Article Detail

Systemic Risk, an Empirical Approach

Journal 32: Applied Finance

Gonzalo de Cadenas-Santiago, Lara de Mesa

We have developed a quantitative analysis to verify the extent to which the sources of systemic risk identified in the academic and regulatory literature actually contribute to it. This analysis shows that all institutions contribute to systemic risk albeit to a different degree depending on various risk factors such as size, interconnection, unsubstitutability, balance sheet, and risk quality. From the analysis we conclude that using a single variable or a limited series of variables as a proxy for systemic risk generates considerable errors when identifying and measuring the systemic risk of each institution.

When designing systemic risk mitigation measures, all contributing factors should be taken into account. Likewise, classifying institutions as systemic/non-systemic would mean giving similar treatment to institutions that could bear very different degrees of systemic risk, while treating differently institutions that may have very similar systemic risk inside. Consequently, we advocate that some continuous approach to systemic risk in which all institutions are deemed systemic, but to varying degrees, would be preferable. We acknowledge that this analysis may prove somehow limited given that it is not founded on a predefined conceptual approach, does not fully consider other very relevant qualitative factors,2 and accounts only for some of the relevant sources of systemic risk in the banking system.3 These limits are currently set due to data availability and the current state of empirical research, but we believe that these should not hinder our work in identifying the true sources of systemic risk and our aim to help avoid any partial and thus limited prudential policy approach.

Motivation and main objectives
Academic and regulatory literature defines systemic risk as the risk of a major dysfunction or instability of the financial system caused by one or more parties, resulting in externalities whose potential effects pose a severe threat to both the financial system and the real sector [Acharya (2009)4, FSB/IMF/BIS (2009)]. International regulatory bodies have identified the need to control such risk as a priority in order to guarantee the financial stability of the system and avoid distortions that could prevent the efficient assignment of savings, investment, consumption, and the correct payment process within the economy [Vesala (2009)]. All those functions are nowadays carried out by the financial system.

The negative externalities associated with the potential risk stemming from financial activity justified the introduction of a specific prudential supervisory framework. However, this framework is insufficient to address the effects of systemic dimensions such as capital quality and quantity, liquidity management, risk inherent to trading activities, etc. Basel III is a new framework designed to fill in the gaps and mitigate the weaknesses identified to date and the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS) are considering ways of modulating regulatory pressure on systemic risk at both the system and institutional level. This would result in heavier penalties for those deemed to be more systemic.

The report by the FSB/IMF/BIS5 shows the enormous variety of approaches to systemic risk that are currently used by the different domestic supervisors, which ranges from sophisticated models to simple synthetic indicators. The report concludes that the nature of systemic risk is both time varying and multi-factor led. This renders its analysis the more challenging. In this context, considering qualitative aspects of banks that could mitigate factors of risk are very appealing to both regulators and academics. The novelty and complexity of the topic suggest adding some type of ex-ante expert’s view in order to better supplement the identification process of our analysis.

The disparity of approaches, together with the complexity of the problem, and the data availability shortages, may encourage regulators to take excessively simplistic solutions to tackle the analysis, such as limiting the number of variables to define systemic risk or to define closed lists of institutions characterized as systemic. Giving too much weight to a limited number of variables (like using solely “size” as proxy for risk) simply because they are easier to gather and measure and ignoring other equally important sources of risk could not only result in a very partial view of the problem, but also have very severe consequences for the financial system itself. Doing this could disregard the benefits of diversification and impede the financial sector from reaping the full benefits of economies of scale and scope. The unintended consequence could be a loss of strength and stability of the financial system and the atomization and increased cost of the banking business with questionable benefits for the stability of the financial system.

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