DTCC Connection

Nov 08, 2016 • DTCC Connection

Interconnectedness Risks Another Financial Crisis

By Andrew Gray, Managing Director and Group Chief Risk Officer, DTCC

Andrew Gray
Andrew Gray, Managing Director and Group Chief Risk Officer, DTCC

Risk managers can no longer view financial companies as standalone local or regional entities because the reality is that they are now a diverse set of interconnected components that distribute risk and are exposed to it, often in ways that are not transparent or expected. Furthermore, the openness and complexity of the financial ecosystem, especially in Asia where local markets are creating new connections, means there is a likelihood that breakdowns will occur.

Companies must do more than monitor these risks. They also need to focus on building enhanced resilience so they can detect potential systemic shocks before they strike and recover from them as quickly as possible.

Constructing an interconnectedness risk management program can be a daunting task for financial companies across Asia and globally, given the intrinsic complexities and lack of precedents. However, any program should be founded on four basic building blocks -- identifying interconnectedness risks, quantifying exposures, prioritizing them and mitigating them.

First, companies must identify their interconnection risks. Risk identification involves carefully mapping the ecosystem of interconnected entities with which companies interact. This process demands high quality business expertise and input from multiple functions within companies. Second, it is prudent, where applicable and operationally feasible, to quantify each critical connection to provide management with an objective assessment of the specific exposure relative to others.

Prioritizing the identified risks is the third step. The severity of the impact of an interconnected entity's failure depends primarily on the importance of the services it provides. For example, clearing and settlement banks support core functions at the heart of the financial system.

Therefore, the impact of their failure could be inherently more severe than the breakdown of other interconnected entities that play a secondary role. The fourth and final phase is to mitigate interconnectedness risks -- the most important but challenging stage due to the multi-dimensional nature and unpredictability of these risks.

Mitigation strategies should be based on three main pillars. First, companies should choose the most robust interconnected entities and diversify their exposure across these entities. Second, they should put in place measures to monitor and control the performance of interconnected entities as well as the associated risks. Third, companies should aim to build resilience by developing strategies aimed at minimizing the impact of an interconnected entity's failure on their core functions.

On balance, we are better equipped to handle the risk posed by highly interconnected entities than in 2008. However, this remains a work in progress. While it is challenging to identify, prioritize and implement plans to mitigate interconnectedness risk at a time when markets in Asia and around the world are continuing to become even more connected, it is a critical goal that companies should work towards to protect their own businesses, the markets and global economies.

This article first appeared in Nikkei Asian Review on November 4, 2016.

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