Effects on Growth and Inflation of the Unraveling of Systemic Risk in the Euro Area Banking Sector: Lessons from the Financial Crisis

Abstract

This study has two objectives. It first assesses the output and inflation effects of systemic risk-taking in the euro area banking sector using a factor-augmented vector autoregressive model that exploits a 519 time-series rich dataset, including coherent measures of systemic risk in all its forms and its time dimension. Then, it evaluates whether the systemic risk measures can be used as early warning signals of severe negative nominal growth outcomes using the Receiver Operating Characteristic approach. The main findings are that, overall, real GDP growth and inflation react negatively to a one-standard deviation shock to systemic risk measures of the euro area banking industry. Inflation depicts a more pronounced response than GDP. There is heterogeneity in the strength of the responses across diverse forms of systemic risk and their time dimension. Specifically, short-term systemic risk measures tend to portray stronger effects on output and inflation than their conditional forward counterparts. In particular, systemic risk in the form of banking sector vulnerability associated with interconnectedness and contagion plays a considerable role in depressing economic activity in the euro area. Finally, all but one systemic risk measure predict with high accuracy the extreme macro-financial instability in the euro area that followed Lehman Brothers’ collapse. The systemic risk measures are potentially good candidates to be included in a macroprudential-policy toolkit for calibrating instruments at thresholds that reflect policymakers’ risk preferences.