Real output costs of financial crises: a loss distribution approach

The adverse effects of financial crises in terms of output losses or output growth below its potential can be treated like losses from catastrophic events which have a low likelihood but a large impact in the event that they occur. We therefore analyze GDP losses in terms of frequency (number of loss events per period) and severity (loss per occurrence). Crises' frequency, severity, and the associated global output losses over periods of five years are identified on the basis of Laeven and Valencia(2008). Applying the Loss Distribution Approach used in insurance and operational risk theory and practice, we estimate a multi-country aggregate GDP loss distribution and thus approximate the conditional losses in the event of financial crises. The analysis of losses produced in the paper suggests that the LDA approach is a useful tool in discussions about the existence and capital requirements of a potential insurance against the risk of financial crises at the aggregate level.