Policymakers must prevent financial institutions from becoming too connected to fail

Jorge A. Chan-Lau, Marco A. Espinosa-Vega, Kay Giesecke, Juan Solé, 2 May 2009

a

A

How should governments handle large and complex financial institutions that are “too big to fail” and “too connected to fail”? The current crisis has brought that question to the forefront. Regulators need to address the too big to fail problem, as implicit guarantees raise the likelihood of crisis. Some have suggested progressive capital requirements, and many endorse macro-prudential regulatory approaches. Many, most prominently Fed Chairman Ben Bernanke (2009), now say that adequate financial regulation of very large financial institutions is crucial to managing systemic risk.

Financial globalisation has proved to be a double-edged sword in this respect. While the growing complexity and globalisation of financial services can contribute to economic growth by smoothing credit allocation and risk diversification, they may also exacerbate the too-connected-to-fail problem. For instance, greater connectedness can lead to situations where an institution’s miscalculations of its risks lead to its demise, spawning a large number of failures of financial institutions, liquidity squeezes, and even severe capital losses in the financial system. Indeed, the ongoing crisis has shown how financial innovations have enabled risk transfers that were not fully recognised by financial regulators or by institutions themselves.

Because governments will likely intervene to keep afloat institutions considered too connected to fail, those institutions enjoy an implicit safety net. But that encourages investors and managers of other institutions to also take excessive risks.

Some policymakers (e.g., Stern and Feldman 2004) have long recognised this problem and have called for “macro-prudential” oversight and regulation focused on systemic risks, not just individual institutions. However, it is easy to ignore such admonitions when times are good because the probability of an extreme or tail event may appear remote—a phenomenon dubbed “disaster myopia.” Moreover, it is difficult to monitor the linkages that lead to the too-connected-to-fail problem. Yet to make macro-prudential oversight a reality—as G20 nations called for in the communiqué following their April 2 summit – —policymakers must be able to observe information on potentially systemic linkages.

Methods of assessing systemic risk

In recent research, we examine methodologies that could shed light on when direct and indirect financial linkages can become systemic (IMF 2009, Chapter 2). Specifically, we present several complementary approaches to assess financial sector systemic linkages, including:

  • The network approach relies primarily on institution-level data to assess ‘network externalities – how interconnections can cause unexpected problems. This analysis, which can track the reverberation of a credit event or liquidity squeeze throughout the financial system, can provide important measures of financial institutions’ resilience to the domino effects triggered by credit and liquidity distress.

Figure 1. Network analysis

  • The co-risk, or conditional credit risk, model. Because detailed institution-level information is hard to obtain, we also illustrate methodologies that use market data to capture direct and indirect systemic linkages. For instance, Figure 2 shows the percentage increase in the conditional credit risk (CoRisk). Co-risk is measured as the increase in credit default swap (CDS) spreads of a “recipient” institution that would result when the CDS spread of a “source” institution (at the base of the arrow) is at the 95th percentile of its distribution. This measures the market’s perception of the increase in the “tail risk” induced by one institution toward others as of March 2008, before Bear Stearns was merged into JPMorgan. Finally, we present a methodology with high predictive power that exploits historical default data for the US to assess direct and indirect systemic linkages bank-system wide. Chapter 3 of the IMF report provides further systemic risk analyses based on market data.

Figure 2. A diagrammatic depiction of co-risk feedbacks

  • The default intensity model, designed to capture the effect of contractual and informational systemic linkages among institutions, as well as the behaviour of their default rates under different levels of aggregate distress. The model is formulated in terms of a stochastic default rate, which jumps at credit events, reflecting the increased likelihood of further defaults due to spillover effects. The model was estimated with data obtained from Moody's Default Risk Service. The data comprises all defaults suffered by all of Moody's rated corporate issuers in the US, and spans the period from 1 January 1970 to 31 December 2008.

Each approach has its limitations, but together these methods can provide invaluable surveillance tools and can form the basis for policies to address the too-connected-to-fail problem. More specifically, these approaches can help policymakers to assess direct and indirect spillovers from extreme events, identify information gaps to be filled to improve the precision of this analysis, and provide concrete metrics to assist in the re-examination of the perimeter of regulation – that is, which institutions should be included and which need not be at various levels of regulation.

Policymakers and regulators are grappling with how to maintain an effective, minimally intrusive, perimeter of prudential regulation. Regulators should have the tools to determine which institutions are affected during plausible rounds of spillovers and thus determine different levels of oversight and prudential restrictions.

Liquidity risk insurance

Information on systemic linkages could help address such questions as whether to limit an institution’s exposures, the desirability of capital surcharges based on systemic linkages, and the merits of introducing a liquidity-risk insurance fund. The improvements in centralised clearing mechanisms currently underway could provide a means to reduce counterparty risk and the potential systemic risks of financial linkages.

Filling information gaps on cross-market, cross-currency, and cross-country linkages to refine analyses of systemic linkages is very important. Closing information gaps will require additional disclosures, access to micro-prudential data from supervisors, more intensive contacts with private market participants, improved comparability of cross-country data, and better sharing of information on a regular and ad-hoc basis among regulators. Although these measures could impose additional demands on financial institutions, they are a far better alternative to waiting until a crisis begins and information becomes apparent only as events unfold.

Because it is virtually impossible for a country to undertake effective surveillance of potential cross-border systemic linkages alone, the IMF should assume a more prominent global financial surveillance role.

Note: The views expressed in this article are those of the authors and should not be attributed to the IMF, its Executive Board, or its management. Any errors are the responsibility of the authors.

References

Bernanke, Ben, 2009, “Financial Reform to Address Systemic Risk,” Speech delivered at the Council on Foreign Relations, Washington, D.C., March 10.

International Monetary Fund, 2009, Global Financial Stability Report, Spring 2009 (Washington: International Monetary Fund).

Stern, Gary H. and Ron J. Feldman, 2004, Too Big to Fail: The Hazards of Bank Bailouts (Washington: Brookings Institution Press).

Topics: Financial markets
Tags: currency crisis, exchange rate, foreign exchange, foreign exchange reserves, IMF, Too big to fail, too connected to fail

Research Fellow at the Fletcher School of Law and Diplomacy, Tufts University, and a Senior Economist at the International Monetary Fund's Chile Desk

Member of the IMF’s Monetary and Capital Markets Department

Assistant Professor of Management Science & Engineering at Stanford University

Member of the Global Financial Stability Division in the Monetary and Capital Markets Department (MCM) of the International Monetary Fund (IMF)