The Micro-Foundation of Systemic Risk: SRISK

The financial sector imposes real costs only when it is under-capitalized as a whole, and these costs are a linear multiple of the extent of under-capitalization of the financial sector. Then, each firm's contribution to the real-sector costs is related to its own under-capitalization in those states of the world where the financial sector is under-capitalized as a whole. SRISK calculates this contribution, proxying for the relevant "states" of the world as a -40% shock to the global market economy.

What matters in the proposed model of Acharya, Pedersen, Philippon, and  Richardson  (2010) and Acharya, Engle and Richardson ( 2012) is when the financial sector is unable to intermediate all of its service provisions to the real economy. One can assume that this is when it finds itself strapped of private funding capital  (in a world without any interventions). In turn, private markets will not  lend to financial firms when their market equity as a whole ( regardless of whether it is called  enterprise value or asset value)  is not high enough to raise other sources of funding, and also not high enough to ensure that monies lent will be well-managed by the bankers/shareholders ( one should note that they have little at stake and may gamble for resurrection rather than go for NPV projects).

Therefore, one could argue that the  market value of a financial firm is not just the market value of assets but also of intangible assets, including issues such as relationships etc.. However, what matters in the model proposed by Acharya, Pedersen, Philippon, and  Richardson  (2010) and Acharya, Engle and Richardson ( 2012) is the  market value of financial firm is what determines banker/shareholder incentives, and in turn, the private funding capacity of the financial firm.  In Acharya, Engle and Richardson’s ( 2012) model, factors such as the nature of assets, the nature of bank intangibles and relationships, monopoly rents, etc., are all captured in market value and in turn also in their  market-value based measure of downside risk. It should be noted that in Acharya, Engle and Richardson’s ( 2012) model "local" downside risk measures, based on -2% shocks, may not capture all of the "global" downside risk in the case of -40% shocks, but this is still likely to be superior to pure book-value accounting.

It should be noted that shifts in pricing kernels are relevant to the downside risk of a financial firm if they affect the firm's funding capacity in private markets. A CEO or a regulator cannot blame the market value of equity collapse on risk premium and let the financial firm be run aground to bankruptcy and let a credit crunch ensue when this happens to many financial firms. So risk premium fluctuations are something regulators should guard the system against as they can cause financial firms to fail or be strapped of private funding.