Financial Systemic Risk and the COVID-19 Pandemic

The COVID-19 pandemic has caused market turmoil and economic distress. To understand the effect of the pandemic on the U.S. financial systemic risk, we analyze the explanatory power of detailed COVID-19 data on three market-based systemic risk measures (SRMs): Conditional Value at Risk, Distress Insurance Premium, and SRISK. In the time-series dimension, we use the Dynamic OLS model and find that financial variables, such as credit default swap spreads, equity correlation, and firm size, significantly affect the SRMs, but the COVID-19 variables do not appear to drive the SRMs. However, if we focus on the first wave of the COVID-19 pandemic in March 2020, we find a positive and significant COVID-19 effect, especially before the government interventions. In the cross-sectional dimension, we run fixed-effect and event-study regressions with clustered variance-covariance matrices. We find that market capitalization helps to reduce a firm’s contribution to the SRMs, while firm size significantly predicts the surge in a firm’s SRM contribution when the pandemic first hits the system. The policy implications include that proper market interventions can help to mitigate the negative pandemic effect, and policymakers should continue the current regulation of required capital holding and consider size when designating systemically important financial institutions.