Extending the forward systemic risk measure: Do sector level variables matter?

Systemic risk is of concern for economic welfare as systemic financial crisis has the potential to inefficiently lower the supply of credit to the nonfinancial sector. Conventional systemic risk measures are parsimonious in nature and are used to assess the current systemic risk contributions of financial institutions and does not highlight future systemic risk. In order to overcome the limitations of conventional systemic risk, $$\Delta {\rm{CoVa}}{{\rm{R}}^\$ }$$ΔCoVaR$ is used predict future systemic risk and the literature outlines the use of firm and state level variables in the computation. This study contributes to the existing body of knowledge by providing empirical evidence on improved computation of forward systemic risk by corroborating the distinctive impact of sector’s nature: munificence, dynamism and level of concentration. The comparison of conventional and proposed forward CoVaR provides interesting insights into the role of sector level variables in the buildup of systemic risk. The results highlight that the forecasting ability of forward ∆CoVaR predicted with sector level variables is reasonably higher than that of predicted without sector level variables. The study provides guidelines to the policy makers by providing an improved measure of future systemic risk that can that can help to avoid procycality pitfall by introducing countercyclical policies before the happening of systemic event. The results present new insights on the drivers of financial instability and provide implications for the micro- and macroprudential regulations of the banks.