Systemic risk is one of the most elusive concepts in finance. The Financial Stability Board (FSB) defined systemically important financial institutions (SIFIs) in its document “Policy Measures to Address Systemically Important Financial Institutions” (released 4 November 2011) as “financial institutions whose distress or disorderly failure, because of their size, complexity, and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity.” Because they pose a major threat to the system, regulators and policymakers around the world have called for tighter supervision, extra capital requirements, and liquidity buffers for SIFIs. Central bankers and regulators use these measures in a macroprudential manner to monitor potentially systemically important firms and limit distress that could affect the whole financial system.

For a given list of SIFIs, the level of the extra capital requirement is the same regardless of the exact ranking of the institution on the list. The goal is then to identify the top-tier financial institutions in terms of contribution to the risk of the system. In practice, a good risk measure for systemic risk should capture many different facets that describe the importance of a given financial institution in the financial system. For instance, the FSB asserts that a systemic risk score should reflect size, leverage, liquidity, interconnectedness, complexity, and substitutability.

In practice, there are two ways of measuring the contribution of a given financial institution to the risk of the system. The first approach relies on the structural modeling of an institution’s balance sheet and strategies in terms of assets and debt, but this approach requires confidential information on positions and risk exposures provided by the institution to the regulator. The second approach relies on only public market data, such as stock returns, option prices, or credit default swap (CDS) spreads, because they are believed to reflect all information about publicly traded firms. The authors’ proposed measure builds on the capabilities of the second approach and can be used by both regulators and investors to assess the relative riskiness of a financial institution and to predict the timing of—and even the firms most affected by—a coming crisis.

Developed by analogy with the component value-at-risk concept, component expected shortfall (CES) measures the contribution of a firm to systemic risk. CES is the change in systemic risk if the financial institution were to be removed from the market. It is an approximation of the financial institution’s contribution to systemic risk that builds on a similar measure called marginal expected shortfall (MES). CES corresponds to the product of MES and the weight of the firm in the system. The sum of the CESs across all firms can be used to measure the aggregate risk in the financial market at any given time.

MES corresponds to a firm’s expected equity loss when the market falls below a certain threshold over a given horizon, namely, a 2% market drop over one day for the short-run MES. The basic idea is that the institutions with the highest MES and larger weights contribute the most to market declines; thus, these firms are the greatest drivers of systemic risk. Different risk measures often identify different SIFIs, but CES SIFIs can be expected to be consistent with MES SIFIs.

Most of the time, systemic risk is concentrated in the top 5–15 firms, which often compose 40% to 70% of the total risk of the 74 firms modeled in the study. The risk in the system is typically concentrated in depository institutions and broker/dealers, with lesser contributions from insurance companies and other firms, such as asset managers or credit card issuers. The rankings of specific firms tend to be somewhat constant over time. One result of this highly concentrated systemic risk is that regulators may be justified in focusing their oversight on, or even enacting firm-specific regulations for, a very small number of firms.

This article is one of a number of recent crisis-related papers that make several contributions to the academic literature on systemic risk. Researchers continue to make progress in developing measures that do not require mixing data that are sampled at different frequencies. Leverage ratios, for example, are available only quarterly, whereas option prices and CDS spreads are available daily. Analytical expressions continue to uncover the theoretical link between systemic risk and standard financial risks (i.e., leverage, tail risk, correlation, and beta).