Economists offer ways to measure and monitor systemic risk

Economists have produced several studies showing ways the new Office of Financial Research and other experts might measure systemic risk and identifying useful data to spot rising risk.

The important point is that regulators were not collecting needed data before the financial criis of 2007-2008, they still aren’t collecting it, and they better start soon.

The European Central Bank has reviewed some of these studies in its Financial Stability Review 2010, Section IVe.

Following are summaries of four: 

— Weekly, the Stern School of Business at New York University ranks financial institutions according to how systemically risky they are. It also calculates the average systemic risk of U.S. financial firms overall.

Based on their expected shortfall of capital in a financial crisis, Stern’s top five risky firms today are, in declining order: Bank of America, JP Morgan Chase, Citigroup, Morgan Stanley, and MetLife.

 For all U.S. financial companies, the average risk level is at 2.8 percent, the lowest level since Stern began calculating its measurement in May 2009, when it was 7 ½ percent. The measure represents the expected capital shortage faced by the firms if the overall market fell more than 2 percent.

An important element of the calculations is leverage. The authors found that the most “pernicious” forms of leverage were repos and ABCPaper.

From their paper:

We investigated the role of leverage (measured as assets to common equity ratio) in determining systemic risk of firms. The form of leverage that had the most pernicious effect in the crisis of 2007-09 was short-term debt: the overnight secured borrowing (“repo”) against risky assets employed heavily by the investment banks, and the short-term (overnight to week maturity) asset-backed commercial paper issued by conduits that were backed by commercial banks.

 Stern’s Systemic Risk Rankings are based on the idea that “a firm is systemically risky if it is likely to face a capital shortage just when the financial sector itself is weak.”

 — Economists Scott Brave and R. Andrew Butters have developed two indexes at the Federal Reserve Bank of Chicago to monitor financial stability and spot trouble brewing across traditional and shadow financial markets. The indexes are updated weekly.

 The first index, the National Financial Conditions Index, uses 100 weighted financial indicators to develop a broad picture of financial stability over time. The second index, the adjusted National Financial Conditions Index, removes variations explained by economic conditions and thus gives a better look at specifically what causes shocks to financial markets, the authors say.

 Among the 100 indicators, 10 are from the repurchase market. Total repo volume by the Federal Reserve’s primary dealers gets the highest rating among all money market instruments for providing leverage and liquidity to the markets.

 In normal times, that’s considered good.  Increased repo volume means more liquidity, more stability and less risk.

 But as bankers discovered during the financial crisis of 2007-08, increased repo volume can also mean too much debt is building up in the system, a bubble is forming and there’s danger ahead.

 Historically, this would show as periods of high liquidity in the repo market, as the bubble develops, followed by periods of low liquidity when it bursts.

 The National Financial Condition Index captures conditions in normal times. The adjusted index attempts to capture the bubble potential.

 From the study:

 One of the key observations to come out of the recent crisis is that financial innovation has made it difficult to capture broad financial conditions in a small number of variables covering just a few traditional financial markets.

 The network of financial firms outside the traditional commercial banking system—that is, the so-called shadow banking system—was at the forefront of many of the major events of the crisis, as were newer financial markets for derivatives and asset-backed securities.

 In the wake of the crisis, policymakers, regulators, financial market participants, and researchers have all affirmed the importance of the interconnections between traditional and newly developed financial markets, as well as their linkages to the nonfinancial sectors of the economy. The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 sets forth a financial stability mandate built on this widespread affirmation.

Monitoring financial stability, thus, now explicitly requires an understanding of both how traditional and evolving financial markets relate to each other and how they relate to economic conditions.

 — Economists Tobias Adrian at the Federal Reserve Bank of New York and Markus K. Brunnermeier at Princeton Univerity present “CoVaR,” which finds that leverage, size and maturity mismatch are effective predictors of the contribution that a financial institution makes to systemic risk in the financial markets. 

Repurchase agreements contribute to all three.

Currently financial institutions and regulators measure risk at each institution, with a measurement called VaR. CoVaR measures an institution’s contribution to risk throughout the system and spots buildup before it reaches crisis levels, the authors claim. Federal Reserve Board Chairman Ben Bernanke has recognized the importance of CoVaR.

From the paper:

During the 2007-09 financial crisis, we saw that losses spread rapidly across institutions, threatening the entire financial system. Distress spread from structured investment vehicles to traditional deposit-taking banks and on to investment banks, and the failures of individual institutions had outsized impacts on the financial system.

These spillovers were realizations of systemic risk—the risk that the distress of an individual institution, or a group of institutions, will induce financial instability on a broader scale, distorting the supply of credit to the real economy.

 Spillover risk in the financial markets has been a recurring theme, say the authors:

The 1987 equity market crash started with portfolio hedging of pension funds and led to substantial losses at investment banks, and the 1998 crisis began with hedge funds and spilled over to the trading floors of commercial and investment banks. In each case, the presence of systemic risk allowed shocks that were initially local to spread rapidly and potentially disrupt the broader economy.

 Even smaller institutions can be dangerous to the financial markets, the authors claim:

A group of 100 institutions that act identically can be as destabilizing and dangerous to the system as one large, merged entity. For example, during the savings and loan (S&L) crisis of the late 1980s, no single S&L was systemic on its own, but as a group, these institutions were highly systemic.

The trick, then, is to be able to measure systemic risk buildup without knowing exactly how or where it will show up.

–In “Risk Topography,” Brunnermeier of Princeton and Gary Gorton of Yale University – whom Federal Reserve Chairman Ben Bernanke has recognized as leading thinkers on the systemic danger of the financial crisis of 2007-2008 – are joined by Arvind Krishnamurthy at Northwestern University to identify new information they believe regulators should collect monthly or quarterly.

They want regulators to ask financial institutions a series of questions designed to get the firms to reveal if they have too much debt and if they have too many illiquid holdings that would be hard to convert to cash in a crisis.

For example, one question might be: What is the capital gain or capital loss to your firm, and how would your liquidity position change, if house prices fall by 5 percent, 10 percent, 15 percent, and 20 percent, and what if they rise by the same increments? The answers to these questions would be influenced by such things as whether the firm owns mortgage-backed securities directly or through derivatives, whether the holdings are funded using short-term debt like repos, long-term debt, or equity, and what are the collateral arrangements in the repo and derivative transactions undertaken by the firm.

From the study:

The financial crisis of 2007-2008 dramatically revealed that it is time to rethink the measurement of economic activity. In particular, because of derivative securities, off-balance sheet vehicles, and other financial innovations, it is imperative that we build an economy-wide risk topography, and sub-maps of different financial sectors of the economy. Measuring only cash instruments, and income and balance sheet items, is not sufficient for understanding the economy; instead we should measure risks, and think in terms of risks, in addition to quantities.


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