Andrew Gray, DTCC Managing Director and Group Chief Risk Officer.
Financial markets have always been interconnected, but dramatic advances in technology and globalization have created a network that is now highly complex and sophisticated. In Asia, fragmented markets have become knitted together through multiple initiatives, including the Shanghai-Hong Kong Stock Connect project and three Asian fund passporting schemes – the Mainland-Hong Kong Mutual Recognition of Funds, the Asia Region Funds Passport and the ASEAN Collective Investment Scheme.
Although these interconnections regionally and globally have created higher levels of efficiency, risk diversification and other advantages, they also have the potential to amplify financial shocks and spark contagion across marketplaces world-wide. The 2008 financial crisis highlighted this risk when the collapse of one financial institution rippled through markets worldwide, affecting thousands of entities and ultimately threatening global financial stability. It underscored not just how devastating the impact of the failure of a large financial institution can be, but also how its aftershocks can reverberate in ways that are unpredictable.
A wave of studies undertaken after the crisis sought to better understand risks related to financial interconnectedness. These found that financial networks tend to be robust and absorb shocks up to a critical tipping point, beyond which they spread risk rather than contain it. They also suggest that, if a financial entity fails, the risk of contagion generally increases with the size and systemic importance of the failing entity.
"Given the potential impact of the failure of a closely connected entity, it is important firms take an overarching approach to managing their associated risks."
Although these high-level insights help to frame the problem conceptually, they do not offer sufficient guidance on how to use this information on a more practical level. It is equally as hard to pinpoint at what level a network can become “too interconnected” as it is to fully determine which critical linkages have become too fragile. This is why many regulators have emphasized measures designed to increase the resilience of highly interconnected – and systemically important – financial institutions, rather than curbing interconnectedness directly.
In addition to regulators, risk managers in Asia and globally are also looking to incorporate insights on interconnectedness into their practices. The below steps are a general guideline firms can follow as they begin thinking about the risks posed by their ever-growing number of connections with other entities:
- Start with an inventory of all external entities on which a firm relies.
- Quantify the risk associated with each link and determine which links are most critical.
- Explore how an impaired connection could affect specific areas of a company’s operation.
- Identify closely connected entities and assess the potential impact of their failure on the business in its entirety.
Given the potential impact of the failure of a closely connected entity, it is important firms take an overarching approach to managing their associated risks. Stress tests and scenario analyses can be very valuable in this respect.
At the same time as recognizing their own firm’s resilience is clearly important, a risk manager can no longer view their firm as a stand-alone entity. This is why many experts agree joint industry exercises offer tremendous value in strengthening industry resiliency. By testing an interconnected network’s ability to respond to incidents, and by allowing players to practice the execution of their procedures and see how they interact with the policies of other participants in a simulated event, firms can assess and enhance their preparedness for a multiplicity of potential systemic threats.
There are also broader external initiatives to help mitigate industry-wide systemic risk, such as creating and assigning globally accepted LEIs (legal entity identifiers) and the establishment of derivatives trade repositories around the world. LEIs are a unique ID associated with a single corporate entity that enable firms and regulators to better understand the exposures of key market participants, individually and at a global level. LEIs also help risk managers better track counterparty exposures. Trade repositories have provided regulators with new insights into derivatives trading, increasing transparency into local derivatives markets and counterparty risk. Although substantial progress has been made on LEIs and trade reporting, more work remains given the scale and global nature of these efforts.
Interconnectedness is a critical area that has grown in importance as markets have become more global and more intertwined. Market participants should incorporate interconnectedness analysis into their risk management frameworks to identify areas of potential vulnerability and respond to it now in order to strengthen their resilience across global financial markets and protect the safety and soundness of the system.
This article first appeared in Regulation Asia on June 3, 2016