BRICS Systemic Risk

Exam Study Guide

Based on: Zeb & Rashid (2019) - Risk Management Journal

Concepts | Analogies | Terminologies | Key Findings

1. What Is This Paper About?
Core Idea: This paper does two things: (1) measures how much systemic risk each type of
financial institution in BRICS countries contributes, and (2) identifies which firm-specific factors
(like size, capital, profitability) drive that risk.

BRICS = Brazil, Russia, India, China, South Africa

These are 5 major emerging market economies that formed an alliance for economic and
financial cooperation. Their growing interconnectedness makes understanding shared
financial risks very important.

Simple Analogy: The Domino Effect

Imagine a row of dominoes. Each financial institution (bank, insurer, etc.) is a domino. If one
falls (goes into financial distress), it can knock over others. Systemic risk is the risk that one
domino falling causes a chain reaction that collapses the whole row (the financial system).

The paper asks: 'Which dominoes are the biggest? Which are most likely to cause the chain
reaction? And what makes a domino unstable?'
2. Key Terminologies

Term Definition
Systemic Risk The risk that the failure of one financial institution spreads to the
entire financial system, causing widespread economic damage.
Think of it as a contagious disease in the financial world.
Value-at-Risk (VaR) The maximum expected loss of an institution over a given time
period at a specific confidence level (e.g., 99%). If VaR = 5%,
the institution expects to lose no more than 5% in 99% of
scenarios.
CoVaR Conditional Value-at-Risk. Measures the VaR of the entire
financial system given that a specific institution is in distress.
Extension of VaR to capture spillover effects.
Delta CoVaR The DIFFERENCE between CoVaR when institution i is in
(DeltaCoVaR) distress vs. when it is in its normal (median) state. This is the
KEY measure of systemic risk contribution in this paper.
Quantile Regression A statistical technique used to estimate relationships at specific
points of a distribution (e.g., the 1% worst-case scenario), not
just the average. Used here to compute VaR and CoVaR.
Tier 1 Ratio Core equity capital divided by total risk-weighted assets. It
measures a bank's financial strength and ability to absorb
losses. Higher = safer. Required under Basel III regulations.
Liquidity Ratio Cash and tradable securities divided by total deposits. Measures
how easily a firm can meet short-term obligations. Higher = more
liquid.
Leverage Ratio Debt divided by equity. High leverage means a firm is heavily
funded by debt, increasing default risk. Higher = riskier.
Loan Ratio Total loans divided by total assets. Reflects how much of the
firm's assets are tied up in loans. High ratio = less diversified,
potentially riskier.
Market-to-Book Value Market value of the firm divided by its book (accounting) value. A
high ratio suggests investors expect high growth but also may
indicate higher risk-taking.
Operating Profit Margin Operating income divided by net sales. Measures profitability
from core operations. Can be a shield against default, but also
signals risk-taking capacity.
Non-Interest Ratio Non-interest income divided by total income. Measures revenue
from non-core activities (trading, investment banking). Higher
can mean more systemic risk.
Deposit Ratio Deposits divided by total liabilities. Banks with more deposits
rely less on interbank markets, potentially reducing systemic
risk.
Loan Loss Provision Loan loss provisions divided by total loans. Measures credit risk
Ratio on the loan portfolio. Higher provisioning = more credit risk
anticipated.
Fixed Effects Model A panel regression technique that controls for unobserved, time-
invariant differences between firms. Used here to isolate firm-
specific effects on systemic risk.
Panel Data Data that tracks multiple entities (firms) over multiple time
periods. This study uses unbalanced panel data (not all firms
have data for all years).
BRICS Alliance Brazil, Russia, India, China, South Africa. An economic bloc
focused on increasing cooperation and financial stability among
major emerging economies.
Basel III International regulatory framework for banks, requiring minimum
capital ratios (like Tier 1) to ensure banks can absorb losses
during crises.
3. Methodology Explained Simply
Step 1: Calculate VaR (Value-at-Risk)
Think of VaR as a 'worst-case scenario threshold.' For each bank/insurer, we ask: 'What is the
worst 1% daily return this institution has experienced?' That answer is its VaR.

