The Portfolio-based Approach to Systemic Risk

Jorge A Chan-Lau

Financial crises impose large losses in the real economy, either directly from losses in the banking and financial sector, or indirectly from a decline in economic activity following the credit contraction in the aftermath of crises. For instance, the global financial crisis in 2008 led to losses in the banking sector of about USD1.3 trillion in the first half of 2009 (IMF, 2009a), while the global economy contracted by 1% in real terms in that year. The economic contraction could have been larger without the massive fiscal stimulus plans adopted by governments worldwide. Among the G20 economies, discretionary spending was estimated at 2% of GDP in 2009 (IMF, 2009b).

The high costs associated with financial crises raise concerns over whether the financial regulatory framework provides adequate safeguards to ensure the stability of the financial system. In particular, risks arise from the TBTF problem that prompted governments in advanced economies to support large financial firms during the global financial crisis in 2008/9. Firms regarded as TBTF tend to benefit from lower funding costs since counter-parts factor in implicit government support (Ueda and Weder di Mauro, 2012). In