Measuring Systemic Risk in the Finance and Insurance Sectors

A significant contributing factor to the Financial Crisis of 2007–2009 was the apparent interconnectedness \namong hedge funds, banks, brokers, and insurance companies, which amplified \nshocks into systemic events. In this paper, we propose five measures of systemic risk based \non statistical relations among the market returns of these four types of financial institutions. \nUsing correlations, cross-autocorrelations, principal components analysis, regime-switching \nmodels, and Granger causality tests, we find that all four sectors have become highly interrelated \nand less liquid over the past decade, increasing the level of systemic risk in the \nfinance and insurance industries. These measures can also identify and quantify financial \ncrisis periods. Our results suggest that while hedge funds can provide early indications of \nmarket dislocation, their contributions to systemic risk may not be as significant as those \nof banks, insurance companies, and brokers who take on risks more appropriate for hedge \nfunds.