Addressing the too connected to fail problem

Addressing the too connected to fail problem

Ways of assessing systemic risk

In recent research, we examine methodologies that could reveal when direct and indirect financial linkages may become systemic (IMF 2009, Chapter 2). Specifically, we present several complementary methods to assess financial sector systemic linkages, including:

  • The network approach relies primarily on institution-level data to assess ‘network externalities – how interconnections could cause unexpected problems. This analysis, that may track the reverberation of a credit event or liquidity squeeze through the entire financial system, can offer important measures of financial institutions’ resilience to the domino effects triggered by credit and liquidity distress.

Figure 1. Network analysis

  • The co-risk, or conditional credit risk, model. Because detailed institution-level information is hard to acquire, we also illustrate methodologies that use market data to fully capture direct and indirect systemic linkages. For example, Figure 2 shows the percentage upsurge in the conditional credit risk (CoRisk). Co-risk is measured as the upsurge in credit default swap (CDS) spreads of a “recipient” institution that could result when the CDS spread of a “source” institution (at the bottom of the arrow) reaches the 95th percentile of its distribution. This measures the market’s perception of the upsurge in the “tail risk” induced by one institution toward others by March 2008, before Bear Stearns was merged into JPMorgan. Finally, we present a methodology with high predictive power that exploits historical default data for the united states to assess direct and indirect systemic linkages bank-system wide. Chapter 3 of the IMF report provides further systemic risk analyses predicated on market data.

Figure 2. A diagrammatic depiction of co-risk feedbacks

  • The default intensity model, made to capture the result of contractual and informational systemic linkages among institutions, along with the behaviour of their default rates under different degrees of aggregate distress. The model is formulated when it comes to a stochastic default rate, which jumps at credit events, reflecting the increased probability of further defaults because of spillover effects. The model was estimated with data obtained from Moody’s Default Risk Service. The info comprises all defaults suffered by most of Moody’s rated corporate issuers in america, and spans the time from 1 January 1970 to 31 December 2008.

Each approach has its limitations, but together these procedures can offer invaluable surveillance tools and will form the foundation for policies to handle the too-connected-to-fail problem. More specifically, these approaches might help policymakers to assess direct and indirect spillovers from extreme events, identify information gaps to be filled to boost the precision of the analysis, and offer concrete metrics to aid in the re-examination of the perimeter of regulation – that’s, which institutions ought to be included and which do not need to be at various degrees of regulation.

Policymakers and regulators are grappling with how exactly to maintain a highly effective, minimally intrusive, perimeter of prudential regulation. Regulators must have the various tools to determine which institutions are affected during plausible rounds of spillovers and therefore determine different degrees of oversight and prudential restrictions.

Liquidity risk insurance

Information on systemic linkages may help address such questions as whether to limit an institution’s exposures, the desirability of capital surcharges predicated on systemic linkages, and the merits of introducing a liquidity-risk insurance fund. The improvements in centralised clearing mechanisms currently underway could give a methods to reduce counterparty risk and the potential systemic risks of financial linkages.

Filling information gaps on cross-market, cross-currency, and cross-country linkages to refine analyses of systemic linkages is important. Closing information gaps will demand additional disclosures, usage of micro-prudential data from supervisors, more intensive contacts with private market participants, improved comparability of cross-country data, and better sharing of information on a normal and ad-hoc basis among regulators. Although these measures could impose additional demands on finance institutions, they are a greater option to waiting until an emergency begins and information becomes apparent only as events unfold.

Since it is virtually impossible for a country to attempt effective surveillance of potential cross-border systemic linkages alone, the IMF should assume a far more prominent global financial surveillance role.

Note: The views expressed on this page are those of the authors and really should not be related to the IMF, its Executive Board, or its management. Any errors will be the responsibility of the authors.

References

Bernanke, Ben, 2009, “Financial Reform to handle Systemic Risk,” Speech delivered at the Council on Foreign Relations, Washington, D.C., March 10.

International Monetary Fund, 2009, Global Financial Stability Report, Spring 2009 (Washington: International Monetary Fund).

Stern, Gary H. and Ron J. Feldman, 2004, TOO LARGE to Fail: The Hazards of Bank Bailouts (Washington: Brookings Institution Press).

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