Dependence Risk of Bank Equity Returns: A Vine Copula Approach

Measuring the dependence risk of bank equity returns is valuable for gauging the stability of the financial system, particularly during periods of financial crises and events such as the COVID-19 pandemic. To achieve this objective, we introduce a more advanced approach than a simple linear correlation to evaluate the dependence risk. This study delves into the assessment of dependence risk among bank equity returns, categorized into 5 portfolios. Specifically, we analyze the multivariate dependence structures of these portfolios through the application of a vine copula. Moreover, symmetric and asymmetric bivariate copula families are used to thoroughly analyze conditional tail dependence in the vine structures. We find that any linear correlation approaches are likely to overestimate the strength of dependence risk among the portfolios. In addition, we present empirical evidence on asymmetric conditional tail dependence, showing a stronger dependence risk in the bull market than in the bear market. These findings provide investors with more accurate information on financial risk management and portfolio construction beyond a simple linear correlation approach.