Systemic Risk and an Extension of the Black-Scholes-Merton Option Pricing Model for U.S. Banks

Abstract

The global credit crisis of 2007-2010 (the "Credit Crisis") thrust the United States and Europe into recessions of a magnitude not seen since the Great Depression. The devastating impact of this event should lead financial market actors to begin treating systemic risk as a distinct risk discipline, much like market risk and credit risk have been treated for decades. In this study a taxonomy of existing systemic risk models is presented that can be utilized by risk managers, regulators or academics, depending on their specific analytical requirements.

From the vast collection of systemic risk models and methodologies surveyed, this study performs an empirical analysis and extension of the landmark Black-Scholes-Merton Option Pricing Model. This study tests whether this model is a reliable predictor of financial stress and credit default by calculating and observing trends in the probability of default ("PD") for a sample of U.S. commercial banks which are analyzed on an individual and portfolio basis. This study also extends the rich history of academic analysis of the Black-Scholes-Merton Option Pricing Model by representing the first academic paper to incorporate banks' derivatives exposures into the total debt input of the model in order to measure the impact on its predictive capability.

When applied to a portfolio of approximately three hundred U.S. commercial banks during the 1994-2010 time period, this study finds that the Black-Scholes-Merton Option Pricing Model demonstrated strong predictive capacity both on an individual and portfolio basis. In addition some evidence was found to support the hypothesis that asset size is a predictor of default and systemic risk. However, weak support was found for the hypothesis that adding banks' derivatives exposures to total debt will have a significant impact on modeled default probabilities.