of a financial crisis in other countries.”