Analogy: Weather Forecasting

If a weather model says '99% of the time, rainfall will be under 50mm,' then 50mm is your
VaR equivalent. The 1% worst case is what we focus on for risk measurement.

Step 2: Calculate CoVaR

Now we ask a broader question: 'If Bank A is having its worst 1% day, how bad does it get for
the ENTIRE financial system?' The answer is CoVaR.
We estimate CoVaR at two states:
• Distress state: Institution i is at its worst 1% return (VaR)
• Normal state: Institution i is at its median (50%) return

Step 3: Calculate Delta CoVaR (the actual systemic risk measure)

Delta CoVaR = CoVaR(distress) - CoVaR(normal)
This difference tells us: 'How much EXTRA risk does the financial system face because this
institution is in distress vs. just being normal?'

Analogy: Hospital Triage

Imagine a hospital. CoVaR(normal) = hospital capacity on a regular day. CoVaR(distress) =

hospital capacity during a major emergency when one department collapses. Delta CoVaR =
the extra strain on the whole hospital caused by that one department failing. A large Delta
CoVaR means one institution's failure creates massive extra strain on the whole financial
system.

Important: Delta CoVaR values are NEGATIVE (because returns during distress are negative
losses). The institution with the LARGEST absolute value contributes the MOST systemic risk.
Step 4: Panel Regression for Determinants
Once Delta CoVaR is calculated for all 330 institutions across 2000-2015, the paper runs a
fixed-effects regression:

DeltaCoVaR = f(Size, LoanRatio, LLP, Leverage, Tier1, Liquidity, MTBV,

NonInterest, OPM, DepositRatio)

This tells us which firm characteristics significantly predict how much systemic risk a firm
contributes.
4. Key Findings
4.1 Which Sector is Most Systemically Important?

Rank Sector Why?

1st Banks Most volatile, highest Delta
CoVaR in all BRICS
countries
2nd (most countries) Insurance Firms More systemically important
than financial services in
Brazil, Russia, India, South
Africa
2nd (China only) Financial Services China's financial services
sector uniquely contributes
more than insurance
3rd (most countries) Financial Services Least systemic in most
BRICS nations

4.2 China's Banks Are the Riskiest

Chinese banks show the highest average Delta CoVaR (-0.41), meaning they contribute the
largest losses to the financial system during distress. This makes China the country with the
most systemically dangerous banking sector among BRICS.

Analogy: Size of a Stone Thrown in Water

The larger the stone (bank), the bigger the ripples (systemic impact). China's large state-
owned banks are massive stones - when they wobble, the whole pond shakes.

4.3 Significant Firm-Specific Determinants (Across BRICS)

Term Definition
Institution Size (+) Larger institutions contribute MORE systemic risk. This supports
the 'Too Big to Fail' concept - when giants fail, they take the
system down with them.
Tier 1 Ratio (-) ONLY consistently NEGATIVE determinant across ALL
 institution types. Higher capital buffers reduce systemic risk.
Validates Basel III capital requirements.
Liquidity Ratio (+) Surprisingly POSITIVE in most cases. More liquid assets can
mean more exposure to volatile market positions, increasing
systemic risk.
Operating Profit Margin Higher profitability is associated with MORE systemic risk in
(+) most countries - likely because profitable institutions engage in
riskier non-core activities.
Market-to-Book Value High market-to-book ratio signals high risk expectations and high
(+) earnings, both tied to higher systemic risk.
Loan Ratio (+) More loans = more credit risk concentration = more systemic
risk, especially in Brazil and South Africa.
Leverage Ratio (+) More debt relative to equity significantly increases systemic risk
(especially in South Africa).
Deposit Ratio Expected to reduce systemic risk but mostly statistically
(Insignificant) insignificant - deposits alone don't shield the system.
5. Country-by-Country Highlights
Brazil
• Size and non-interest ratio are key drivers of systemic risk for banks
• Tier 1 ratio significantly reduces systemic risk across all institution types
• Liquidity ratio INCREASES systemic risk - more liquid assets tied to volatile positions
• Market-to-book value significantly increases systemic risk for all sectors

Russia
• Bank size strongly positively associated with systemic risk
• Leverage ratio significantly increases systemic risk at the system level
• Tier 1 ratio is a significant negative determinant for banks
• High profit margins increase systemic risk - banks earn more by taking on more risk

