Thursday, October 29, 2015

DTCC Studies the Risks of Interconnectedness

Author: David Schwartz

The financial crisis made clear that interconnectedness and complexity have the potential to magnify localized shocks and amplify and transmit them to the greater financial system.  Understanding the risks posed by our ever more interconnected global financial system is crucial to managing those risks.  To that end, DTCC has published a whitepaper providing an overview of the subject, surveying a selection of interconnectedness studies conducted thus far, and highlighting regulatory measures designed to address interconnectedness risks. Among other things, DTCC concludes that “firms must do more than monitor and mitigate these risks – they also need to focus on building resiliency so they can detect potential systemic shocks before they strike or recover from them as quickly as possible.”

Interconnectedness, the network of credit exposures, trading links and other relationships and dependencies between financial agents, is not all bad, however.  DTCC notes that in some cases, “these intra-financial and/or legal linkages help dampen shocks by distributing and dispersing their impact throughout the financial system." The key is for risk managers to understand what interconnectedness means to their business and factor interconnections into their risk management strategies:

“risk managers can no longer view financial firms as stand-alone entities because, in reality, they are now a diverse set of interconnected components that distribute risk and are exposed to it, oftentimes in ways that are not transparent or expected.” 

Consequently, DTCC concludes that considerations regarding interconnectedness should become an aspect of a firm's day-to-day risk management function. By thinking about interconnectedness routinely, DTCC believes risk managers will have a more holistic view of actionable and inherent risks.  The paper provides some guidelines for risk managers to analyze interconnectedness risk:

  • Make a comprehensive inventory of external entities on which you rely
  • Determine which interconnections are critical to your business
  • Quantify your critical interconnections if practical
  • Assess in detail how an impaired interconnection could affect specific areas
  • Identify highly interconnected entities and assess the potential impact of their failure on your business in its entirety
  • Manage exposures to interconnected entities holistically
  • Cooperate across departments and
  • Take a gradual approach.

According to the paper, studies of market interconnectedness are clustered in two main areas:  

  • Network-Based. Network-based studies map the relationships between institutions and use those relationships as inputs to model and measure interconnectedness. Some network-based studies use simulations to assess the robustness of the system. Both direct and indirect forms of interconnectedness can be mapped to perform these studies.
  • Non-Network Based. Non-network-based studies, by contrast, use econometric techniques to analyze the variation between equity returns and other factors as a way to infer interconnectedness between entities or sectors. Default probability models, which try to understand the potential for systemic distress, are also related to this type of research.

DTCC's synthesis of these studies yields the following conclusions:

  • Financial networks tend to be robust yet fragile, absorbing shocks up to a critical tipping point, and spreading risk beyond this threshold.
  • The failure of a centrally located node tends to increase the likelihood and extent of contagion.
  • Some research suggests that networks with a moderate level of interconnectedness may be the most resilient ones.

The study of the nature and effect of interconnectedness is neither complete nor simple, however. DTCC notes that "studies on the relationship between a network’s interconnectedness and its ability to withstand shocks also suggest that many other factors come into play, including the type of financial shocks, the maturity structure of banks’ liabilities, existence of information problems and other financial frictions. Researchers continue to study the impact of these and other factors as they try to gain a better insight into the impact of a network’s topology on its resilience." 

By its very nature, policy responses to interconnectedness require a multi-national approach.  DTCC finds that policy-makers have wisely chosen not to try to reduce or elminiate financial market interconnectedness.  Rather, "than curbing interconnectedness directly, they have chosen to emphasize measures designed to increase the resilience of highly interconnected – and systemically important – financial institutions." Basel III, EMIR, the Volcker Rule, and other regulatory initiatives address interconnectedness by directly controling and limiting interconnectedness by imposing direct restrictions on the scope of businesses conducted by large banks. These restrictions aim to safeguard core banking activities from contagion that might originate in riskier areas – while simplifying the banks’ organizational structures in the process.  Still others like CPMI, IOSCO, and FFIEC are working, not to limit interconnections, but to make those interconnections safer and more stable.