The financial system is a public good, with banks at their heart. Shocks that hit one bank tend to spill over to other banks, and can cause a cascade of effects through to the whole economy. The more systemically important a bank is, the larger these spillovers are likely to be. More systemically important banks are therefore generally required to hold additional capital to reduce the overall riskiness of the banking system.
Researchers estimate the size of spillovers between the volatility of equity prices in one bank and those in other banks. They then look to see if this is related to how systemically important the different banks are, focusing on the world’s most systemically important banks, as identified by the Financial Stability Board. Spillovers were measured using vector-autoregressive models of range volatility of the equity prices of G-SIBs, together with machine learning methods.
Findings show a strong link between the size of volatility spillovers and how systemically important a bank is. The research showed that banks with more capital have smaller spillovers to other banks, and the effect is stronger for more systemically important banks. These results provide support for current policy, where higher capital standards for more systemically important banks help to reduce the riskiness of the banking system.