Systemic Risk Hub is an independent and collaborative initiative, which groups together leading researchers, academics and professionals, acting separately or altogether within various institutions around the world. The aim of this Hub is to bring together the most outstanding developments in the current literature regarding systemic risk, creating a platform for transfers of knowledge and dialogue. This Hub also encourages collaborative cross-fertilizations, evaluations and propositions of improved methodologies for assessing this type of risk.
What is Systemic Risk?
Systemic risk generally refers to the risk of a disruption to the flow of financial services that is (i) caused by an impairment of all or parts of the financial system and (ii) has the potential to have serious negative consequences on the real economy.
Systemic risk arises when the failure of a single entity or cluster of entities can cause a cascading failure, due to the size and the interconnectedness of institutions, which could potentially bankrupt or bring down the entire financial system.
In the video below, Dr. Jón Daníelsson and Dr. Jean-Pierre Zigrand (co-directors of the Systemic Risk Center at the London School of Economics) explain and illustrate what is systemic risk with a pedagogical analogy, which is based on the instability of the Millennium bridge in London due to homogeneous behaviors of pedestrians.
Please click here to see our video section.
Why Does Systemic Risk Matter?
The recent Global Financial Crisis has clearly demonstrated the need for the financial industry, policymakers and citizens to develop a better understanding of systemic risk. A great deal of work is underway, intended to shed light on a number of fundamental questions: What is systemic risk? Where does it originate and how does it manifest itself? How can it be measured? And what can the industry and policymakers do to minimize and contain it?
Identifying “Systemically Important Financial Institutions” (SIFI) constitutes a major concern for both academics and regulators. While historically “systemic importance” has been associated with an institution's size through the “too-big-to-fail” issue, recent events suggest a more complex picture. The interconnectedness of an SIFI is also determined by its interbank market linkages, and its effects are amplified by high leverage. The Financial Stability Board (2011) thus defines SIFI as “financial institutions whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause a significant disruption to the wider financial system and economic activity”.
Consequently, regulators and policy makers have called for tighter supervision, extra capital requirements, and some liquidity buffers for SIFI (Financial Stability Board, 2011). Moreover, a Pigouvian tax calibrated on the systemic importance of institutions has also been proposed to address the externalities of these too-big-to-fail or too-interconnected-to-fail institutions. Indeed, while all firms share the benefits of financial stability, market mechanisms do not exist to enforce firms to internalize the full cost of threats to stability created by their own activity.
Therefore, measuring the financial systemic importance of financial institutions is crucial in identifying the potentially destabilizing constituents of the global financial system. Several ways have been proposed in the recent literature, from – without being exhaustive: cascade network representations, early warning signals with or without private information, degrees of connectedness – to quantitative measures of extreme under-performances and their impacts… One path in the current literature, for instance, consists of defining some proper systemic risk measures – such as the Delta Conditional Value-at-Risk (ΔCoVaR) of Adrian and Brunnermeier (2011), the Multi-Conditional-VaR (MCoVaR) by Cao (2012), the Marginal Expected Shortfall (MES) of Acharya et al. (2010) and Brownlees and Engle (2012), the Component Expected Shortfall (CES) of Banulescu and Dumitrescu (2012), and the Systemic RISK measure (SRISK) of Acharya et al. (2012) and Brownlees and Engle (2012).
However, it has been also shown by some academics how fragile some of these systemic risk measures are, as they are subject to model errors and are significantly linked to extreme quantiles. Moreover, the systemic risk rankings of financial institutions depend highly upon the adopted measure. A fair and robust system should take into account the complexity of the overall problem. We hope our initiative will contribute to the adoption of appropriate measures and, finally, to a safer global financial system and a more robust global economy.