Dr. Franz-Christoph Zeitler, vice president of the Deutsche Bundsbank, speaking in Frankfurt on September 24, 2009, noted the failures of backward-looking quantitative risk measurement methods, such as value-at-risk or expected- shortfall models, which “have proved necessary but inadequate and should be supplemented by forward-looking instruments such as stress tests and scenario analyses, which also take into account changes in third party behaviour.” On the same day, Dr. Weber was speaking on the same topic, as were other central bankers around the world.
Deutsche Bundsbank: If we want to address the causes of the financial crisis in full, supervision has to be taken one step further. In particular, systemic risk has to be identified and guarded against. This raises new questions, such as how systemic risk can be identified and whether the systemic relevance of an institution should be considered by introducing capital surcharges for systemically important banks. … When trying to identify systemic risk, a crucial point is to find adequate measures for indicating economic stress. … Compared with indicators derived from banks’ balance sheets, financial market data have the advantage that they are available on a timely basis and are forward- looking. However, market-based risk measures are much more influenced by market movements than balance sheet related data. Consequently its suitability has to be reviewed more often. … As justified as the intention to regulate banks and financial institutions according to their contribution to systemic risk may be, it is even more difficult to design and implement a rule that puts this into practice. Here, too, it is crucial to identify appropriate indicators of the contribution to systemic risk. The attendant risk – which can never be eliminated entirely – is that regulation focuses in too mechanical a manner on prominent risk indicators while overlooking other, less obvious ones. [1]
Central Bank of Luxembourg: The analysis and control of systemic risk was a key missing ingredient in the run-up to the crisis. The problem is that although banks may seem resilient when considered individually, the banking system as a whole may still be vulnerable. This paradox can be explained through the two key dimensions of the macro-prudential framework. First, the cross-sectional dimension focuses on the risk of joint failures that reflects similar exposures or interconnectedness. Second, the time dimension focuses on interactions within the financial system, as well as feedback between the financial system and the real economy. These links account for the pro-cyclical behaviour of the financial system, which can aggravate systemic risk by amplifying the effects of the business cycle. [2]
European Central Bank: The analysis for systemic risk surveillance and assessment is indeed very demanding, and as much of the credibility of the entire framework depends on it. In my view, the most difficult pieces will be the analysis of the implications of interlinkages in complex systems and understanding how a potential risk might spread throughout the system. Risk surveillance and risk detection call for early warning indicators and approaches capable of indicating when the financial system as a whole or parts of the system are approaching a “danger zone”. Risk identification calls for the monitoring of a comprehensive set of macro-financial variables and forward-looking indicators. This task will require a detailed understanding of the channels through which emerging risks are transmitted.[3]
Bank for International Settlements: The first dimension of systemic risk - the common exposures/interlinkages in the cross section - relates to how a specific shock to the financial system can propagate itself and become systemic. The focus is on how risk is distributed within the financial system at a given point in time. A shock may take two main forms: The financial system is a network of interconnected balance sheets. As a result, an increasingly complex web of daily transactions means that a shock hitting one institution can spread to the other institutions that are connected to it and become systemic. The Herstatt and Continental Illinois crises both started with problems in one specific financial institution. Because of settlement and interbank linkages, thefailure of each of these specific firms threatened wider problems for connected institutions that were otherwise sound. Alternatively, a shock can have wide ramifications and become systemic because of direct common exposures. By its nature, a nationwide downturn in commercial real estate or housing markets tends to have this character. As the recent crisis has shown, such common exposure can have a profound international sweep. A negative exogenous shock, or, metaphorically speaking, a meteor strike or perfect storm, is indeed how many practitioners viewed this crisis, at least initially. The procyclicality dimension of systemic risk relates to the progressive build-up of financial fragility and how aggregate risk evolves over time. [4]
[1] Dr Axel A Weber, President of the Deutsche Bundesbank, London, 24 September 2009
[2] Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Luxembourg School of Finance, Luxembourg, 28 January 2010.
[3] Mr Jean-Claude Trichet, President of the European Central Bank, London, 11 December 2009
[4] Mr Jaime Caruana, General Manager of the BIS, “Systemic risk: how to deal with it?”, 12 February 2010