We present an economic model of systemic risk in which undercapitalization of the financial sector as a whole is assumed to harm the real economy, leading to a systemic risk externality. Each financial institution’s contribution to systemic risk can be measured as its systemic expected shortfall (SES), that is, its propensity to be undercapitalized when the system as a whole is undercapitalized. SES increases in the institution’s leverage and its marginal expected shortfall (MES), that is, its losses in the tail of the system’s loss distribution. We demonstrate empirically the ability of components of SES to predict emerging systemic risk during the financial crisis of 2007–2009. Received December 1, 2015; editorial decision August 5, 2016 by Editor Andrew Karolyi.

We argue that the fundamental cause of the financial crisis of 2007–2009 was that large, complex financial institutions (“LCFIs”) took excessive leverage in the form of manufacturing tail risks that were systemic in nature and inadequately capitalized. We employ a set of headline facts about the build-up of such risk exposures to explain how and why LCFIs adopted this new banking model during 2003–2Q 2007, relative to earlier models. We compare the crisis with other episodes in the United States, in particular, the panic of 1907, the failure of Continental Illinois and the Savings and Loan crisis. We conclude that several principal imperfections, in particular, distortions induced by regulation and government guarantees, developed in decades preceding the current one, allowing LCFIs to take on excessive systemic risk. We also examine alternative explanations for the financial crisis. We conclude that while moral hazard problems in the originate-and-distribute model of banking, excess liquidity due to global imbalances and mispricing of risk due to behavioral biases have some merit as candidates, they fail to explain the complete spectrum of evidence on the crisis.

We present a model for pricing risky debt and valuing credit derivatives that is easily calibrated to existing variables. Our approach expands a classical term-structure model to allow for multiple rating classes of debt. The framework has two salient features: (1) it uses a rating-transition matrix as the driver for the default process, and (2) the entire set of rating categories is calibrated jointly, which allows arbitrage-free restrictions across rating classes as a bond migrates among them. We illustrate the approach by applying it to price credit-sensitive notes that have coupon payments linked to the rating of the underlying credit.

The rise of shadow banking and attendant financial fragility in China can be traced to intensified deposit competition following the 2008–2009 global financial crisis (GFC). A large, state-owned bank’s deposits from cross-border money inflows fell significantly following the GFC, and it supported the government’s fiscal stimulus more aggressively than other large banks by issuing larger volumes of new loans. Small and medium-sized banks with more branch-level overlaps with this large bank relied more on shadow banking and issued more wealth management products (WMPs)—short-maturity, off-balance-sheet substitutes for deposits. Greater amounts of WMPs created rollover risks for the issuers, as reflected by higher yields on new WMPs, higher borrowing rates in the interbank market, and lower stock-market performance during liquidity stress. This paper was accepted by Victoria Ivashina, finance. Funding: This work was supported by the National Natural Science Foundation of China [Grants 71272024, 71972051, and 72071117]. Supplemental Material: The internet appendix and data files are available at https://doi.org/10.1287/mnsc.2023.04233 .