(An) empirical analysis of connectedness and systemic risk in the Korean finance sector using principal components analysis and granger causality

Abstract

The increase in the interconnectedness among financial institutions causes financial losses of individual financial companies to spread through the whole financial system. Thus, it is crucial to monitor the trend of interconnectedness in the macro-prudential regulation respect aimed to mitigate the risk of the financial system crashing down. Starting from this concern, the interconnectedness between domestic financial institutions is to be assessed using principal components analysis and Granger causality methodology. The indirect measures are presented with a broad view of connections: the cumulative risk fraction, the DGC measure, and system variance from GARCH(1,1) model. And PCAS measures and Granger-causality-network measures i.e. connectedness measures are to be calculated, and with those measures, the out-of-sample tests are conducted for the 1997-98 Korean IMF Crisis and the financial crises from 2008 through 2012 including the global credit crisis of 2008-09, the Euro financial crisis of 2010-11, and the Korean IB crisis of 2011-12. Also, the robustness is checked with leverage, illiquidity, and size proxies. Finally, it is possible for some significant connectedness measures to be possible to be used in macro-prudential regulation.