Abstract Regulators charged with monitoring systemic risk need to focus on sentiment as well as narrowly defined measures of systemic risk. This chapter describes techniques for jointly monitoring the co-evolution of sentiment and systemic risk. To measure systemic risk, we use Marginal Expected Shortfall. To measure sentiment, we apply a behavioral extension of traditional pricing kernel theory, which we supplement with external proxies. We illustrate the technique by analyzing the dynamics of sentiment before, during, and after the global financial crisis which erupted in September 2008. Using stock and options data for the S&P 500 during the period 2002–2009, our analysis documents the statistical relationship between sentiment and systemic risk.

Keywords Systemic risk, Marginal Expected Shortfall, Pricing Kernel, Overconfidence, Optimism; JEL Codes: E61, G01, G02, G28

Introduction

The report of the Financial Crisis Inquiry Commission (FCIC, 2011) emphasizes the importance of systemic risk and sentiment. These two concepts, and the relationship between them, are important for regulatory bodies such as the Financial Stability Oversight Council (FSOC) who, with the support of the Office of Financial Research (OFR), is charged with the responsibility for monitoring systemic risk throughout the financial system. This chapter describes tools regulators can use to monitor sentiment and its impact on systemic risk.