investment viewpoints

Do today’s banks pose a systemic risk?

Do today’s banks pose a systemic risk?
Jerôme Collet - Head of Portfolio Management for Fixed Income

Jerôme Collet

Head of Portfolio Management for Fixed Income
Florian Ielpo - Head of Macro, Multi asset

Florian Ielpo

Head of Macro, Multi asset

The recent banking crisis brought back bad memories for the more experienced among us: the spectre of 2008, the Lehman Brothers bankruptcy and the systemic turmoil that followed. Since then, some water has flowed under the bridge and the experience has been digested by authorities and investors. Now that the dust is starting to settle on the UBS takeover of Credit Suisse, what can be said about the risk of contagion?


Need to know

  • Systemic risk has increased since 2022 and has recently been intensified by the banking sector, which is a concern for markets
  • Testing for systemic risk, we judge that the magnitude of shocks being generated by banks are constrained relative to the sector’s long-term average
  • From this perspective, the policies of central banks and regulators are bearing fruit – but we advise investors to remain cautious


If in 2008 the medical treatment was given to a seriously ill patient, this time the medication was administered in the early days of the disease – before the symptoms became too severe. Has systemic risk been contained, and above all, have risks in the banking sector been reduced?


The notion of ‘volatility spillover’

Among the many measures of systemic risk – beyond what we presented our Global Chief Risk Officer Trevor Leydon with a few weeks ago – two econometric methods, measuring the causality and transmission of shocks, have stood out in the years since 2008. Both methods fundamentally employ the same technology but use it differently.

Earlier this month, we analysed markets’ ability to withstand shocks. But these two methods take significant steps forward by focusing on the origins of these shocks. Systemic risk reflects the markets’ difficulty in absorbing additional stress, which generally originates in the ‘weakest link’ in the financial chain. This strained link therefore becomes the source of this systemic risk.

In 2008, the banking sector was the weak link in the chain and the origin of the shock that spread to financial markets. Two methods can therefore be used to measure the origin and propagation of systemic events:  

  1. The approach developed by Monica Billio, Mila Getmansky, Andrew Lo and Loriana Pelizzon, which is based on causality teststo determine which sector causes an increase in overall volatility. But this does not allow us to gauge the intensity of these shocks between sectors
  2. The approach of economists Francis Diebold and Kamil Yilmaz,2 which precisely measures the intensity of the transmission of shocks. It is based on the same foundation as that of Billio et al, analysing how variations in volatility are transmitted from one sector to another

Here we unearth the latter approach, which emerged from the ashes of 2008, and apply it to judge the severity of the current situation, following the steps of an article we wrote on that occasion.


Two indicators in one

Diebold and Yilmaz’s approach can be summarised as follows: systemic risk increases when shocks are transmitted between sectors, but when shocks do not propagate, this same systemic risk is low. The first of the indicators they propose is therefore one identifying aggregate systemic risk: it measures, on a scale of zero to 100%, what percentage of shocks in each sector generates severe stress in others – the essence of contagion.

Figure 1 presents this indicator, recalculated over the period 1999-2023, on the basis of the volatility of corporate bond returns in excess of government bonds by sector.3 While the historical percentage of shocks that cross sectors rises around 65% in the long run, this percentage fluctuates.

As the chart clearly shows, this percentage naturally increases around the major systemic shocks in our history. Over the last 18 months, from the perspective of this metric, systemic risk has risen on two occasions: with the first Federal Reserve rate hike in late 2021 and, more recently, with the rise in banking risk.

The indicator shows an overall increase in contagion risk. But unlike our previous analysis, this time we can look at the origin of the shock and, more specifically, at the risk of the banking sector.


FIG 1. Index of contagion between credit sectors (estimated), 1999-2023

Multi-Asset-simply-put - Fig1-Contagion-01.svg

Source: LOIM, Bloomberg as at March 2023.


Growing banking risk

What is interesting about Diebold and Yilmaz's method is the ability to attribute systemic risk: if it is being transmitted, from which sector does it come? Obviously, the focus of our analysis is to study the figures we obtain in the case of the banking sector, still based on the volatility of the ‘excess returns’ of corporate bonds by sector.

Figure 2 presents what the authors call the "net spillover given score". This is a measure of a sector's capacity to be more a source of shock rather than a recipient, for a set of sectors. The level of the indicator is difficult to read, but its level relative to history and variation are both meaningful.

Figure 2 presents this source score for different sectors and different time periods. The systemic risk of the banking sector, as measured on the basis of its volatility, increased between the end of 2022 and March 2023. However, with the actions that have been initiated by central banks and authorities more broadly, this risk remains below its long-term level.

This is an important message: the risk is not definitively eliminated – that goes without saying – but it is, for the time being, well below its long-term average and therefore lower than its 2008 level. Let's also keep an eye on the consumer cyclicals sector, which has recently become a source of shock and is currently in line with its long-term average.


Figure 2. Decomposition of the contagion index by sector

Multi-Asset-simply-put - Fig2-Decomposition-01.svg

Source : Bloomberg, LOIM as at March 2023.
Reading note: LT stands for long-term value. A positive index score means that a sector is a net source of shocks – i.e., it tends to generate and transmit more shocks than it receives.



Simply put, systemic risk has increased and banks have contributed to it. Nonetheless, the level of risk that banks present to the broader financial world is lower than in 2008. This is an important message for investors.




[1] Billio, M., Getmansky, M., Lo, A. W., & Pelizzon, L. (2012). Econometric measures of connectedness and systemic risk in the finance and insurance sectors. Journal of financial economics, 104(3), 535-559.
[2] Diebold, F. X., & Yilmaz, K. (2012). Better to give than to receive: Predictive directional measurement of volatility spillovers. International Journal of forecasting, 28(1), 57-66.
[3] We follow here an old paper from ours: Collet, J., & Ielpo, F. (2018). Sector spillovers in credit markets. Journal of Banking & Finance, 94, 267-278.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. 

Our nowcasting indicators currently point to:

  • Our nowcasting growth indicator stays in recession territory and is stable this week. This stability is explained by a marginal deterioration in the European numbers offset by an improvement in the Chinese numbers
  • Our inflation nowcasting indicator rose marginally this week, as Chinese inflationary pressures progress with the reopening of the economy
  • Our monetary policy nowcasting indicator remains between 45% and 55%: moderation should be the modus operandi of central bankers in the second quarter

World growth nowcaster: long-term (left) and recent evolution (right)

Multi-Asset-simply-put-Growth nowcaster-07 Mar-01.svg

World inflation nowcaster: long-term (left) and recent evolution (right)

Multi-Asset-simply-put-Inflation nowcaster-07 Mar-01.svg

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Multi-Asset-simply-put-Monetary Policy nowcaster-07 Mar-01.svg

Reading note: LOIM’s nowcasting indicators gather economic indicators in a point-in-time manner to measure the likelihood of three macro risks – growth, inflation surprises and monetary policy surprises. The nowcasters vary between zero (low growth, low inflation surprises and dovish monetary policy) and 100% (high growth, high inflation surprises and hawkish monetary policy).


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