Crises such as the one that has been roiling markets for more than a year could be contained if regulators were to endorse a new gauge of risk, according to two prominent economists.
The traditional measure of risk value at risk, or VaR solely calculates the loss in dollar terms that an investor might suffer when an asset drops by a certain percentage. It does not capture the contagion or spillover risk from one financial institution to another a specific characteristic of the current market crisis.
Tobias Adrian, economist at the Federal Reserve Bank of New York, and Markus Brunnermeier, professor of economics at Princeton University, have come up with a new gauge of risk, CoVaR, where Co stands for contagion or conditional.
We define CoVaR as the VaR conditional on other institutions being in distress, more specifically conditional on other institutions' return being at their VaR level, the authors wrote in CoVar, a staff report issued by the New York Fed in late September.
While two institutions might have the same VaR profile, one may be far more exposed to contagion, which CoVar captures, said the two authors who pondered the issue before subprime woes made headlines in August 2007.
The groundwork was done before the crisis hit as we wrote most of the paper last year. But we were focusing more on hedge funds at the time. We included investment and commercial banks more recently, Mr. Brunnermeier said in an interview.
The authors concluded that institutions should report their greater exposure to contagion and face stricter capital requirements.