India
• Tier 1 ratio is the strongest negative determinant (-0.933 at system level)
• Leverage ratio of banks and financial services increases systemic risk
• Operating profit margin is NEGATIVE for banks and insurance - more profitable = less
risky (opposite of other BRICS)
• India's insurance firms are the most volatile in all of BRICS

China
• Largest systemic risk contributor among BRICS (Delta CoVaR = -0.41 for banks)
• Tier 1 ratio strongly negative for all institution types
• Liquidity ratio significantly positive for banks - more liquid assets, more system risk
• Market-to-book ratio insignificant - unlike other BRICS countries

South Africa
• Leverage ratio is significant and positive - highly leveraged firms add systemic risk
• Operating profit margin is the strongest predictor across all sectors
• Tier 1 ratio consistently negative - capital adequacy is protective
• South Africa has lowest average systemic risk (Delta CoVaR = -0.21)
6. Did the 2008 Financial Crisis Show Up?
YES. All the Delta CoVaR graphs in the paper show a sharp dip around 2008-2009, confirming
that systemic risk spiked dramatically during the Global Financial Crisis. This is visible across all
BRICS countries and all types of financial institutions.

What this confirms

The Delta CoVaR methodology effectively captures real-world financial stress. The 2008
spike validates the measure - just as the world experienced crisis, the model registered
maximum systemic risk.
7. Concept-to-Analogy Quick Reference

Concept Real-World Analogy What It Means

Systemic Risk Infectious disease spreading in One sick institution infects
a city others
VaR Maximum flood level in 99% of Worst-case loss under normal
years conditions
Delta CoVaR Extra hospital strain when ER Extra system stress from one
collapses firm's failure
Too Big to Fail A dam bursting upstream Large firms cause catastrophic
downstream damage
Tier 1 Capital Emergency fund / savings Absorbs losses before
cushion bankruptcy
Leverage Buying a house with a large High debt = high risk of default
mortgage
Liquidity Having cash in your wallet Can meet immediate obligations
Contagion Dominoes falling One failure triggering others
Quantile Regression Looking only at rainy days Focusing on the worst
scenarios, not averages
8. Policy Implications
The findings are important for BRICS regulators and policymakers. Key takeaways:

• Enforce stronger Tier 1 capital requirements - it is the only consistent systemic risk
reducer across all institution types and all BRICS countries.
• Monitor large financial institutions closely - size is a significant predictor of systemic risk
(Too Big to Fail problem).
• Non-interest income activities should be regulated - banks earning heavily from
trading/investment banking contribute more to systemic risk.
• Leverage limits matter - high debt in financial firms amplifies systemic risk, especially in
South Africa.
• Profitability signals should be interpreted carefully - high profits may indicate high risk-
taking rather than soundness.

Big Picture Takeaway

The regulatory framework in BRICS countries should be built around firm-specific

determinants of systemic risk - especially Tier 1 capital adequacy - rather than one-size-fits-
all rules. Each country's financial system has unique risk drivers that need tailored
supervision.
9. Exam Quick Review Checklist

Be able to define and explain:

• Systemic risk (with the domino/contagion analogy)
• VaR vs. CoVaR vs. Delta CoVaR (and how each builds on the other)
• Why Delta CoVaR values are negative
• Why banks are more systemically important than insurers or financial services
• Why China's banks have the highest systemic risk in BRICS
• The role of Tier 1 ratio (the only consistently negative determinant)
• Why liquidity INCREASES systemic risk (counterintuitive finding)
• The data source (Thomson Reuters Financial DataStream, 2000-2015, 330 firms)
• The regression method used (Fixed Effects Panel Model with Hausman test)
• Basel III connection to Tier 1 capital requirements

Key numbers to remember:

• 330 financial institutions across 5 BRICS countries
• Time period: 2000-2015
• China banks Delta CoVaR = -0.41 (most risky)
• South Africa overall Delta CoVaR = -0.21 (least risky)
• India insurance firms most volatile in BRICS
• 1% quantile = distress state; 50% quantile = normal state

Good luck on your exam!

Prepared from: Zeb & Rashid (2019), Risk Management Journal