The idea that the collapse of one financial institution could trigger a near-meltdown of the global marketplace once seemed unlikely. That is, until 2008.
A highly interconnected financial system has many benefits, such as increased efficiency and, in certain cases, risk absorption. But as we saw during the global financial crisis, distress in one entity can lead to widespread shocks. We can no longer view financial firms as standalone entities. Rather, they are part of a network of components that can absorb or create risk, depending on the circumstances, often in ways that are not transparent or expected. As a result, firms need to have a deeper understanding of all aspects of the risks they face, as well as of the intricate web of interconnections they create.
Research on systemic risk has found that financial networks tend to be robust but also fragile, absorbing shocks up to a certain tipping point, after which they begin to spread risk. Yet whereas a moderate level of interconnectedness helps diversify risks, a very densely connected network may be less robust and actually spread shocks — rather than absorb them.
Certainly, the more highly connected and systemically important an entity is, the greater the impact of its failure. Furthermore, the openness and complexity of the financial ecosystem, and the likelihood that breakdowns will occur, mean that firms must do more than monitor and mitigate risk. They also need to focus on building resiliency so they can detect potential systemic shocks before they strike and, when they do, recover from them as quickly as possible.
Although no two financial institutions are the same, there are certain guidelines all can follow:
Take a full inventory of the external entities that your firm uses. Most financial institutions rely on adequate funding and liquidity, credit, access to markets and market infrastructures, as well as the provision of reliable and timely data — among many other processes. External entities that provide or support these services represent external interconnections to your firm. Given that insolvencies occur at a legal entity level, intragroup dependencies between distinct legal entities should also be represented as external interconnections.
Determine which interconnections are essential to your business. Use the following criteria to assess the level of criticality of your interconnections: severity, time sensitivity and substitutability.
If practical, quantify the criticality of your essential interconnections. This can be useful as a straightforward and objective way to aggregate, rank and assess the related risks. It may also help your firm prioritize risks and monitor their evolution over time. That said, operational interconnections with providers of data and other financial services may be harder to quantify than those with borrowers and lenders, trade counterparties and funding providers.
Assess in detail how an impaired interconnection could affect specific areas. Depending on the circumstances, the failure of an interconnected entity may cause a credit or trading loss, but it may also cause a loss of revenue, affect funding or have a different type of impact altogether. It may be more appropriate to take into account peak volumes and associated risks, rather than average values.
Figure out which entities would cause multiple problems if they failed. The failure of a highly interconnected entity may have a combined effect — for instance, by causing credit losses, which can simultaneously affect your firm’s funding as well as access to other financial services.
Manage exposures to interconnected entities holistically. Concentration risk should be managed by assessing not only the relative exposures to funding, trading, credit and other counterparties in isolation but also in its entirety across these various areas.
Cooperate across departments. Organize risk reviews across departments and job functions, and foster discussions to make interconnectedness awareness an integral part of your organization’s risk management culture.
Take a gradual approach. As is the case for other risk management disciplines, interconnectedness analysis is an iterative process. Start small, and expand gradually. Periodically assess in which areas you may need to become more sophisticated.
The discipline of risk management has become more complex than ever. In the coming years industrywide adoption and integration of systemic risk management programs will be critical to the resiliency of the financial system and in helping to lessen the blow of — if not prevent outright — the next financial crisis.
Andrew Gray is managing director and group chief risk officer at the Depository Trust & Clearing Corp. in New York.
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