Integrating Systemic Risk Management into Firm-Level Financial Risk Management Practices

March 12th, 2012 by under Uncategorized. No Comments.

The financial crisis reinvigorated discussions over the importance of systemic risk analysis to ward off potential market crashes leading to new oversight structures such as the Financial Stability Oversight Council and its research affiliate, the Office of Financial Research (OFR).  Moreover, a host of other regulatory agencies in the US and abroad have begun efforts to strengthen their focus on systemic risk analysis.  But risk managers at individual large financial institutions should also consider leveraging progress made to measure systemic risk and build it in to other risk management processes used for firm-level risk assessment. 

 

The case for integrating systemic risk analysis into firm-level financial risk management practices is rather straightforward.  First, traditional financial risk management practices are inwardly-focused which are necessary to fully understand the breadth of risk-taking across the enterprise.  However, in doing so, risk management functions can tend to adopt a “missing the forest for the trees” mentality where systemic risks building across the industry and global markets can have as we have painfully witnessed catastrophic effects on the individual firm.  Many firms preceding and during the crisis had access to macroeconomic indicators and specialized market performance metrics, however, such information was insufficient to provide any warning of a buildup of risk across the entire financial system.  Second, a number of systemic risk measures could provide additional insight into the relative contribution to systemic risk by an institution, potential linkages between institutions manifesting in greater risk exposure and understanding market-specific systemic risk exposure.  Such metrics could augment firm counterparty risk assessment, business line risk management, as well as help shape internal strategies to guide risk-taking and risk mitigation under varying economic conditions at the executive committee and board levels.

 

The degree of interconnectedness of systemically important financial institutions (SIFIs) has been well-documented since the crisis; requiring risk managers going forward adopt a much broader view of risk than traditionally exists within the firm.  This is not meant to abandon or in any way diminish the activities in place for accomplishing enterprise risk management (ERM), but to add an important missing link to the discipline for large institutions.  But what exactly do we mean by implementing a systemic risk assessment process into traditional ERM?  These days with so much focus on systemic risk, the phrase suffers a bit from overuse as a blanket definition encompassing a broad spectrum of contributing factors to the breakdown in the overall financial system.  To gain a better idea of the breadth of scope in defining and measuring systemic risk, the OFR published its first working paper cataloging 31 measures of systemic risk. 

http://www.treasury.gov/initiatives/wsr/ofr/Pages/ofr-working-papers.aspx

The measures fall into a highly diverse typology that includes such topics as network measures, stress tests, macroeconomic measures, cross-sectional measures and illiquidity and insolvency.  Disentangling which of these to focus attention on by financial institutions seems daunting for those unfamiliar with specific measures outlined in the document, however, a few seem particularly appropriate based on the following criteria for inclusion in a systemic risk assessment framework.  Three areas that clearly firms should have had better insights into in the period preceding the crisis are liquidity risk, counterparty risk and capital.  Understanding how individual institutions contributed to systemic risk along each of these dimensions would have helped firms better anticipate and react to conditions ahead of any problem.  However, many systemic risk measures are estimated at a point-in-time and while useful as a benchmark for assessing risk need to be augmented with an array of dynamic measures capable of assessing changes in liquidity and capital, among others as conditions deteriorate.  Systemic Expected Shortfall (SES) is one such example of a static measure of a firm’s impact on systemic risk, but others such as Marginal Expected Shortfall (MES) and/or leverage (LVG) can be used as leading indicators of systemic risk for specific firms.  Other measures that firm risk management teams could apply include CoVaR and Co-Risk, measures of the interconnectivity between financial institutions.  While clearly not an exhaustive list, the point is that firms should be working with their economics office to determine which metrics should be included in an ongoing reporting package on systemic risk.

 

To be useful to firms, the measures need to be implementable, in large part meaning that there is relevant data on which to measure them.  In many cases data is readily available for these measures and with most, there are always limitations in their utility.  But waiting for the best metric to come along can be a worse decision than not implementing a process to measure systemic risk and establishing a review process as part of the regular risk dialogue.  Certain metrics included in the working paper may also be useful to specific industries and firms such as metrics assessing crowded trades in currency funds, equity market illiquidity metrics, and other metrics designed to measure systemic risk in hedge funds.  Momentum has been building since the crisis for firms to provide greater transparency around their risk to the financial system.  The release by the Fed this week of stress test results for the largest banking institutions in the US illustrates the new regime to periodically assess the strength of these institutions.  Forward-looking financial institutions will find it in their long-term best interest to start developing a process for analyzing systemic risks of important counterparties, industry segments and markets generally.

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